Don’t look now … the pegs are back

Much like Mark Twain, reports of the death of fixed exchange rates have been exaggerated. It seems each time a peg collapses, there is a clamoring that “soft pegs” are unsustainable in today’s big bad world of rapid capital movement. Pegs, it is often noted, are fragile. And yet, when we look around, there always seem to be plenty of pegs – ready targets for complaints of exchange rate misalignment or predictions of collapse.

In recent work (The Dynamics of Exchange Rate Regimes: Fixes, Floats, and Flips – Journal of International Economics, forthcoming, NBER Working paper no. 12729), Michael Klein and I note a few important regularities regarding the dynamics of pegs. First, many are in fact fragile (only 40% of pegs that start make it 3 years or more), but once they settle in, they tend to last (86% of pegs that last 3 years make it at least one more).

But, it is our observation about floats that is relevant to the post title. Floats are as fragile as pegs. That is, once a peg is broken – and a float begins – about half will reform a new peg within 3 years. In fact, despite the spectacular collapses in the last decades, there are now more sustained pegs (those lasting at least 5 years) than at any time since the early 1970’s.

In general, a large number of countries are now pegged that at some point were recently floating. Taking the most spectacular crisis recently as an example: Argentina’s currency board collapsed in early 2002 and its exchange rate ranged over 130% against the dollar in 2002 and still had a range of movement of 19% in 2003 (that is it was ranging within + or – 10% bands). But, by 2004-5 it was what we might call a loose peg (a range of +/- 3%) and by 2006 was tightly moving within +/- 2% bands as a true peg. Just glancing around Latin America, there are the obvious examples of El Salvador and Ecuador adopting the dollar as their currency, but there are plenty of others who have pegged more conventionally lately. Bolivia tightened the bands of its currency in 2004 and it is now a true peg to the dollar. Guatemala, Honduras, and Uruguay have all narrowed their bands to now move within +/- 2% bands against the dollar. All three were not tightly pegged at the start of the century, but are now. Costa Rica, Mexico, and Peru are loose pegs with bands that have been narrowing, and Nicaragua has a crawling peg to the dollar. All these countries pegged at some point, saw their pegs break, and have now reformed to some extent – many to full fledged pegs.

In short, the death of the peg appears over-rated, but in part because even when pegs die, they are frequently reborn. Many of those listed will possibly break in the near future (some may have since I downloaded the data a few months ago) but others will likely reform.

For those interested in this topic, see the paper with Michael Klein listed above and the citations in it. Much of the data is also available on my website. Michael and I are currently writing a book on this topic and many others relating to exchange rate regimes – look for it from MIT Press in a year of so.

8 Responses to "Don’t look now … the pegs are back"

  1. Firsty   May 9, 2008 at 4:16 pm

    Firstastically First!

  2. Stormy   May 9, 2008 at 6:55 pm

    If more and more peg to the dollar, then we will have a de facto world currency.As a thought experiment, imagine everyone pegging to the dollar. Consequences?

  3. Nicolas   May 10, 2008 at 1:26 am

    All those countries know that the U.S. dollar will be replaced with a currency possibly called THE AMERO

  4. Anonymous   May 10, 2008 at 3:15 am

    How does your analysis relates to the persistence of the Bretton Woods 2 regime? And for how long will BW2 survive?

  5. Guest   May 10, 2008 at 3:16 am

    Excellent analysis and discussion. But why are such pegs coming back?

  6. Guest   May 10, 2008 at 4:53 am

    Pegs are back but how stable are enduring are they? How long do they on average last? How fragile are they? Are they associated with capital controls?

  7. Brian Shriver   May 10, 2008 at 7:51 am

    I think you ought to distinguish between undervalued pegs and overvalued pegs, defined as follows. If a country is running a persistent trade deficit, it’s currency is above "trade balance parity" and therefore overvalued. Conversely, iff trade surplus then undervalued relative to TBP.Overvalued pegs are unstable because sooner or later the country runs out of reserves. Undervalued pegs, on the other hand, can persist for much longer, with several benefits to the pegging country – trade surplus, increasing production base, increasing wealth vis-a-vis the world, more stable currency, etc. The drawback, eventually, is excess money supply and possible reserve losses. On balance though, as Japan, China, etc, amply demonstrate, it is better to have a trade surplus than deficit – regardless of what the Washington Consensus may recommend.Of course, some countries start with undervalued pegs which subsequently become overvalued due to poor fiscal and/or monetary restraint. But this is a separate issue.I really wish economists would look at this. We are witnessing a new round of neo-mercantilism with important consequences, both good and bad. It seems the lessons inspiring the formation of the IMF have been forgotten.

  8. Nouriel   May 10, 2008 at 10:49 pm

    Jay, a very good and interesting discussion on the return of the pegs. Welcome to our Global Macro EconoMonitor and great yours was the very first contribution. Nouriel