William Davidson Institute Working Paper 402
assume that it is only lower than under fixed rates). Additional public borrowing
involves small increases in interest rates above the world rates, which would lead to
inflows of capital. This additional foreign capital not only allows financing the deficit
but also would increase the currency reserves of the board, the monetary base and the
money supply. The automatic response of the currency board consists in
accommodating any increase in public spending. Ceteris paribus the public deficit
and the current account deficit increase in pair.
Under a fixed exchange rate regime, and under imperfect information of
private agents on policymaker’s priorities, a government truly committed to zero
devaluation policy is in a worse situation than with a currency board. While this
government still cannot have an autonomous monetary policy, the risk of devaluation
is positive and adds as a premium on interest rates. This discourages investment,
output and employment and further increases the devaluation risk. For a given fiscal
deficit, output is lower under fixed exchange rates than under the currency board
7
regime.
To sum up, under a currency board, monetary policy cannot be used to foster
demand and employment, but fiscal policy is a powerful expansionary instrument.
High unemployment countries, like those from Southeast Europe may thus be tempted
to recourse to the fiscal stimulus in order to reduce high unemployment, but this
endeavour may prove detrimental over the longer term if it undermines overall policy
credibility (due to too high public deficits and related high interest rates). In addition,
by the moment of the accession to the EU, successive periods of high deficits may
raise a problem of debt and debt reduction, hard to be tackled in one stroke. There is
another risk that would occur if governments rely too much on fiscal polices; as
suggested above, above a certain level of indebtedness, the default risk can become
significant and further penalise investment and growth. To counter these risks,
additional limits on fiscal deficits, of the kind laid down in the Maastricht Treaty,
should be enforced. But these would leave governments empty hands in face of
asymmetric shocks and associated increases in unemployment.
With fully flexible rates, the government has no incentive to recourse to the
fiscal stimulus, given that it can only crowd-out exports in an equivalent amount. So it
can freely follow a low deficit fiscal strategy and stimulate activity by increasing the
money supply. This will put downward pressure on interest rates, which stimulates
investment and tends to depreciate the currency, which in turn fosters exports, at least
in the short run. As a partially offsetting effect, this depreciation is taken into account
by foreign investors who require a depreciation premium. By the moment of the
accession, the recourse to devaluation will no more be allowed, but hopefully, the
economy would have grown enough.
Of course, the main risk arising from an incautious recourse to monetary
expansion is to fuel inflation. The risks are higher in those transition economies where
soft-budget constraints are still the rule rather than the exception. In such countries,
injections of liquidity would rapidly transform in price increases and would have little
impact on portfolio choices. The weak response of interest rates would then explain a
modest output increase. Thus, structural reforms and the enforcement of firm hard-
budget constraints are a basic precondition for monetary policy effectiveness.
So far, we have shared with supporters of currency boards the implicit
7 In a dynamic perspective, maintaining the zero devaluation policy for a long period may help
reducing the risk, as people update their expectations downwards (Besancenot, Vranceanu and Warin,
2000). In turn, this improves the employment performance of the economy. But a strict rule of no-
devaluation like the currency board still brings a better result.