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The “hollowing-out”, or “two poles” hypothesis is tested in the context of a Markov chain model of exchange rate transitions. In particular, two versions of the hypothesis—that hard pegs are an absorbing state, or that fixes and floats form a closed set, with no transitions to intermediate regimes—are tested using two alternative classifications of regimes. While there is some support for the lack of exits from hard pegs (i.e. that they are an absorbing state), the data generally indicate that the intermediate cases will continue to constitute a sizable fraction of actual exchange rate regimes.

Some have argued that the only sustainable regimes are free floating and hard exchange rate commitments—essentially currency boards or monetary unions Eichengreen, 1994, Eichengreen, 1998 and Obstfeld and Rogoff, 1995. For instance, Eichengreen (1994, pp. 4–5) says that “…contingent policy rules to hit explicit exchange rate targets will no longer be viable in the twenty-first century… [C]ountries…will be forced to choose between floating exchange rates on the one hand and monetary unification on the other.” Similarly, Obstfeld and Rogoff (1995, p. 74) state “…there is little, if any, comfortable middle ground between floating rates and the adoption of a common currency.” Hence, in the view of these authors, in the future we will see a disappearance of the middle ground that corresponds to soft commitments to some sort of intermediate exchange rate regime-adjustable pegs, crawling pegs, or bands, and perhaps also managed floating. This view is sometimes called the “two poles” or “hollowing out” (e.g. Eichengreen, 1994, p. 6) theory of exchange rate regimes, and is based on the observation that higher capital mobility makes exchange rate commitments increasingly fragile. However, like the optimal currency area literature, which is essentially static, an explicit or implicit assumption is made that regimes are chosen to last forever, and from this perspective, one would only choose a regime that could be sustained once and for all. Only the hardest peg and the absence of any exchange rate commitment whatsoever are likely to qualify on that basis. Thus, Eichengreen (1994, p. 5), states “This will rule out the maintenance for extended periods of pegged but adjustable exchange rates, crawling pegs, and other regimes in which governments pre-announce limits on exchange rate fluctuations…” (italics added). However, exchange rate regimes, like other aspects of economic policy, are not chosen once and for all. In fact, history shows us that countries change their regimes frequently, either voluntarily or involuntarily.1 A particular exchange rate regime may suit the country's needs at the time—for instance, a peg may be the only way to halt a hyperinflation—but eventually be abandoned even though inflation has been brought down, because there has been a substantial loss of competitiveness.2 This is the typical sequence with exchange rate based stabilizations—only rarely do they lead to “permanent” pegs. For instance, Poland in 1990 introduced a fixed peg to the dollar to provide an anchor for the price level, which was followed a year later by a crawling band introduced to limit appreciation of the real exchange rate, and, more recently, has moved to flexibility of the zloty exchange rate. Similarly, Brazil succeeded in eradicating hyperinflation in the mid-1990s through the “real plan”, which involved a dollar peg with a very slow rate of crawl. Since 1999, this regime has been replaced by a flexible rate accompanied by inflation targeting. Only if we believed that countries will never be in the situation of using an exchange peg to disinflate (or never again suffer strong inflationary shocks) would it make sense to argue that countries will never use adjustable pegs as a temporary strategy, but instead will always be at one of the two poles.3 Regimes intermediate between a hard fix and a clean float may also be chosen as part of a regional integration strategy. The Exchange Rate Mechanism (ERM) of the European Monetary System, and its predecessor, the Snake, are examples of this. While the ERM has led to membership in a currency union (one of the poles) for 11 of the countries concerned, it lives on in the form of the ERM2 for countries that may subsequently want to join EMU. And it remains an open question whether for other regions integration may stop short of monetary union, and only involve limiting fluctuations among members' currencies. Transitions between regimes may also reflect the shifting preferences of policymakers (and the public): a populist government may attempt to stimulate output at the expense of exchange rate stability, only to be followed by a more conservative and stability-oriented administration. The exchange rate regime chosen in each case need not be at one or another of the poles. Indeed, for many developing countries, free floating is not a viable option because of a lack of well-developed financial markets and institutions, including a deep foreign exchange market, while the hard constraints of currency boards are not politically acceptable. As a result, the exchange rate regime is not necessarily stable, but fluctuates among various alternative intermediate regimes, depending on the relative weight given to sustaining activity or limiting inflation, and on the shocks hitting the economy. It is therefore useful to think of exchange rate regime choice not as a once-and-for-all decision but rather in terms of the likelihood of moving from one regime to another. In what follows, it is assumed that the probability of being in one or another regime next period depends only on the current regime. While somewhat restrictive, it supposes that the typical country will face the same likelihood that some shock will push it from its current regime to one of the others—independent of past history. As a first approximation, this would seem an adequate framework for testing hollowing out, which is a hypothesis concerning the direction of transitions, not their cause. Here, the historical data gives us some evidence on the transition between regimes. If we divide the regimes into three categories: hard pegs, floating, and a middle category that includes adjustable or crawling pegs and bands, and managed floats, we can see what the likelihood was in the past of remaining in each of the regimes, or of moving to the two others. At any point in time, the distribution of regimes reflects these probabilities. However, if the probabilities have changed over time (for instance, as a result of increased capital mobility), the current distribution may not be the same as the steady-state distribution of regimes.4 The latter is of interest also, because it tells us what the long-run equilibrium should look like, if the current transition probabilities remain unchanged. This steady-state distribution is the natural way to test the hollowing-out hypothesis, since the latter implies that the proportion of countries in the middle should be zero in the long run. We can begin by asking whether there are any cases of exits from hard pegs or pure floats to intermediate regimes. As a notable dissenter to the hollowing-out hypothesis, Frankel (1999) notes that there have been exits from monetary unions (when Czechoslovakia broke up, and when the ruble area became limited to Russia after the CIS states left it). If one goes back further, Canada, which had a free float in 1951–1962, had an (adjustable) peg from 1962 until 1970, when it went back to a float. Also, a number of colonies which had currency boards abandoned them upon independence in favor of intermediate regimes, but this was arguably a specific historical episode. A more systematic test of the hypothesis would involve looking at the probabilities of regime transitions, and projecting them into the future. The two poles view would be strictly correct (if the past is a guide to the future), if there were no exits from either hard pegs or floats (or if so, only to each other). We can test these restrictions on the transition matrix formally, and also calculate the long-run probabilities of the regimes; if the hypothesis is correct, the long-run probability of the middle regime would be zero. In what follows, data on exchange rate regimes over the past two-and-a-half decades are used for constructing transition matrices, whose properties are then examined, to see whether they support the hypothesis of the disappearance of intermediate regimes. Because classification of regimes is difficult and contentious, we use two different sources. In neither case do the data support a substantial or continuing move away from intermediate regimes.

Historical evidence of regime transitions gives an indication of whether the trend towards the poles of exchange rate regimes, which some commentators have divined in the 1990s, will eventually lead to the disappearance of intermediate regimes. Projecting transitions into the future does not produce such a hollowing out. The hypothesis that there are only transitions toward the two poles, and not toward the middle, can generally be overwhelmingly rejected by data samples based on the widest possible set of countries. We have guarded against the danger of arbitrary classification of regimes by using two different data sets that depart from the official classification. Both data sets suggest that a range of exchange rate regimes will be present for the foreseeable future, and will constitute roughly a quarter to a third of all regimes, though the Ghosh et al. data for the 1990s cannot reject the hypothesis of fixed rates as absorbing state. The Levy Yeyati–Sturznegger data set, which is based on what governments do, not what they say, overwhelmingly rejects all variants of hollowing out. Of course, using historical data for transitions raises the danger that we are using data which are no longer relevant, or that the trends in capital mobility, which have affected some countries (emerging markets) will spread to others in the future, producing an irreversible movement toward the poles. We therefore also look at a restricted set of countries, those classified as emerging markets, in the 1990s. Results for the Ghosh et al. data set suggest that eventually fixed rates will prevail as the single exchange rate regime for these countries. This result emerges because of the small number of hard pegs and the short time period, leading to the absence of any exits from this regime. As mentioned in the Introduction, there are earlier examples of breakdowns of both monetary unions and currency boards, and this experience is still relevant to an environment with higher capital mobility (capital mobility can be expected to make all exchange rate commitments, including fixes, more fragile). The starkly different implications of the Levy Yeyati–Sturzenegger data set, which strongly rejects the two forms of hollowing-out hypothesis for even this restricted set of countries, also throw doubt on hard pegs as the solution for all countries. The evidence of transitions thus suggests that intermediate regimes will continue to constitute an important fraction of actual exchange rate regimes.