Paul Krugman: Currency Regimes, Capital Flows, and Crises: Noted
Start from the balance of payments accounting identity:
Capital account + Current account = 0
A loss of foreign confidence produces a sudden stop – a sharp decline in the capital account. This must necessarily be matched by an equally sharp rise in the current account. But the mechanism of that rise is crucially dependent on the currency regime. Under fixed rates, interest rates must rise enough to achieve the current account change through import compression. Under floating rates, the adjustment takes place through depreciation and export growth. As a result, a shock that is contractionary under fixed rates or a common currency is actually expansionary under floating rates. A Greek-style crisis is not something that can happen to the United States or the UK.
In the last two sections I tried to show that the popular story about how a debt crisis might unfold in the United States or the UK doesn’t hold together. Again, the usual argument is that a reduction in capital inflows (whose counterpart must be a rise in net exports) will drive up interest rates, causing the economy to slump. If you think about it, this is essentially the same as the classic fallacy of arguing that deficit spending will drive down demand by driving up interest rates; the logic is just wrong, because rates won’t rise unless output rises. But when I have tried laying out this argument to other economists, I have found that in general they recognize the point but argue that real-world complications mean that a sudden stop will nonetheless be contractionary even in countries with independent currencies and floating rates. Why? They offer a variety of reasons. None of these alternative stories resurrects the popular account in which the US or the UK could end up being just like Greece; still, whatever the mechanism, a crisis is a crisis. So how plausible are these alternatives?... Long-term versus short-term interest rates.... Banking crisis.... Private foreign currency debt.... Inflation...