The Currency Peg: A Compulsive Loyalty Program with No Opt-Out Clause!

Inertia in international finance is a powerful force in its own right. But loyalty programs built on one member’s permanent goodwill tend to look sturdiest in the years just before their members start reading the fine print.

On paper, a peg is refreshingly simple: fix your currency’s value to a stronger one, usually the dollar, sometimes the euro, and enjoy the borrowed credibility. Hard pegs lock the rate outright; soft or “crawling” pegs allow it to drift within a leash. Either way, the defending central bank has exactly two tools: burn through foreign reserves buying back its own currency when it weakens or blindly mirror the anchor country’s interest rate decisions, whatever domestic conditions might actually call for.

It is a simple system. It is also, on inspection, a fairly complete surrender of the instruments a state normally uses to run its own economy.

To be fair to the arrangement, pegging has genuinely delivered for some. The Gulf states priced their oil in dollars and pegged their currencies to the same dollar, which insulated government budgets from the currency swings that plague less disciplined exporters.

Hong Kong’s Linked Exchange Rate System, running since 1983, turned the territory into a byword for predictability, drawing in capital that a freely floating Hong Kong dollar might never have attracted. Switzerland’s euro ceiling, imposed in 2011, bought its exporters and hoteliers several years of breathing room against a currency that otherwise wanted to appreciate itself out of the tourism business. Even the CFA franc zone in West and Central Africa, for all the baggage attached to it, has produced inflation rates its non-pegged neighbors can only envy.

None of this is anything. It is simply the entry price of a subscription whose real terms are printed in a font nobody reads, but is compelled to follow them anyways, for multiple reasons.

Importing Inflation: The Fed Sneezes, You Catch Pneumonia

Here is the fine print. A pegged central bank does not merely borrow the anchor currency’s credibility; it inherits the anchor’s monetary policy wholesale, timing included. When the U.S. Federal Reserve raises rates to cool an American economy that a Gulf or Hong Kong policymaker had no hand in overheating, the pegged state must raise its own rates in lockstep, regardless of whether its domestic economy is booming, stagnant, or in outright recession.

The reverse is just as damaging: when Washington keeps rates low for its own reasons, cheap borrowing floods into pegged economies and inflates asset bubbles that have nothing to do with local fundamentals. Ask any Hong Kong property buyer who lived through the last two decades; they will tell you, if they’re honest.

Michael Hudson, the economist most associated with tracing the plumbing of this system, has spent decades describing what happens on the other end of that arrangement. Central banks that peg to the dollar are structurally obliged to keep buying U.S. Treasury debt to defend their currencies, recycling their trade surpluses straight back........

© New Eastern Outlook