Can market forces incrementally defuse a worrisome buildup in a nation’s current account deficit and net external debt before a crisis more abruptly does so? The answer seems to lie with the degree of flexibility in both domestic and international markets. In domestic economies that approach full flexibility, imbalances are likely to be adjusted well before they become potentially destabilizing.
Many years ago, Mundell argued that if a group of countries wanted to adopt a common currency, the shocks that they were exposed to had better be similar. If that were not the case, they would need to have strong alternative adjustment mechanisms.1 Mundell and others identified key conditions for such alternative adjustment mechanisms: price flexibility, factor mobility and fiscal transfers.