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Free Currency Markets, Financial Crises and the Growth Debacle: Is There a Causal Relationship?

Nov 1999
Working Paper
99-004
By  Yasuyuki Sawada, Pan Yotopoulos
The paper develops an alternative hypothesis that attributes collateral responsibility for the recent spate of financial crises to a basic flaw of the architecture of the international financial system, free markets for foreign exchange. A valid positional distinction between reserve/ hard and soft currencies, based on reputation, accounts for the systematic substitution of the former currencies for a country's soft currency in liquid asset holdings. The result of this "asymmetric reputation" in an environment of free currency markets is the systematic devaluation of soft currencies. Moreover, bubbles, devaluations and financial crises, far from being self-correcting monetary phenomena, can lead to sharp contractions in the economy through the misallocation of resources in competitive devaluation trade, as opposed to comparative advantage trade. In a case that is parallel to asymmetric information and incomplete credit markets, the appropriate policy intervention in asymmetric-reputation driven incomplete currency markets is maintaining mildly repressed exchange rates. The operational definition of "mild" is imposing restrictions on currency substitution, whether it is home-grown or it is the result of foreign financial capital taking short positions on the local currency.