July 20, 2001

Argentina's government has struggled to sell its T-bills to a largely captive domestic debt market. The Brazilian real is down more than 20% since January. Other Latin currencies are also down. In the rest of the world there is doubt about Asia's economic prospects and Turkey's commitment to reform. Taken together these events raise the prospect of financial contagion spreading across the emerging markets. One can make an argument that in some cases the emerging markets' currency crisis is created by a deterioration of the terms of trade brought about by a contractionary fiscal policy. However, in a classic article, Nobel Prize winner Robert Mundell argued that the optimal policy mix is one where fiscal policy is devoted to the real economy and monetary policy is devoted to price/exchange rate stability. Fiscal policy only accelerates the demise of the monetary arrangement, and it can never be the solution to an exchange rate crisis. We believe that the root of many problems can be traced to the organization of these countries monetary system. History suggests that exchange rate crises are a recurrent event in developing countries.

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