Fixed Exchange Rate Regimes and Financial Markets as Sources of Macroeconomic Discipline

This paper analyzes the arguments that fixed exchange rates and financial markets can provide strong discipline over domestic macroeconomic policies. We conclude that such discipline works only under a rather limited set of circumstances. A key aspect of our analysis is the distinction between actual constraints and effects on incentive structures. Fixed exchange rates provide actual constraints only over monetary policy and only for hard fixes like common currencies, not adjustable pegs. With adjustable pegs the long run costs of excessive stimulus are increased, but the short run effects can often be more favorable as inflation is initially reduced due to the failure of traded goods prices to rise. The net effects on incentives would depend strongly on the government's discount rate. A low rate would be needed for positive discipline effects, but it is the high discount rate generated by short time political pressures that generate much of the incentive for inflationary surprises in the first place. Financial markets influence only incentive structures. Where markets also operate with short time horizons this can help loosen fiscal discipline in the short run by providing easy financing of deficits. Thus the effects on discipline depend heavily on the degree to which financial markets behave according to rational expectations. Arguments from behavioral finance suggest that this will not always be the case. An informal model is presented in which financial markets are too forgiving in the short run, but become more rational after the outbreak of crises serve as a wake up call. On this view financial markets provide strong discipline after crises break out, but not before. A number of episodes are examined that seem to fit with this story.