And even if that were possible, the burden of debt, denominated in nominal terms, would rise relative to income. These countries, then, are heavily dependent on the pattern of spending elsewhere and would benefit greatly from an expansion in domestic demand in countries with stronger balance sheets. The main lesson from the experience of the imbalances is that national policy frameworks alone were unable to prevent domestic demand from growing at an unsustainable rate. Intertemporal budget constraints do not exercise the same discipline as constraints that are immediately binding. So unsustainable paths of spending and precarious stock positions developed. As a result, abrupt, and costly, adjustment at some point in the future was always likely. Markets can enforce inter-temporal budget constraints only over a long-time horizon. As a result, countries can pursue inconsistent policies for long periods, and a range of imperfections in the financial system encourages them to do so. An example of those imperfections is that opportunities to insure against exchange rate fluctuations are limited – markets are incomplete. Exchange rates can move in surprising and unpredictable ways. Over the past twenty years, the ratio of the highest to the lowest dollar-yen exchange rate was almost 2 to 1, and the same was true of the dollar-euro rate. The difficulty in insuring against such swings means that this volatility can induce large fluctuations in output with unnecessary costs incurred in the relocation of resources and employment.
Fixed, or managed, exchange rate regimes may help to limit the real economic costs of “excessive” volatility that reflects short-lived shifts in market sentiment, but if they impede desirable adjustments of real exchange rates, they contribute to unsustainable patterns of spending. There are other reasons why emerging economies, in particular, have managed their exchange rates. Perhaps the most important is that pushing down on the exchange rate is a means to pursue a strategy of export-led growth. Another motive, important in the wake of the Asian financial crisis, was to build up large precautionary balances of foreign exchange reserves as a way of insuring against sudden reversals in capital flows, especially of shortterm bank lending, that proved so damaging in the 1990s. 2  BIS central bankers’ speeches  Such policies distorted saving and exchange rates, and created large capital flows unrelated to the distribution of profitable real investment opportunities. Given imperfections in financial markets in both borrowing and lending countries, such capital flows can lead to a degree of fragility, such that, when adjustment comes, there is a high probability that it will be abrupt. For example, the distortion from a “too important to fail” implicit subsidy to the funding costs of banks in the industrialised world led to excessive leverage in these countries. Creditors were prepared to lend at lower rates and on a greater scale than they would have without the implicit subsidy. In other countries, financial repression artificially raised saving rates by making borrowing too costly.