The men­ace of cen­tral banks: Iran and Turkey front and cen­tre

Financial Nigeria Magazine - - Contents -

Coun­tries that have em­ployed cur­rency boards have de­liv­ered lower in­fla­tion rates, smaller fis­cal deficits, lower debt lev­els rel­a­tive to the gross do­mes­tic prod­uct, fewer bank­ing crises, and higher real growth rates than com­pa­ra­ble coun­tries that have em­ployed cen­tral banks.

Cur­rency crises, like those grip­ping some emerg­ing mar­ket coun­tries to­day, give rise to ques­tions about the de­sir­abil­ity of cen­tral bank­ing. And why not? Af­ter all, cen­tral banks armed with dis­cre­tionary pow­ers to cre­ate money and credit are be­hind each and ev­ery cur­rency cri­sis. They are also the en­gine that gen­er­ates in­fla­tion. And, it is in­fla­tion that de­stroys wealth, un­der­mines growth, and desta­bi­lizes so­ci­eties.

The ten cen­tral banks that are cur­rently flunk­ing my “in­fla­tion test” are pre­sented in the ta­ble be­low. These cen­tral banks are pro­duc­ing an­nual in­fla­tion rates that ex­ceed 35% – the thresh­old for a fail­ing grade. I, along with my Johns Hop­kins-Cato In­sti­tute Trou­ble Cur­ren­cies Project team, mea­sure in­fla­tion rates, we do not project in­fla­tion rates. We em­ploy high­fre­quency data, so that an­nual in­fla­tion rates can be mea­sured on a daily ba­sis.

There are two ways in which to rid coun­tries from the men­ace of cen­tral banks. Coun­tries can re­place their do­mes­tic cur­ren­cies with for­eign cur­ren­cies – the “dol­lar­iza­tion” op­tion. With of­fi­cial dol­lar­iza­tion, a for­eign cur­rency has le­gal ten­der sta­tus. So, a for­eign cur­rency is not only used for con­tracts be­tween pri­vate par­ties, but also for gov­ern­ment ac­counts and the pay­ment of taxes. At present, thirty-two coun­tries are dol­lar­ized.

An­other at­trac­tive op­tion for coun­tries with fail­ing cen­tral banks is a cur­rency board sys­tem. A cur­rency board is­sues notes and coins con­vert­ible on de­mand into a for­eign an­chor cur­rency at a fixed rate of ex­change. As re­serves, it holds low-risk, in­ter­est-bear­ing bonds de­nom­i­nated in the an­chor cur­rency. The re­serve lev­els (both floors and ceil­ings) are set by law and are equal to 100%, or slightly more, of its mone­tary li­a­bil­i­ties. So, the do­mes­tic cur­rency is­sued via a cur­rency board is noth­ing more than a clone of its an­chor cur­rency. A cur­rency board gen­er­ates prof­its (seignior­age) from the dif­fer­ence be­tween the in­ter­est it earns on its re­serve as­sets and the ex­pense of main­tain­ing its li­a­bil­i­ties.

By de­sign, a cur­rency board, un­like a cen­tral bank, has no dis­cre­tionary mone­tary pow­ers and can­not en­gage in the fidu­ciary is­sue of money. It has an ex­change rate pol­icy (the ex­change rate is fixed) but no mone­tary pol­icy. A cur­rency board’s op­er­a­tions are pas­sive and au­to­matic. The sole func­tion of a cur­rency board is to ex­change the do­mes­tic cur­rency it is­sues for an an­chor cur­rency at a fixed rate. Con­se­quently, the quan­tity of do­mes­tic cur­rency in cir­cu­la­tion is de­ter­mined solely by mar­ket forces, namely the de­mand for do­mes­tic cur­rency.

A cur­rency board can­not is­sue credit. Ac­cord­ingly, a cur­rency board im­poses a hard bud­get con­straint and dis­ci­pline on the gov­ern­ment. This is an un­der­ap­pre­ci­ated fea­ture of cur­rency boards. Un­like cen­tral banks, a cur­rency board can’t be used as a means to fi­nance gov­ern­ment bud­gets.

Cur­rency boards have ex­isted in about 70 coun­tries, and none have failed. The first one was in­stalled in the Bri­tish In­dian Ocean colony of Mau­ri­tius in 1849. By the 1930s, cur­rency boards were wide­spread among the Bri­tish colonies in Africa, Asia, the Caribbean, and the Pa­cific Is­lands. They have also ex­isted in a num­ber of in­de­pen­dent coun­tries and city-states, such as Danzig and Sin­ga­pore. One of the more in­ter­est­ing cur­rency boards was in­stalled in North Rus­sia on Novem­ber 11, 1918, dur­ing the civil war. Its ar­chi­tect was none other than John May­nard Keynes, who was a Bri­tish Trea­sury of­fi­cial at the time.

Coun­tries that have em­ployed cur­rency boards have de­liv­ered lower in­fla­tion rates, smaller fis­cal deficits, lower debt lev­els rel­a­tive to the gross do­mes­tic prod­uct, fewer bank­ing crises, and higher real growth rates than com­pa­ra­ble coun­tries that have em­ployed cen­tral banks.

Given the su­pe­rior per­for­mance of cur­rency boards, the ob­vi­ous ques­tion is “What led to their demise and re­place­ment by cen­tral banks af­ter World War II?” The demise of cur­rency boards re­sulted from a con­flu­ence of three fac­tors. A choir of in­flu­en­tial econ­o­mists was singing the praises of cen­tral bank­ing’s flex­i­bil­ity and fine-tun­ing ca­pac­i­ties. In ad­di­tion to chang­ing in­tel­lec­tual fash­ions, newly in­de­pen­dent states were try­ing to shake off their ties with former im­pe­rial pow­ers. Ad­di­tion­ally, the In­ter­na­tional Mone­tary Fund and the World Bank, anx­ious to ob­tain new clients and “jobs for the boys,” lent their weight and money to the es­tab­lish­ment of new cen­tral banks. In the end, the Bank of Eng­land pro­vided the only in­sti­tu­tional voice that favoured cur­rency boards.

Since their post-World War II demise, cur­rency boards have wit­nessed some­thing of a resur­gence. In terms of size, the most sig­nif­i­cant cur­rency board to­day is Hong Kong’s. It was in­stalled in 1983 to com­bat ex­change rate in­sta­bil­ity. In the wake of the col­lapse of the Soviet Union, sev­eral coun­tries adopted cur­rency boards. They suc­cess­fully crushed in­fla­tion and ush­ered in sta­bil­ity and growth.

It is im­por­tant to stress that Ar­gentina’s Con­vert­ibil­ity Sys­tem (1991-2001) was not a cur­rency board. Nev­er­the­less, Kurt Schuler found that some 97% of the world’s ma­jor econ­o­mists misiden­ti­fied Ar­gentina’s Con­vert­ibil­ity Sys­tem, assert­ing that is was a cur­rency board. This misiden­ti­fi­ca­tion has arisen be­cause most have failed to re­al­ize that Con­vert­ibil­ity al­lowed Ar­gentina’s cen­tral bank (BCRA) to en­gage in dis­cre­tionary mone­tary poli­cies, which the BCRA ex­er­cised with reck­less aban­don. In con­trast, a cur­rency board has ab­so­lutely no dis­cre­tionary pow­ers.

The world needs fewer cen­tral banks. Venezuela and Ar­gentina should moth­ball theirs and dol­lar­ize. For other coun­tries with fail­ing cen­tral banks, cur­rency boards are a proven elixir. Spe­cial cases of Iran, Rus­sia, and Turkey are note­wor­thy. To pro­duce cur­ren­cies that are as good as gold – a cur­rency not is­sued by a sov­er­eign – these coun­tries should go for gold-backed cur­rency boards.

Steve Hanke is a pro­fes­sor of ap­plied eco­nomics at The Johns Hop­kins Uni­ver­sity and se­nior fel­low at the Cato In­sti­tute. Over four decades Hanke has ad­vised dozens of world lead­ers from Ron­ald Rea­gan to In­done­sia’s Suharto on cur­rency re­forms, in­fra­struc­ture de­vel­op­ment, pri­va­ti­za­tion, and how to tame hy­per­in­fla­tion. He also trades cur­ren­cies and com­modi­ties and was the pres­i­dent of the world’s best per­form­ing mu­tual fund in 1995 (+79.25%). Fol­low him on Twit­ter @Steve_Hanke.

Head­quar­ters of Cen­tral Bank of Iran

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