Project Syndicate
July 7, 2011
Once upon a time, there was a country plagued by large deficits, high inflation, and decades of economic stagnation. When economic problems once again became particularly acute, the country’s leadership embraced a radical approach to achieving price stability.
A new currency was introduced and pegged to the US dollar at a one-to-one exchange rate. A new law stipulated that this quasi-monetary union was to last forever. Moreover, the economy was opened, state enterprises were privatized, and the country participated in an important regional free-trade initiative.
Initially, the new arrangement worked very well. Growth returned, and confidence among foreign investors was such that large inflows of foreign direct investment, especially in the banking sector, arrived.
But, after about 10 years, the success story turned bitter. The region’s dominant trading partner devalued, and the US dollar appreciated considerably. The country thus had problems exporting. It developed external deficits and growth slowed.
Moreover, fiscal policy had not been kept under control, resulting in increasing public debt. International investors were initially quite willing to finance the government, but risk premia started to increase when the deficits became chronic.
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