There were fundamental inconsistencies between rapidlyliberalised capital accounts, still under-developed financial systems, and pegged exchange rates. This led to excessive investment through financial intermediaries, and the accumulation of a great deal of foreign-currency debt, much of which was un-hedged. When the full extent of this vulnerability became apparent, there were full-blown currency and financial sector crises. Second, are different countries’ policy frameworks consistent with one another? If different members’ policy frameworks are inconsistent, this could inhibit external adjustment, and pose a potential threat to external stability. So the key area for multilateral surveillance would be to identify where different countries’ policy frameworks might conflict with one another and to propose remedies before this threatened the stability of the international monetary system. You can argue that inconsistent policy frameworks lay at the root of the European Exchange Rate Mechanism crisis in 1992. German monetary policy successfully targeted domestic price stability. The UK was pegging its exchange rate to the DM in order to import this stability. But when the Germans  BIS Review 103/2006  5  adopted a new approach to fiscal policy, running a structural deficit to finance infrastructure investment in the east – essentially adopting a new fiscal policy framework - German interest rates had to rise to keep domestic inflation in check. But keeping UK interest rates high enough to maintain the exchange rate would have been very contractionary. Arguably, the UK and German policy frameworks had become incompatible. Something had to give – in this case sterling’s membership of the ERM.
References International Monetary Fund, "The Managing Director’s Report on Implementing the Fund’s MediumTerm Strategy", April 2006, Washington DC, available at http://www.imf.org/external/np/pp/eng/2006/040506.pdf Mervyn King, "Reform of the International Monetary Fund", speech at the Indian Council for Research on International Economic Relations in New Delhi, India, February 2006, available at http://www.bankofengland.co.uk/publications/speeches/2006/speech267.pdf Independent Evaluation Office of the IMF, "An Evaluation of the IMF's Multilateral Surveillance", February 2006, Washington DC, available at http://www.imf.org/external/np/ieo/2006/ms/eng/pdf/report.pdf International Monetary Fund, “World Economic Outlook”, September 2006 and others, available at http://www.imf.org/external/pubs/ft/weo/2006/02/index.htm  8  BIS Review 103/2006