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Pegging at an overvalued rate is not sustainable in the long term, because it requires using foreign exchange reserves, and the central bank of a currency zone has no ability to create new foreign exchange. Since its not sustainable in the long term, it can also attract speculative activity, and since the defense against that speculative activity consumes the foreign exchange reserves at an even faster rate, the speculative attack itself is likely to attract further speculation, creating a "feeding frenzy".
Explains Soros' ejection of the Pound from the European Monetary union as well as the Argentine corralito crisis and many others coming from pegging weak currencies to the dollar. It also might explain what happened in 1925 when Churchill as Chancellor of the Exchequer ignorantly set the exchange rate of the pound to the gold standard too high.

However, it is impossible for everyone to attempt a long-term peg of their currency as not every currency can be (slightly) undervalued at the same time. Was that the basic weakness of the gold standard and then of the bretton-woods systems before Nixon foated the dollar?

When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. — John M. Keynes

by Carrie (migeru at eurotrib dot com) on Mon Jun 2nd, 2008 at 06:33:06 AM EST
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