The Global Crisis: A monetary fable to fill us all with foreboding

`After four years of rolling crisis, the world was looking a dangerous place'
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ONCE UPON a time, the world had a single currency, the globo. It was generally well managed: the Global Reserve Bank (popularly known as the Glob), under its chairman Alan Globespan, did a pretty good job of increasing the global money supply when the world threatened to slide into recession, trimming it when there were indications of inflation. Indeed, in later years some would remember the reign of the globo as a golden age.

But there was trouble in Paradise. You see, although careful management of the globo could prevent a boom-bust cycle for the world as a whole, it could not do so for each piece of that whole. Indeed, it turned out that there were often conflicts of interest about monetary policy. Sometimes the Glob would be following an easy-money policy because Europe and Asia were on the edge of recession; but that easy money would fuel a wild speculative boom in North America. Other times the Glob would feel obliged to tighten money to head off inflation in North America, aggravating a developing recession in Latin America.

Over time frustration at this impotence built up; and when the globo failed, through policy misjudgements, to prevent a serious global recession the system broke up. Each region introduced its own currency: Europe adopted the euro, Latin America the latino, North America the gringo. But how should these local currencies be managed?

At first officials were afraid to let the new currencies be traded freely: you were only allowed to exchange latinos for euros or gringos if the government granted you a licence, and licences were given only for "legitimate" imports. But over time it became clear that this system both discouraged beneficial trade and offered many opportunities for corruption. One by one, the world's regions moved back to free convertibility of currencies. But they were still afraid of instability, so governments tried to stabilise the rates at which these currencies exchanged by buying and selling on the foreign exchange markets.

Alas, this system too turned out to have serious problems. After all, the whole point of going from a world currency to multiple local currencies was to give governments the ability to have independent monetary policies, so they could fight recessions when necessary. But a country could not simultaneously print money to fight a recession and maintain the value of its currency on the foreign exchange market. It could improve its competitive position by devaluing. But once latinos were freely convertible into other currencies, the mere hint that a devaluation might be in the offing would cause massive speculation against the vulnerable currency.

One answer was simply to give up the attempt to stabilise exchange rates, and just let the market do the job. The trouble was that experience showed the market did the job badly.

But when the world's poorer regions tried to behave like the First World, responding to speculative attacks on their currencies by simply letting them float, disaster struck. When the kilogram was allowed to float against the euro, nothing terrible happened: the currency fell by 15 per cent, then stabilised. Indeed, the central bank found itself able to cut interest rates, and engineer an economic recovery. But when the latino was allowed to float against the gringo, it went into free fall, losing half its value in a matter of weeks. Since many companies had debts denominated in gringos, this was a financial catastrophe. So the government tried to stabilise the latino by raising interest rates to 75 per cent, hoping that this would induce investors to keep their money in the country; the effect, however, was a disastrous recession, which ratified the investors' panic.

The same story played itself out repeatedly. Indeed, after a while the whole thing started to feel like a recurrent nightmare. Each time a team from the Global Monetary Fund would arrive, promising to save the country by lending it money, but only if it did things that were guaranteed to produce a severe slump: raising taxes, cutting spending and increasing interest rates to punitive levels. These measures were supposed to restore market confidence, but by depressing the economy, and often destabilising its internal politics, they would usually precipitate a new crisis. Some countries eventually recovered, and these cases were celebrated as demonstrations of the success of the GMF's recommendations; but after four years of rolling crisis, which had devastated the economies of eight nations and counting, the world economy was starting to look a very dangerous place.

Most economists were pessimistic. It seemed to them that in general developing countries were held by financial markets to a different standard than First World nations; and for them floating rates did not work. One possible answer was to achieve credibility by tying oneself to the mast: to adopt a currency board - that is, back every latino with a gringo of reserves, and pledge never ever to change the parity - or, if even this wasn't enough, to give up on having your own currency at all, and "gringoise" (or euroise) the economy. In effect, this would mean going back to a sort of inferior version of the globo standard. You see, while Alan Globespan managed the globo on behalf of the world as a whole, his successors - Mr Gringspan, who controls the gringo supply, and Mr Euroberg, who controls the euro supply - have more parochial concerns.

Another possible answer was to reimpose exchange controls, to limit the vulnerability of economies to speculative attack. Perhaps, in an imperfect world, the costs of controls were a price worth paying.

The worst thing to do, of course, was to put off making a choice: to try to defend a currency of suspect credibility with high interest rates, producing a recession and budget crisis that inevitably led investors to worry that capital controls might be the next step. And yet of course, politics and human nature being what they are, that is what most countries did.

And so the world lurched from crisis to crisis; and they all lived unhappily ever after. Paul Krugman is Professor of Economics at Massachussetts Institute of Technology