Exchange rate regimes and external adjustment: New answers to an old debate
Before writing off Friedman’s argument, however, it is useful to look at the empirical evidence from a different angle, namely to look at the size of external imbalances across exchange rate regimes. Arguably, this is an even more direct test of Friedman’s claim that flexible exchange rates encourage “corrective movements before tensions can accumulate and a crisis develop” than testing the persistence properties of the current account balance. Table 6.2 presents some facts about the distribution of current account deficits and surpluses across regimes and country groups. It shows that on average, and for every country group except for emerging markets, current account balances are much smaller in absolute size in floating regimes than in fixed regimes. In addition, there is a monotonic relationship between regimes and current account imbalances, with the size of absolute deviations rising the more fixed the regime. Importantly, emerging markets are only a seeming exception to this pattern, as fixed regimes are associated both with very large average deficits and large average surpluses, which tend to cancel across countries. Once the sample is stratified in terms of deficit countries and surplus countries, the association between regime “rigidity” and current account imbalances is visible for all country groups except the advanced countries with surpluses, and is very strong in both emerging markets and other developing countries. Although Table 6.2 is suggestive, it is too crude to serve as a “test” of Friedman’s hypothesis, particularly because it does not tell us whether the accumulation of larger average imbalances is a problem in any sense among the countries with fixed regimes. To address this point, we use criteria commonly used in the literature on current account reversals (among others, Milesi-Ferretti and Razin 1997, 1998; Freund 2005; Freund and Warnock 2005; Eichengreen and Adalet 2005) to identify episodes of sudden, large reversals in the current account.9 If Friedman is right that flexible rates encourage corrective movements in the current account before imbalances get very large and disruptive adjustments occur, we should be observing two things. First, large, sudden current account reversals should be much less frequent in flexible regimes. Second, on average, current account reversals should occur starting from larger initial imbalances if
regimes are fixed. As it turns out, both of these predictions are strongly supported by the data (Table 6.3 and Figure 6.1). Table 6.3 shows, first, that with only one exception (large surpluses in “other” developing countries) large imbalances have been far more frequent in fixed and/ or intermediate regimes than in floating regimes. Indeed, in the emerging market sample, there have been no large imbalances as defined here – whether from surpluses or from deficits – in floating exchange rate regimes. Even more significantly, as is shown in both Table 6.3 and Figure 6.1, the average imbalances prior to the current account reversal were much larger, in all country groups, under fixed regimes compared to floating regimes. Pre-reversal surpluses tend to be about twice as large in fixed regimes as in floating regimes, while pre-reversal deficits in fixed regimes on average exceed pre-reversal deficits in floating regimes by 40 to 70 percent. When comparing intermediate regimes and floating regimes, the ratios are smaller (though still positive) for advanced countries, and about the same for developing countries. Hence, this provides strong support in favor of Friedman’s contention that under fixed regimes (and, to a perhaps lesser extent, intermediate regimes) imbalances are allowed to fester and grow much more than under flexible regimes. We also found some evidence suggesting that current account deficit reversals are more costly under fixed regimes. Following Eichengreen and Adalet (2005), Table 6.4 compares changes in growth – defined as the difference between three-year average growth after a reversal and growth in the reversal year – across the three regimes. The more floating (or less fixed) the regime, the lower the growth cost or (in the case of surplus reversals) the larger the growth benefit. These findings are not surprising, as less fixed regimes are associated with smaller adjustments (see second column of Table 6.4) and lower initial imbalances, and the empirical literature on current account reversals suggests a robust link between the size of the initial imbalances and the output cost of reversals (Freund and Warnock 2005).10 This leads to the question whether adjustment under flexible regimes is less costly even controlling for the size of external imbalances (for example, because it allows relative prices to adjust more easily in the presence of nominal rigidities). This remains to be explored in future work.