erosion of political support might boards suggest that they may have tempt governments to abandon successfully prevented devaluations Can Currency currency boards during financial solely because they were run by stress. Then, the policies govern- foreign powers. Indeed, currency Boards Prevent ments impose to replace currency matters in those colonies were the boards may lead to the same de- responsibility of the British Secre- valuations and financial crises the tary of State for the Colonies, who Devaluations boards were designed to prevent. issued currency board regulations The recent experience of Argen- and appointed board members. And Financial tina suggests that currency boards Obviously, monetary policy in are not the panacea their advocates Mexico would be more credible claim. (See the sidebar.) were it administered by the Bundes- Meltdowns? bank. Hanke and Schuler’s pro- A Historical Perspective posed model for a modern currency board confirms the suspicion that Advocates claim there have been currency boards succeeded not many successful currency board because of their structure but be- experiences. For example, Hanke cause foreign powers controlled and Schuler (1994, 54) assert that them. According to Hanke and “approximately 70 countries have Schuler (1994, 81), currency boards had currency boards....” They fail should be run by “foreign directors to mention that most of those 70 appointed by commercial banks.” o the surprise of most, if not all, countries were British colonies in It is difficult to conceive how the T analysts and economic advisors, Africa, Asia, the Caribbean and the authority of foreign directors could Mexico’s December 1994 currency Middle East. be enforced against eventual popu- crisis quickly spread to other emerg- Few currency boards have ever lar opposition. Enforcement could ing economies. Investors’ fears that operated in independent countries. require military intervention by a those economies would devalue Those that did—North Russia, foreign power, something that might soon became evident in a swift, Danzig and Malaya—never lasted be unacceptable to the international massive and indiscriminate outflow more than four years. No orthodox community. of capital from Latin America that currency board operates today in observers dubbed the tequila effect. any independent country. The so- Currency Boards and the As the tequila effect rippled called Singapore currency board is Money Supply across the continent, living standards actually a department of the Mon- deteriorated for millions of Mexicans etary Authority of Singapore, which The currency board is a rule for and other Latin Americans. Mexico’s has the formal powers and respon- money creation: the currency board heightened risk of debt default sibilities of a central bank. Argentina’s issues money only against a desig- prompted a bailout by the Interna- current regime is perhaps the nated reserve currency at a fixed tional Monetary Fund and the closest to an orthodox currency exchange rate. Two common re- United States. board that exists today. serve currencies are the U.S. dollar Some observers contend that the The institutional arrangements and German mark. Mexican crisis and its damaging of all the British colonies’ currency The example in Chart 1 relies on spillover effects might have been avoided had Mexico had a currency board. Their arguments may sound Chart 1 Money Creation in a Currency Board System convincing, but they presume that once a currency board system is in $2 million place, a country will adhere to it forever. This assumption is as un- XX Currency Board XXXXXX realistic and naive as the belief that XXXXXX Deposits X $1 = 2 pesos a wedding ring guarantees an ever- 4 million pesos XXXXXXXX

lasting marriage. XXX Public Stubborn adherence to a currency Bank’s vaults 4 million pesos 2 million board exposes societies to severe pesos and protracted credit crunches, as in the Great Depression. Rising Wallets unemployment and consequent 2 million pesos

6 the U.S. dollar as the reserve cur- rency. An investor (foreign or do- mestic) decides to invest $2 million Argentina’s Currency Board During a Financial Crisis in a country with a currency board. To buy the local goods, machines Argentina’s recent experience demon- Chart A Argentina: Base Money and Foreign Reserves, 1995 and labor required for the invest- strates what can happen with a currency board during a financial crisis. Argentina’s Billions of pesos ment, the investor needs the local monetary policy has operated very much currency and to that end, hands as a currency board would have since April 17 over $2 million to that country’s 1, 1991, when the country’s congress 16 currency board. In exchange, the approved a convertibility law. 15 local currency board gives the The law obligated the central bank 14 Base money to issue domestic currency (the peso) only investor local currency (say, pesos) 13 against the dollar value of foreign re- at the rate established by the fixed 12 serves. The law also fixed the exchange exchange rate (say, 2 pesos per rate at 1:1, or $1 per peso. This standard 11 Foreign reserves dollar). In other words, the currency is the basic rule for money creation under 10 board gives the investor 4 million a currency board arrangement. 9 January February March pesos of the currency board’s money Under the convertibility law, Argen- in exchange for the investor’s $2 tina’s base money and foreign reserves should move very much in tandem, as they do in Chart A. This million. This currency board money pattern is typical of currency board regimes, under which base money increases as foreign reserves rise is nothing but the bills and coins and decreases as foreign reserves fall. As the chart shows, foreign reserves started to fall in Argentina in January 1995, when the tequila people carry in their wallets. These effect spread and investors withdrew capital from the country in fear of a devaluation. The chart makes bills and coins are actually the apparent that currency boards are not seen as everlasting protection against devaluation. The reason is currency board’s liabilities—that is, because the same currency board features that prevent devaluations can exacerbate fears that the currency upon demand the currency board board will be abandoned. Under a currency board, a relatively minor Orange County-like liquidity crisis must exchange those bills and can become a full-blown financial panic almost overnight. This is what happened in Argentina. In such coins for the reserve currency. circumstances, governments come under rising pressure to restore the lender of last resort function that Part of the fiduciary money issued is part of monetary policy under a central bank but is incompatible with a currency board regime. Argentina’s problem started with a liquidity squeeze in Bank Extrader, a small bank that held barely by the currency board will remain 0.2 percent of all the deposits in Argentina’s financial system. Extrader was heavily exposed in Mexican in the public’s wallets, but the rest bonds and securities. When the value of those assets fell dramatically in the aftermath of Mexico’s December will be deposited in commercial 20, 1994, peso devaluation, the bank could no longer cover its short-term liabilities, particularly time deposits. banks. Those bills and coins (that This shortage triggered a bank run, making matters even worse. On January 18 the central bank was forced is, the currency board’s liabilities in to liquidate Extrader. Suddenly, the effect seen elsewhere in Latin America spilled into Argentina’s domestic the form of money) in the banks financial markets. Fear that other banks were also heavily exposed to the collapsing Latin American capital become the commercial banks’ cash markets led depositors to withdraw their money from the banks for the security of their mattresses or accounts abroad. reserves, which they use to make By April 30, the financial system had lost 18 percent of the deposits it had before the Mexican peso loans and create deposits through devaluation. To cover the withdrawals, the banks were forced to liquidate assets. One liquidation method the standard money multiplier. was not to renew lines of credit to consumers and businesses. Many businesses and consumers could Chart 1 depicts a hypothetical not pay off the loans on such short notice. When they did, it was by not paying other obligations. In economy in which half the money turn, the beneficiaries of those debts could not meet their obligations, and so on. created by the currency board stays In the wake of this panic, many banks had to suspend the payment of deposits. Some investors— in the public’s wallets and the rest foreign and domestic alike—have not yet been able to recover their savings. Real economic activity in Argentina has followed the decline of financial indicators. Sales of cars, apparel and consumer electronics is deposited in commercial banks. had fallen 20 to 40 percent by the end of April. Although currency boards are supposed to prevent the Typically, the public withdraws only kind of financial meltdown Mexico experienced, Argentina found itself in a crisis despite its monetary policy. a fraction of the banks’ cash reserves Given the magnitude of Argentina’s credit crunch, one wonders why Argentina has not followed Great on any given day. In this example, Britain’s example and suspended its currency board arrangement until the financial crisis is resolved. The banks must satisfy, on average, answer, as a great deal of economic research suggests, lies in the monetary authority’s credibility. daily cash withdrawals of only half Argentina lacks the distinguished track record that the Bank of England had when it suspended the their cash reserves, or 1 million gold standard. In fact, Argentina has made into the Guinness Book of World Records for its historically high inflation rates and, in particular, its hyperinflations of 1989–90, when inflation rates reached 200 pesos. One million pesos, then, percent per month. Therefore, it’s likely that investors would perceive a temporary suspension of the currency would be left idling in the banks’ board announced by the monetary authority as permanent. Such a perception would weaken investor confidence vaults. Of course, profit-driven and make the reconstruction of the financial sector more difficult and protracted, which, in turn, would bankers will lend that money by validate the perception that the suspension was not temporary but permanent. opening accounts against which Argentina’s bad credit history is what motivated policymakers there not to follow the British example borrowers can issue checks for up but to stand by the currency board, even at the risk of defeat in the recent presidential election. The hope to 2 million pesos. is that investors will recognize that a country willing to endure a severe recession and soaring unemployment rates to preserve its commitment to avoid inflation has set aside policies of the past and achieved reform. In this example, total deposits in the banking system after the loans

7 are 4 million pesos: (1) 2 million Moreover, the bills and coins issued Chart 2 pesos of the original deposit plus by the currency board are fully The Currency Board Rule Amount of bills and coins (2) the 2 million pesos of the ac- convertible on demand at the fixed = Promised fixed exchange rate counts opened to borrowers. The exchange rate into the reserve cur- Amount of reserve currency cash reserves are 2 million pesos, rency, and vice versa. 6 million exactly enough to cover presumed Because a currency board views cash withdrawals for 50 percent of the money issued by banks (depos- Pesos the deposits. In other words, the 2 its) as the banks’ private business, 4 million million pesos of cash reserves sup- currency boards do not regulate, 3 million port twice as much in deposits. If, supervise or provide any lines of Pesos however, all depositors simul- credit to financial institutions. Finan- 2 million 2 million taneously decided to cash in their cial institutions make their own U.S. $ U.S. $ Pesos checking account balances, the credit policies and their own deci- 1 million U.S. $ financial system would not be able sions about how much to maintain Reserve Bills Reserve Bills Reserve Bills to satisfy the demand for 4 million in cash reserves. Under a currency currency and coins currency and coins currency and coins

pesos in cash. board, financial institutions are on The difference between the their own. There is no discount win- money created by the currency dow they can go to if they have a board can always buy back the board (actual bills and coins) and sudden and severe liquidity problem. base money at the fixed exchange the money created by the commer- This is why countries with currency rate of 2 pesos per dollar. There cial banks is important: the currency boards are more prone to bank runs will never be devaluations. board’s money is fully backed by and financial panics than countries foreign reserves. In other words, with full-fledged central banks. Central Banks and Devaluation the currency board is able to buy back all of its liabilities (bills and Armor Against Devaluation If a monetary authority does not coins) in exchange for foreign follow the strict rule of printing currency at the established fixed Why, then, are currency boards money only against foreign reserves, exchange rate. seen as protection against devalua- it is no longer a currency board. It’s In contrast, deposits in the private tion? The reason is because the a central bank. When the monetary financial system are not backed by base money is fully backed by authority prints money that is not the currency board’s foreign re- foreign reserves. If reserves shrink backed by reserves, the country serves. The currency board is not by $1 million, the money base has risks devaluation. responsible for these deposits be- to shrink by that amount times the Central banks can issue money cause they are private money, exchange rate. In the example through the discount window to money created by private financial shown in Chart 2, this loss of re- provide funds to financial institu- institutions and, therefore, the pri- serves means the currency board tions with short-term liquidity prob- vate banks’ liabilities. In particular, reduces bills and coins in circula- lems. In effect, this action adds to this means that the currency board tion by 2 million pesos ($1 million the base money (Chart 3 ) without does not exchange checks for re- times 2 pesos per $1). If foreign adding foreign reserves and breaks serve currency. Anyone who wants reserves increase instead by $1 mil- the delicate balance between them. to carry out such a transaction will lion (from $2 million to $3 million), This imbalance introduces the possi- first have to go to the bank, ex- the base money increases by 2 bility that the central bank will be change the private money (check) million pesos. forced to devalue the currency. If for the currency board money (bills In other words, under a currency the public decides to exchange all and coins) and then go to the cur- board, the mechanism for expand- the base money in circulation for rency board window to exchange ing and contracting the money foreign currency, the central bank the cash for the reserve currency at supply ensures that the proportion will not be able to defend the the fixed exchange rate. of base money to reserves stays current exchange rate. In sum, the currency board’s constant at the fixed exchange rate. In the case of Chart 3, the cen- money is the base money, or in less As Chart 2 shows, a currency board tral bank would need $3 million to technical terms, the bills and coins keeps the base money (bills and buy back the base money of 6 mil- in the public’s pockets. Under a coins) and the reserve currency lion pesos at the exchange rate of currency board, the base money is proportionate, the proportion im- 2:1. The central bank, however, has fully backed by foreign reserves plicit in the fixed exchange rate. only $2 million of foreign reserves, because the currency board prints For example, the ratio of the base so it must exchange at the rate of 3 money only against the reserve money to foreign reserves is always pesos per $1. Thus, the local cur- currency at a fixed exchange rate. 2:1, which means that the currency rency has devalued 50 percent.

8 Armor or Straitjacket? Given the serious recessions that this question. In the meantime, two usually follow the credit crunches facts are evident. The armor against devaluation associated with bank panics, it is First, if there are such institutions, provided by a currency board can easy to understand why countries the currency board is not one of become a straitjacket in times of will be tempted to abandon cur- them. Currency boards can be aban- financial panic. As explained earlier, rency boards and similar systems doned, and the fallacy behind their private banks typically keep only a during financial panics. In fact, that alleged effectiveness is the assump- fraction of their deposits in cash. is precisely what Great Britain did tion they will never be. With a currency board, banks do on three occasions with its gold Second, the track record of a not have the safety net of a dis- standard, which works much like a country seems far more important count window when they need to currency board, but with gold for policy credibility than the par- borrow short-term funds to face playing the role foreign reserves ticular label (central bank or cur- transitory liquidity problems. Under play under a currency board sys- rency board) of the institutions that a currency board regime, the de- tem. In 1847, 1857 and 1866, Great conduct policy. The monetary posits and the banking system are Britain suspended the gold stan- policy of a central bank in a country literally running on the confidence dard to abort incipient financial that has always shown fiscal and of depositors. When that confi- panics. monetary discipline and never de- dence is broken, a bank panic can Scholarly research has shown faulted on its debts will be far more ensue quickly. The mere suspicion that, in Great Britain’s case, investors credible than the monetary policy that a bank is insolvent can cause expected convertibility to resume of a currency board in a country depositors to fear for their savings eventually (Bordo and Kydland that has a history of letting inflation because a bank typically does not 1995). Argentina’s current financial run unleashed, confiscating deposits have enough cash to cover all crisis raises the question of whether and defaulting on its debt. outstanding deposits (See Chart 1). Argentina could do as England did A currency board might help an This fear will trigger a run against and temporarily suspend its currency inflation-addicted country avoid a the bank, whose failure will create board without hurting its credibility. devaluation, but only if the country fears of other bank failures, in a The answer is probably not, be- maintains the currency board at all chain reaction that can end up in cause Argentina’s monetary policy costs. Countries adopting currency a full-blown financial panic. track record is not what Great boards must be ready to endure the Bank runs are less frequent and Britain’s was at the time the gold severe financial crisis and high severe with a central bank system. standard was suspended. unemployment that come with the With a central bank, an essentially credit crunch that is sure to follow solvent bank with short-term liquid- Conclusions a financial panic. Such panics are ity problems will not automatically likely because a currency board is go under as it would in a currency A currency board does not not a magic pill that restores cred- board system because it can appeal magically restore the credibility of a ibility instantly and painlessly. to the discount window to cover country’s economic policies, as When recommending currency the temporary cash shortage. some advocates claim. The reason boards, their advocates should is because currency boards can be warn policymakers that currency abandoned. When investors fear a boards will not spare them the time Chart 3 Devaluation: Central Bank Lends to Banks government is about to abandon its and economic hardships necessary currency board, they take their to restore the credibility lost at the Promised Fixed Exchange Rate capital out of the country, and hands of bad policies of the past. $1 = 2 pesos Before After financial panic typically ensues, as 6 million it recently did in Argentina. In such —Carlos E. Zarazaga circumstances, the armor against Discount window = 2 million pesos devaluations that a currency board References supposedly provides becomes a 4 million suffocating straitjacket societies and Bordo, M.D., and Finn E. Kydland (1995), their governments will be tempted “The Gold Standard as a Rule: An Essay in to cast off. Exploration” in Explorations in Economic Pesos Pesos History (forthcoming). 2 million 2 million Behind these issues is a deeper U.S. $ U.S. $ one. Are there political and eco- Hanke, Steve H., and Kurt Schuler (1994), nomic institutions that can guarantee Currency Boards for Developing Countries: Reserve Bills Reserve Bills governments will never break their A Handbook (San Francisco: Institute for currency and coins currency and coins promises? Economists and social Contemporary Studies Press). Effective exchange rate Effective exchange rate $1 = 2 pesos $1 = 3 pesos scientists are still trying to answer

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