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Currency Boards for Developing Countries: a Handbook (Revised Edition, 2015)

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Currency Boards for Developing Countries: a Handbook (Revised Edition, 2015) CURRENCY BOARDS FOR DEVELOPING COUNTRIES: A HANDBOOK (REVISED EDITION, 2015) by Steve H. Hanke and Kurt Schuler The original version of this study was published by ICS Press, San Francisco, in 1994 for the International Center for Economic Growth. It is copyrighted 1994 by the Institute for Contemporary Studies. This revised version is issued with the permission of the International Center for Economic Growth. All rights reserved by the International Center for Economic Growth for the original edition and by the authors for additions. i In the beginning God created sterling and the franc. On the second day He created the currency board and, Lo, money was well managed. On the third day God decided that man should have free will and so He created the budget deficit. On the fourth day, however, God looked upon His work and was dissatisfied. It was not enough. So, on the fifth day God created the central bank to validate the sins of man. On the sixth day God completed His work by creating man and giving him dominion over all God's creatures. Then, while God rested on the seventh day, man created inflation and the balance-of-payments problem. —Peter B. Kenen (1978: 13) ii CONTENTS Preface to this version………………………………………………………………………………………………………………………vi About the authors……………………………………………………………………………………………………………………………..vii 1. The case for currency boards…………………………………………………………………………………………………………1 Currency board versus central bank Currency boards versus dollarization, multinational central banks, and free banking Currency boards and wider economic reforms Outline of this study 2. The case against typical central banks……………………………………………………………………………………………13 The functions of money Stability and credibility Credibility and exchange rates Convertibility and foreign-exchange controls Central banking and deficit finance Political independence: an unattainable goal Inadequate staff Flexibility: a problem even in theory 3. Currency boards, central banks, and the money supply…………………………………………………………………26 Money supply in a currency board system Money supply in a central banking system Central banks sometimes mistaken for currency boards A brief history and assessment of currency boards Currency boards and currency board-like systems today 4. How to establish a currency board…………………………………………………………………………………………………45 How to convert a central bank into a currency board The alternative: a parallel currency approach How to establish the currency board as the issuer of a parallel currency How to choose a reserve currency How to calculate the initial foreign reserves How to obtain the initial foreign reserves 5. How to operate and protect a currency board……………………………………………………………………………….56 How to operate a currency board How to protect a currency board How to change the reserve currency, if necessary iii 6. Objections to currency boards……………………………………………………………………………………………………….63 No lender of last resort Does size matter? Fixed versus floating exchange rates Deflation The inflation tax The cost of reserves Colonialism The worst case 7. Conclusion……………………………………………………………………………………………………………………………………72 Appendix: A model currency board constitution……………………………………………………………………………….74 Selected Bibliography……………………………………………………………………………………………………………………….77 iv Figures Figure 1.1. A typical currency board versus a typical central bank Figure 3.1. Balance sheets Figure 3.2. Money supply increase in a currency board system Figure 3.3. Money supply increase in a currency board system, initial stage Figure 3.4. Money supply increase in a currency board system, intermediate stage Figure 3.5. Money supply increase in a currency board system, final stage Figure 3.6. Money supply decrease in a currency board system Figure 3.7. Money supply decrease in a currency board system, initial stage Figure 3.8. Money supply decrease in a currency board system, intermediate stage Figure 3.9. Money supply decrease in a currency board system, final stage Figure 3.10. Money supply increase in a central banking system with a floating exchange rate Figure 3.11. Money supply decrease in a central banking system with a floating exchange rate Figure 3.12. Central bank and currency board balance sheets Figure 3.13. Currency boards today and in the recent past Figure 7.1. Summary of proposals v PREFACE TO THE REVISED EDITION The International Center for Economic Growth, through its offshoot ICS Press, published the original version of this study in 1994. With their permission, we posted a slightly updated version on the Internet in 2000. We thank them again in connection with this edition, which updates a few references to events but is not a comprehensive revision. We are working on a big book about currency boards with Nicholas Krus that will summarize our quarter-century or more of thinking on the subject. The study has had substantial influence. It has been translated into Bulgarian, French, Spanish, Turkish, and Georgian. A modified version, adapted to the specific circumstances of Lithuania, influenced that country’s monetary reform of 1994 (Hanke and Schuler 1994b). Both an unauthorized and an authorized Bulgarian translation were widely read during the high inflation that preceded Bulgaria’s adoption of currency board-like rules in 1997 (Hanke and Schuler 1996, 1997). Recently, there have been expressions of interest in an Arabic translation. July 2015 vi ABOUT THE AUTHORS (2015) Steve H. Hanke (Email: [email protected], Twitter: @Steve_Hanke) is Professor of Applied Economics and Co-Director of the Institute for Applied Economics, Global Health, and the Study of Business Enterprise at The Johns Hopkins University in Baltimore. He is a Senior Fellow and Director of the Troubled Currencies Project at the Cato Institute in Washington, D.C.; a Senior Advisor at the Renmin University of China’s International Monetary Research Institute in Beijing; a Special Counselor to the Center for Financial Stability in New York; and a contributing editor at Globe Asia Magazine. Prof. Hanke is also a member of the Charter Council of the Society of Economic Measurement and the Financial Advisory Council of the United Arab Emirates. In the past, Prof. Hanke taught economics at the Colorado School of Mines and the University of California, Berkeley. He served as a Member of the Governor’s Council of Economic Advisers in Maryland in 1976-77; as a Senior Economist on President Reagan’s Council of Economic Advisers in 1981-82; and as a Senior Advisor to the Joint Economic Committee of the U.S. Congress in 1984-88. Prof. Hanke also served as a State Counselor to both the Republic of Lithuania in 1994-96 and the Republic of Montenegro in 1999-2003. He was also an advisor to the presidents of Bulgaria in 1997-2002, Venezuela in 1995-96, and Indonesia in 1998. He played an important role in establishing new currency regimes in Argentina, Estonia, Bulgaria, Bosnia-Herzegovina, Ecuador, Lithuania, and Montenegro. Prof. Hanke has also advised the governments of many other countries, including Albania, Kazakhstan, and Yugoslavia. Prof. Hanke is a Distinguished Associate of the International Atlantic Economic Society; a Distinguished Professor at the Universitas Pelita Harapan in Jakarta, Indonesia; and a Professor Asociado (the highest honor awarded to international experts of acknowledged competence) at the Universidad del Azuay in Cuenca, Ecuador. He has been awarded honorary doctorate degrees by the Bulgarian Academy of Sciences, the Universidad San Francisco de Quito, the Free University of Tbilisi, Istanbul Kültür University, and Varna Free University in honor of his scholarship on exchange-rate regimes. In 1998, he was named one of the twenty-five most influential people in the world by World Trade Magazine. Prof. Hanke is a well-known currency and commodity trader. Currently, he serves as Chairman of Hanke- Guttridge Capital Management, LLC — an investment manager located in Maryland that employs a long- short equity strategy. He is also a member of the Supervisory Board of Advanced Metallurgical Group N.V., in Amsterdam, and Chairman Emeritus of the Friedberg Mercantile Group, Inc. in Toronto. During the 1990s, he served as President of Toronto Trust Argentina in Buenos Aires, the world’s best- performing emerging market mutual fund in 1995. Prof. Hanke’s most recent books are Zimbabwe: Hyperinflation to Growth (2008) and A Blueprint for a Safe, Sound Georgian Lari (2010). Prof. Hanke and his wife, Liliane, reside in Baltimore and Paris. Kurt Schuler is an economist in the Office of International Affairs at the U.S. Department of the Treasury. (This book was written while he was a post-doctoral fellow at The Johns Hopkins University, long before he began working at the Treasury, and does not necessarily reflect the Treasury’s views.) In his spare time he is a Senior Fellow in Financial History at the Center for Financial Stability in New York, where he founded and edits the Historical Financial Statistics database. Previously he worked as a senior vii economist at the Joint Economic Committee of the U.S. Congress and as a consultant on monetary matters in a number of countries. His most recent book is The Bretton Woods Transcripts, edited with Andrew Rosenberg, which won the 2014 Best Scholarly Edition award from the European Society for the History of Economic Thought. viii 1. THE CASE FOR CURRENCY BOARDS Since the final breakup of the Bretton Woods monetary system in 1973, the gap that once existed between the currencies of developed and developing countries has widened into a gulf. During the Bretton Woods system
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