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Department of Economics Working Paper Series Monetary Policy in Post-Conflict Countries: Restoring Credibility by Martha A. Starr No. 2004-07 September 2004 http://www.american.edu/cas/econ/workpap.htm Copyright © 2004 by Martha A. Starr. All rights reserved. Readers may make verbatim copies of this document for non-commercial purposes by any means, provided that this copyright notice appears on all such copies. 2 Monetary Policy in Post Conflict Countries: Restoring Credibility* Martha A. Starr** Abstract Monetary chaos typically grows out of conflict situations. Governments commonly finance military operations by printing money, which along with falling output propels inflation into high- or hyper-inflationary ranges. Consequently, at the end of the conflict period, the value of the currency is usually highly degraded, there has been substantial substitution into foreign currencies, and the financial system is inoperative. This paper uses case studies and econometric analyses to examine post-conflict monetary experiences in several countries that underwent violent conflicts in the 1990s: Bosnia-Herzegovina, Croatia, Serbia-Montenegro, Kosovo, Moldova and the Transdniestria region, Georgia and the regions of Abkhazia and South Ossetia, Afghanistan, and Tajikistan. It is found that timely overhauls of monetary policy that re-establish the credibility of money lay a good foundation for post-conflict recovery: they both reduce inflation quickly and move money out of the realm of powers and authorities used to the benefit of some parties to a conflict, and into the realm where it serves the common good. However, credibility-oriented reforms do not necessarily have a beneficial effect on growth, at least in the short-run –- potentially posing a problem for making peace work. Key words: Conflict, monetary policy, macroeconomic performance JEL classification: D74, E31, E42 * I am grateful to participants at the UNU-WIDER conference on “Making Peace Work,” held in Helsinki in June, 2004 as well as Trish Juhn, for valuable comments on an earlier version of this paper. ** Contact: Martha A. Starr, Department of Economics, American University, 4400 Massachusetts Avenue, NW, Washington, DC 20016-8029. Email: [email protected]. 3 Introduction Among the problems faced by post-conflict countries, the restoration of macroeconomic stability is important for promoting a return to normal economic activity. Periods of conflict are associated with highly adverse macroeconomic conditions. In addition to profoundly disrupting production, employment, consumption, and distribution, fighting often forces people out of locations in which they ordinarily earn their livelihoods and destroys stocks of productive resources such as factories, bridges, and roads. While peace settlements typically work out arrangements to halt conflict and establish guidelines for resolving unsettled issues, the aggregate uncertainty of post-conflict situations can work significantly against economic recovery: Because the sense of outstanding risks makes it difficult to foresee how the post- conflict environment will unfold, people and businesses avoid committing themselves to projects and activities that would take time to yield and for which returns are uncertain. Consequently, wealth often continues to be held in precautionary forms like foreign-currency cash; productive investment is slow to materialize; and displaced populations hesitate to return to their pre-conflict locations and activities, yet without developing new homes and livelihoods either. This state of limbo is especially problematic because failure to restore economic conditions may jeopardize the ability to make peace stick. An important issue here is the monetary chaos that typically grows out of conflict situations. With production declining, the tax base shrinking, and tax collection disrupted, governments often meet the fiscal burdens of wartime by printing money –- either literally, or by circulating government ‘coupons’, or by granting credits to the government through the central bank.1 In the face of falling output, high rates of monetary growth push inflation rates into high or even hyperinflationary ranges, with prices rising at seemingly unfathomable rates and the real value of the domestic currency nose-diving. Indeed, two-thirds of all hyperinflations -- defined by Cagan (1956) as episodes in which monthly inflation exceeds 50% -- in the contemporary period had a period of violent conflict associated with them, as can be seen from Table 1. Inevitably this extent of inflation erodes confidence in the national currency, and often provokes substitution of foreign currencies for national money. People shift their savings to the extent possible into strong foreign currencies, like the U.S. dollar and Deutsche mark (or now euro); given that banks and other financial institutions often stop functioning in periods of conflict, these foreign currency holdings are most often kept in cash. In addition to using foreign currency as a store of value, it may also come to be used in the two other traditional 1 See FitzGerald (1997) and Addison, Murshed and Le Billon 2000). 4 functions of money, that is, as a medium of exchange for conducting transactions, and as a unit of account in denominating values. With such monetary degradation and financial collapse, it is virtually impossible to begin reconstruction without monetary overhaul: without a credible currency and minimal payments system, the government cannot make payments to employees or suppliers, prolonging problems of lack of cohesion and control. Thus, in many recent post-conflict situations, high priority has been given to restoring a rational monetary system, to the extent that provisions for monetary policy were included in the Dayton Peace Accord. And yet, what type of monetary régime is appropriate in a given post-conflict context is not at all clear. For one, developing viable institutions and mechanisms for monetary policy is a matter of governance –- that is, of determining goals of policy, defining rules and authority for its conduct, and codifying them in law –- and as such, it relates integrally to processes of re-building trust and sense of shared public responsibility among formerly antagonistic parties. Moreover, establishing the credibility of monetary policy is especially important in a post-conflict context: with urgent needs for public spending on reconstruction, the public may doubt that deficits will not be monetized, unless the rules of monetary policy specifically limit government recourse to this possibility. And finally, choice of monetary-policy regime also plays into broader questions of national economic development: Many post-conflict economies are small, underdeveloped, and/or in stages of post-socialist transition (Collier et al 2003). They may also need or want to position themselves favorably towards opportunities for international economic and financial integration, which in turn depends on having a currency that is stable and convertible at low cost (Alesina and Barro 2002). As such, they may benefit particularly from monetary-policy options other than the traditional ‘one-country-one-money’ paradigm, such as currency boards. This paper examines monetary-policy experiences in several post-conflict cases. After first discussing monetary-policy options and the special problems of post-conflict countries, we examine the experiences of several countries that went through violent conflicts in the 1990s: Bosnia-Herzegovina, Croatia, Serbia-Montenegro, Kosovo, Moldova and the Transdniestria region, Georgia and the regions of Abkhazia and South Ossetia, Afghanistan, and Tajikistan. Both case studies and econometric analyses demonstrate that in the aftermath of conflict, credibility-oriented monetary reforms are needed to bring inflation down into a normal range; however, monetary reform does not necessarily have beneficial effects on growth, at least in the first years after conflict ends. Broadly, it is argued that establishing credible monetary policy is important for post-conflict recovery; that the means for accomplishing this depends on the country’s circumstances in ways that we identify; that contrary to a standard element of peace agreements, monetary policy is often not workable as a function of a minimalist federal 5 state (or requires special measures to stand a chance of working); and finally, that it is not necessarily unacceptable to have regions within a country using a currency other than the national one as their primary money. In the end, what matters is moving money out of the realm of powers and authorities used to the benefit of some parties to a conflict, and into the realm where it serves the common good. Options for monetary policy and the special problems of post-conflict countries In some respects, the context of monetary reform in post-conflict countries is not dissimilar to that of other countries that have undergone periods of very high inflation. In both cases, inflation has substantially eroded the real value of the domestic currency, so that the proverbial ‘wheelbarrows of currency’ may be required to make major purchases. If high inflation has persisted for several years, people and businesses will have adopted practices aimed at minimizing its real effects, including frequent adjustments in wages and prices, fast pass-through of exchange-rate changes, and/or growing use of foreign currencies as store of value, unit of account, and/or medium of exchange. In both cases, the scope for