87

Currency Boards

By STEVE H. HANKE

Steve H. Hanke is a professor of applied economics at the Johns Hopkins Universityin Baltimore and chairman of the Friedberg Mercantile Group, Inc., in New York. Hehas played a role in the design and establishment of the currency board systems estab-lished in the 1990s (Hanke and Schuler 1991a, 1991b; Hanke, Jonung, and Schuler1992; Hanke and Schuler 1994b; and Hanke 1996/1997).

ABSTRACT: In contrast to central banks, currency boards are rule-bound monetary institutions without discretionary monetary poli-cies. Currency boards first appeared in the mid-nineteenth century,were widespread prior to World War II, were replaced by centralbanks after the war, and have made something of a resurgence in the1990s. This article discusses the distinguishing features of currencyboards and central banks. Data that compare the performance of cur-rency boards to that of central banks are presented. The argumentsagainst currency boards are itemized and evaluated. The article con-cludes that the opposition to currency boards ignores the empiricalevidence and is, at best, half baked. In developing countries, currencyboards are superior to central banks. By applying a remediablenesscriterion, the article concludes that there are more than sixty coun-tries that should replace their central banks with currency boards.

NOTE: The author thanks Matt Sekerke for his assistance in preparing this article.

88

In the beginning God createdsterling and the franc.

On the second day He created thecurrency board and, Lo, moneywas well managed.

On the third day God decidedthat man should have free will

and so He created the budgetdeficit.

On the fourth day, however, Godlooked upon His work and wasdissatisfied. It was not enough.

So, on the fifth day God createdthe central bank to validatethe sins of man.

On the sixth day God completedHis work by creating man andgiving him dominion over allGod’s creatures.

Then, while God rested on theseventh day, man createdinflation and the balance-of-

payments problem.-Peter B. Kenen (1978, 13)

Central banks issue currency andexercise wide discretion over the con-duct of monetary policy. Althoughwidespread today, central banks arerelatively new institutional arrange-ments. In 1900, there were only18 central banks in the world. By1940, forty countries had them, andtoday there are 174. Of those, 6 arebound by currency board rules thatdo not permit discretionary mone-tary policies. In addition, there areseven monetary authorities thatoperate as stand-alone currencyboards (see Table 1).An orthodox currency board issues

notes and coins convertible ondemand into a foreign anchor

currency at a fixed rate of exchange.As reserves, it holds low-risk, interest-bearing bonds denominated in theanchor currency and typically somegold. The reserve levels are set by lawand are equal to 100 percent, orslightly more, of its monetary liabili-ties (notes, coins, and if permitted,deposits). A currency board’s conver-tibility and foreign reserve coverrequirements do not extend to depos-its at commercial banks or to anyother financial assets. A currencyboard generates profits (seigniorage)from the difference between theinterest it earns on its reserve assetsand the expense of maintaining itsliabilities. By design, a currencyboard has no discretionary monetarypowers and cannot engage in the

fiduciary issue of money. Its opera-tions are passive and automatic. Thesole function of a currency board is to

exchange the domestic currency itissues for an anchor currency at afixed rate. Consequently, the quan-tity of domestic currency in circula-tion is determined solely by marketforces, namely the demand fordomestic currency (Walters andHanke 1992).The currency board idea origi-

nated in Britain in the early 1800s. Anotable proponent was DavidRicardo. Sir John Hicks (1967) madethis perfectly clear when he wrote,&dquo;On strict Ricardian principles, thereshould have been no need for CentralBanks. A Currency Board, workingon a rule, should have been enough&dquo;(pp. 167-78).

Currency boards have existed inabout seventy countries. The firstone was installed in the BritishIndian Ocean colony of Mauritius in

89

TABLE 1

CURRENCY BOARDS AND CURRENCY BOARD-LIKE SYSTEMS TODAY

SOURCES: Hanke, Jonung, and Schuler (1993); Central Intelligence Agency (1999).a. Expressed in terms of purchasing power parity, not at current exchange rates.b. Currency board-like system.

1849. By the 1930s, they were wide-spread in British colonies in Africa,Asia, the Caribbean, and the Pacificislands. Currency boards have alsoexisted in a number of independentcountries and city-states, such asDanzig and Singapore. One of themore interesting currency boardswas installed in North Russia on 11November 1918, during the civil war.Its architect was John MaynardKeynes, who was a British Treasuryofficials responsible for war finance atthe time (Hanke, Jonung, andSchuler 1993).

DISTINGUISHING FEATURESOF CURRENCY BOARDSAND CENTRAL BANKS

The features that distinguish typi-cal currency boards and centralbanks are itemized in Table 2 and are

generally self-explanatory. Severalmerit further comment, however.

One concerns balance sheets. Unfor-

tunately, most economists are in-capable of performing basic balancesheet diagnostics and ignore theseimportant documents. This was notalways the case. Sir John Hicks-ahigh priest of economic theory and1972 Nobelist-thought there wasnothing more important than a bal-ance sheet (Klamer 1989). I agree,particularly when it comes to under-standing monetary institutions.A balance sheet reveals a mone-

tary authority’s liabilities (high-powered base money). It also showsthe make-up of those liabilities, orthe split between net domestic assets(the domestic component of basemoney) and net foreign reserves (theforeign component of base money).

The asset side of a central bank’sbalance sheet contains both netdomestic assets and net foreignreserves. This means that a centralbank can engage in discretionary

90

TABLE 2

A TYPICAL CURRENCY BOARD VERSUS A TYPICAL CENTRAL BANK

monetary policy-or fine-tuning-bybuying and selling domestic assets(bonds and bills). This results inchanges in the fiduciary issue ofmoney, with the domestic componentof the monetary base increasingwhen a central bank buys bonds andbills and contracting when a centralbank sells bonds and bills.

Net foreign reserves are the onlyasset on a currency board’s balancesheet because it cannot buy and selldomestic assets. Consequently, a cur-rency board cannot engage in fine-

tuning, and its monetary liabilities(base money) are exclusively madeup of a foreign component. Changesin base money in a currency boardsystem are, therefore, exclusively

driven by changes in the balance ofpayments and net foreign reserves.A quick glance at a monetary

authority’s balance sheet will showwhether it is engaging in discretion-ary monetary policy and whether it isoperating as a currency board or acentral bank. Since currency boardsconduct no monetary policy and havenothing to hide, they post their cur-rent balance sheets on the Web andare transparent. This is not the casefor central banks. Of the 174 central

banks, only 124 have Web sites. And,only 82 post some form of balancesheet. Of those, only 14 display cur-rent balance sheets (Hanke 2001).This lack of central bank trans-

parency causes no end of problems

91

for those who wish to conduct bal-ance sheet diagnostics and deter-mine what central banks are actuallydoing.A second feature that distin-

guishes currency boards and centralbanks is the exchange rate regimesthey employ. With currency boardrules, a monetary authority sets theexchange rate-it is fixed-but it hasno monetary policy. The quantity ofbase money in the system is solelydetermined by the demand for it inthe market. Consequently, there canbe no conflicts between exchangerate policies and monetary policies ina currency board system. Balance-of-payments problems cannot rear theirugly heads because market forcesautomatically act to rebalance finan-cial flows. This explains why specula-tive attacks against currenciesissued by currency boards havealways ended in failure, with nodevaluations. Argentina in 1995 and2001 is but one example.

Central banks in developing coun-tries simultaneously manage ex-change rate policies and monetarypolicies. They operate with peggedexchange rate systems that are vari-ously referred to as pegged, peggedbut adjustable, bands, or managedfloating systems. With pegged rates,the monetary base contains bothdomestic and foreign componentsbecause both net domestic assets and

foreign reserves on the monetaryauthority’s balance sheet can change,and these changes cause its mone-tary liabilities to fluctuate.

Pegged rates invariably result inconflicts between exchange rate poli-cies and monetary policies. For exam-ple, when capital inflows become

excessive under a pegged system, amonetary authority often attemptsto sterilize the effect by reducing thedomestic component of the monetarybase through the sale of governmentbonds. And, when outflows becomeexcessive, the authority attempts tooffset the changes with an increase inthe domestic component of the mone-tary base by purchasing governmentbonds. Balance-of-payments criseserupt as a monetary authorityincreasingly offsets the reduction inthe foreign component of the mone-tary base with domestically createdbase money. When this occurs, it is

only a matter of time before currencyspeculators spot the contradiction.This is exactly what happened inTurkey during February of 2001.A third feature that merits atten-

tion concerns the issuance of credit

by a monetary authority. Centralbanks can act as a lender of lastresort and extend credit to the bank-

ing system. They can also make loansto the fiscal authorities and state-owned enterprises. Consequently,central banks can go bankrupt. TheBank of Indonesia is the most recent

example of an insolvent central bank(Hanke 2000a).A problem in many developing

countries is that the rule of law isweak and so are the institutions of

government. Consequently, a principal-agent problem exists because the vot-ers (principals) have very little effec-tive control over their agents (politi-cians) (Williamson 1996). Currencyboards remedy the principal-agentproblem, in part, because they cannotextend credit to the fiscal authoritiesor state-owned enterprises. In addi-tion, currency boards cannot engage

92

TABLE 3

CURRENCY BOARD VERSUS CENTRAL BANK PERFORMANCES

(NINETY-EIGHT DEVELOPING COUNTRIES,1950-1993)

SOURCE: Based on Hanke (1999).NOTE: Number of observations in parentheses.

TABLE 4

CURRENCY BOARD VERSUS CENTRAL BANK PERFORMANCES

(MEMBERS OF THE INTERNATIONAL MONETARY FUND, 1970-1996)

SOURCE: Based on Ghosh, Gulde, and Wolf (1998).

in lender of last resort activities. Thefiscal regime, therefore, is subordi-nated to the monetary regime, and ahard budget constraint is imposed onthe politicians.Much as the gold standard was

adopted to control the fiscal authori-ties (James 2001), I can attest to thefact that every currency board in the1990s was adopted primarily toimpose a hard budget constraint.With few exceptions, this key cur-rency board feature has been over-looked by economists (Horvdth andSz6kely 2001).

PERFORMANCE OFCURRENCY BOARDSAND CENTRAL BANKS

All currency boards have per-formed well, when compared to cen-tral banks (Hanke, Jonung, andSchuler 1993). Countries with

currency boards have realized pricestability, respectable growth rates,and fiscal discipline (for the firstdetailed quantitative study thatcompares currency boards and cen-tral banks in 155 countries, seeSchuler 1996).

Tables 3 and 4 present pooledtime-series, cross-section data for alarge number of countries spanningnearly fifty years. The data speak forthemselves. The currency boards’

performance is unambiguously supe-rior to the central banks’. Currencyboards, therefore, satisfy KarlSchiller’s (cited in Marsh 1992) testof a sound monetary system: &dquo;stabil-ity might not be everything, but with-out stability, everything is nothing&dquo;(p. 30).

Karl Schiller’s test is particularlyrelevant when judging the perfor-mance of the five currency boardsinstalled in the 1990s. All were

93

installed in countries that were polit-ically and/or economically veryunstable. Furthermore, prior to theinstallation of currency boards, allcountries had soft budget constraintsand faced the prospect of continuedinstability. Argentina was attempt-ing to cope with repeated bouts ofhyperinflation. Estonia had justgained independence from theU.S.S.R and was still using thehyperinflating Russian ruble. Lithu-ania was in the grip of a collapsingreal economy and very high inflation.To make matters worse, its new polit-ical institutions could not effectivelycontrol what threatened to be a run-

away fiscal deficit. Bulgaria haddefaulted on its international debt,narrowly escaped a revolution in late1996, and was battling hyperinfla-tion that had virtually wiped out itsbanking system and sent the realeconomy into a free fall. Finally, thenewly independent Bosnia andHerzegovina had just come out of abloody civil war, one that had dis-rupted and displaced most of the pop-ulation, destroyed 18 percent anddamaged 60 percent of the housingstock, and covered much of the terri-tory with land mines. Its economywas in shambles, declining to about20 percent of the 1990 level. With theexception of the deutsche mark, theother three currencies in circulation-the Bosnia and Herzegovina dinar,the Croatian kuna, and the Yugoslavdinar-were either unstable or veryunstable.

Tables 5 through 9 constituteevent studies, with the events beingthe installation of a currency board.Economic and financial data are pre-sented before and after the event.

Although these basic data speak forthemselves, several points meritattention. For each of the five coun-

tries, the foreign reserves increaseddramatically after the currencyboard was introduced. Given that the

monetary liabilities of the boards aresolely a function of the demand forthose liabilities and given that theymust be backed by a minimum of100 percent foreign reserves, thedemand for the domestic currency, asindicated by foreign reserve levels,increased dramatically after theintroduction of the currency board.

The currency boards’ imposition ofa hard budget constraint is not fullyrevealed by the fiscal balance data.These data show fiscal balances on astandard cash basis, which excludesrevenues from privatization. Also, inthe years prior to the introduction ofthe currency boards, the fiscalauthorities were all running up largearrears. This practice stopped afterboards were installed. Consequently,the fiscal deficits prior to their intro-duction would have been larger ifbills had been paid on time. In addi-tion, in the years following their intro-duction, privatizations increased sig-nificantly. If these were included inthe fiscal data, the deficits after theinstallation of the currency boardswould have been much smaller.

Therefore, the fiscal effects of cur-rency boards are, in reality, muchmore impressive than those impliedby the standard data presented inTables 5 through 9.

For the four countries in whichdata were available (see Tables 5-8),foreign direct investment and portfo-lio flows registered healthy increasesafter currency boards were installed.

94

:;z0)

-iOECLout

inone

9mPozwCECE=»¡L)<

_ mw =»-JCJ

CDZ~ï:

ujU)0:1LU

LJL I4c.Z<WCE0U.UJmc(zPzUJCJone<

/

.c: ,2.. 6 ~ å:sf6CwURU’- 0 Q) Q)Q)Q)o.ê3ë~ ~ ~ S ~:::E.£2&dquo;’Oå)%j*f6@fl~ C 7 ~ f~

N U j,~16~’5ëC ‘ 3~~8Q)u

(/) . (/) g>co - 0> cn.oE~ -~ o ~ c ~ -a& 0) M D m g0 0) M ’o > <0

&dquo;’,....co.c:16(/)~~~’~ic &horbar; ~= .= o -cco -5,.g ~ ~ a~{-CO~MC~r s o ~ co a~f b912’b&dquo;’ Q) 5 S 5 ~_mOmf6uI c ~ v ~ ~-o-g Q)~~=6..~Q) 3: Q) ~ co ~~ ~ <D $ <D E ~ U S ~ S- ’5~ ~~&dquo;5@og§W#f6°~&°~§,mzElo.~j9C:å)(/)ae «Cl#ac gjcDf c ~c~ a~ c > cWn ojf6 :J >’&dquo;ëi) (/) >wo ~ o.QO

&dquo;ê ~ á5 co .~ ~ a

~ C Q) <D -Q)i a~ c o ~ c a~ s a~ ’~ ‘ o~()Ctíco3:>.~

§~~~~5 .~ 5 -- ~ g’u.=m’§mC~~§~~i..o >; .° 47 u~ > U ~ ~ ° c ~ cc = n U c ~,5 g ~ U o CD 0 ~ S ~ ~ C: S t=C:-o>oc: ...

~~§~3&dquo;.., ’U = O Q -ÕC:oå)-2Q); v tn ~ C O d3N_ ,tA ~ï:: co c: (/) .- co Q)~ .- S W v~ ~ -5~ :g .~ ~~ ~ :c á5 .5 ~ ~

C ULUC~’O IC ~~co2e>Q)coQ), á5 c: .5 < (/) 0 ’>.0>0 CJ>’~ï::u. <D <D M U .=’ ~-ô ~ Q) Q) .5 ae .0c:-.o (/) C:-O>~~S ~?-.,. (0 <0 ... K ~ 0‘ >, U (~ L cC C &dquo;.U., OU Lå) ’Q; &dquo;5 ~ :å 5>;’c 8 oo§CD£o c: 3: - .- ~~E;!O-~Q).£2gI (ij co Q 0>.0 >.:E c&fllJCEf5.Q ~ Õ 32 ê :Q 8-fl_mm£mQ’w~ ~ .S .E s M 5.E~Q)(/)8-~>.m&horbar;~tOCt.M:~cijS~~coco&Scaron;LlJfmj &dquo;mlO£0u_C#Cfi.tS3 l~o 0 :’= (/) &dquo;á! e> (ijCI)Z~2=<g.’C U ~ C ’+,0-

95

i

Nm%i

UJz03lw

To

s0cc

9CD»uzulcc«Z)0

(~O <WQ.m =3

j~ayzr-wUJOELU

t:<13z<w«01,wm

<E0

(j)Ui

zjw j Cj CD’2~’E~~?«n#f6U£j§8 #cu @$ CzO::JNO)-e>-C1> ~ .~ ~ ;.g> ~ ’; .S2 -g ,E .QnO , Õ .- >- Õ.g~~Ø~:gECcr~ ° ’o a ~ ~ °QSMcjE o ~~2-o

-6 §’5-~~ ~t?.;; Q) Q) .g ’0; 1;3 ~ >-§2#@ m%l#£e:6-gen~&C«icl£Q’ Q) co .~ Q)f6l£#j -’f@S§.M~.Eg~om%m1 §<w_-1~&dquo;’O~C/).g£cfm.Umj,l6’gom $b >-äiõ Ø10Q) ~ .8 ° .~ := ~ Cmf6WjWOm wg- ’ë ~ ê .~ 15 ~ ~~ N ~ ~ O G7 C>mgv zGWz .r

~~5~~0~~’-’<D-0~~-*-MC-g~á555;Qj~~uf6mmmmo’wClf£ ~!!?’ê 5C(])&dquo;’03:co~....o OÕ ~ ’c - Q) 0 .Q Q)

1##’C8@Qr- -C ~ I~ N ~ ,~..C a 0 ~ fn ~ C a§~~~~.o CO UJ ~ ~ L ~ (~ fh a ~ ’+. > <Ii~S-§~ SO~~r- O r Q - O~ 0 ~ ~~ ~ CO g>

C

v, cJ) o cn -a .t~ C ~ (LS co U co C Q. ~ w U I~ C §1D:õ COc.o e-u ae ~C~O’-’C~UtOS0~~~_.:aQ Q .-O ~ ~ C ~ ~ Q~U&dquo;&dquo;õQ)::Jc:õcoa. N~ c .;; 8 ,Q ~ ~ ~Q)- ==Q)O&dquo;’O fl~ «i ° .$ ’E .... ~ 0cC/)ë-S~Q)oe> O

N Q ~ r U O ~&horbar; S <-’’00-5~ MtOomCEoE.EM..~. tn Q, b9 Q ,r N.... C/) a. (/) c (]) C/)c g) ~-M Q) c ~ MQ)&dquo;&dquo; .CI.!Q»co~s&s~!i&!c -- &dquo;’0 (]) C/) C/) .... C/)!I~~~!sÕ - ~ >- Q) CO .Q> áN ~ r ~ ~ (~ v~w c~ ~ ~ ~ :cUJcoO>(])&dquo;-.c°o-ë ~..-~ á~_-;’~Q i3 9fl’+5&dquo; CLL~(0§g~M-=u..enco8.2~Q)a.c~,‘a >, ~ ~ c ~ U .~ ai °(§.~#~’381 .

g-~<UM50cEg~o-c:~c§.!C~5~’’w<S~!5~c-Qb :;¡’{0~§’SMt=0’0~}fl%§£8#£§8.g-O~g~OLuToQ,:aeE2::J&dquo;’OQ)~o.Qm~i! ~§~~ssJEfS~-gg~~.~cer~&dquo;’O°ae::QQ)£M~Sc i.~-5 &~ae::::-~ ae ~~~ 0:0 CU Cn -p ° ~’ ° ~ O .°ü ae &dquo;8 &dquo;’0 ~ ¡yj ’0; .~ ~00 ~~.~~ ~(/)-ga~ &dquo; ~ m ~ c~g~~~~§:5 ~ .... C/) .-

96

TABLE 7

LITHUANIA BEFORE AND AFTER SETTING UP A CURRENCY BOARD (1 APRIL 1994)

SOURCES: International Monetary Fund, European Bank for Reconstruction and Development,Lehman Brothers.

NOTES: (1 ) For portfolio assets, a negative number indicates an increase in holdings of foreign as-sets by Lithuanians (a net outflow of capital), while a positive number reflects a decrease in holdings.Conversely, for portfolio liabilities, a positive number indicates an increase in holdings of Lithuanianassets by foreigners (a net inflow of capital), and a negative number reflects a decrease in Lithuanianassets held by foreigners. (2) Seigniorage is calculated by multiplying foreign reserves less gold, spe-cial drawing rights, and the country’s net International Monetary Fund position by the long bond yield inthe reserve currency.

This, in part, can be attributed to thefixed exchange rate regimes and themarked reduction in exchange raterisks that accompany a currencyboard system.

The story of Hong Kong providesanother event study. The authoritiesallowed the Hong Kong dollar to floatin November 1974. The floating HongKong dollar became wildly volatile

and steadily lost value against theU.S. dollar. The volatility reachedepic proportions in late September1983, after the fourth round of Sino-British talks on Hong Kong’s future.Financial markets and the HongKong dollar went into tailspins.

At the end of July 1983, the HongKong dollar was trading at HongKong$7.31 to U.S.$1. By Black

97

p0)r~i-rQ«

9m

o

zOEcc

04

,o 0.UJ &dquo;’@a9 sr_

uimmLU

4c0z4cwm0

wm4OE<0-i

3m

(1) CD> U)~5 ~~o ~ ~’g.~ §c,3

L

:E.ae ~s: 0 c:

Z5CtSQ)O)c’a~~~0 =3 cE0

co<0 M ~0 ~~ U Uc ,CtS c: ¡:: 32 ,- 0 (ij 0 0 Q) Q) ....C ) 750 C)5.~.C Q) &dquo;L7 C

~~ ~i(D -0 Q),2.~Q ~ u o-oc: U .- Q) C

C M c U) 0Cc CZ ’n -.0 CD0 5, ~ U)g ~_ ~ U U N f6 -°t5,g:o~~C ~: E .2)0 C 0 g ~irB!C) CM -0 E -0c,g õ c: &dquo;0 .wHiMC U) U) ’C7 CCDQ)8êDC:CO CZ U) (a. 0 cn (n LL n

~~~~>.0 5 c tO

g-,~ ~ ae ~0 C :E tO Q)

LU (Z .0 0ll! q7 L ~ (G ~ ~ ~~ (0 m p~ C C OCD âi .2 ~ Cü0,- (D °èõ .~ 0 ~ 1üC:CDa.Q)Ec U w L UCtS .0 0.... 7Z5EE--Q)~

Q)c:ä5CtSêD....J~~2C:(D -~5) 0 cU- a) 0 0~- ~ ~ 8V E (D~ ~3 ~ § S0 U)

(n -CCo ,0 .S :ae ~o co0 c . 0 ~ ~ a~ v’ s0 0 0c:CtS 0 ~ = .2>

(DLL 0 -o mcocij_en:::5caw:sõ,ae-cU &dquo;T ~ -5~~s~!

.-

g~~U) z E 0

98

TABLE 9

BOSNIA AND HERZEGOVINA BEFORE AND AFTERSETTING UP A CURRENCY BOARD (11 AUGUST 1997)

SOURCES: Central Bank of Bosnia and Herzegovina, International Monetary Fund.NOTES: (1) Interest rate data for 1996 are for April. All interest rates are for the federation only.

(2) Between 1995 and 10 August 1997, the National Bank of Bosnia and Herzegovina (NBBiH) oper-ated and issued a Bosnia-Herzegovina dinar (BHD). That currency was pegged to the German markat BHD = DM 100. During that period, the NBBiH operated as a pseudo-currency board. However,there were some deviations in which credits were issued to the government. Moreover, those creditswere not fully backed by DM assets. On 11 August 1997, the Central Bank of Bosnia and Herzegovina(CBBiH) was established, and the convertible marka (KM) became the unit of account. The CBBiH op-erates under currency board-like rules. On 22 June 1998, the KM notes were put into circulation, andon 9 December 1998, KM coins were put into circulation. On 7 July 1998, the BHD ceased to be legaltender. (3) The last cease-fire agreement in the civil war was signed on 10 October 1995; the Dayton/Paris Treaty that ended the war was initialed in Dayton on 21 November 1995 and signed in Paris on14 December 1995.

Saturday, 24 September, it had fallento Hong Kong$9.55 to U.S.$l, withdealer spreads reported as large asten thousand basis points. HongKong was in a state of panic, withpeople hoarding toilet paper, rice,and cooking oil. The chaos ended

abruptly on 15 October, when HongKong reinstated its currency board.

In the seventeen years since the

currency board, Hong Kong’s GDPgrowth has been positive and strongin all but one year, 1998, the yearafter the Asian crisis engulfed theregion. Annual inflation has comedown from 9.2 percent during thefloating period to an average of 3.7percent during the currency boardperiod. And, the fiscal authoritieshave generated budget surpluses infourteen out of the seventeen years.

THE DEMISE ANDRESURGENCE OFCURRENCY BOARDS

Given the superior performance ofcurrency boards, the obvious ques-tion is, What led to their demise andreplacement by central banks afterWorld War II?The demise of currency boards

resulted from a confluence of threefactors. A choir of influential econo-mists was singing the praises of cen-tral banking’s flexibility and fine-tuning capacities. In addition tochanging intellectual fashions,newly independent states were try-ing to shake off their ties with formerimperial powers, which sometimesincluded chasing away foreigninvestment. And, the InternationalMonetary Fund (IMF) and World

99

Bank, anxious to obtain new clientsand ’jobs for the boys,&dquo; lent theirweight and money to the establish-ment of new central banks. In the

end, the Bank of England providedthe only institutional voice thatfavored currency boards. That was

obviously not enough (Tignor 1998).Why, then, did currency boards

begin to make something of a resur-gence in the 1990s? As someone whoobserved these developments at closerange, I can attest that it had very lit-tle to do with the usual things econo-mists write about currency boards.

Instead, the resurgence was largelymotivated by the desire to install amonetary regime to which the fiscalregime would be subordinated. Byputting the monetary authorities in astraitjacket, currency boards wereviewed as a means to impose fiscaldiscipline. And, as Tables 5 through 9indicate, they have satisfied thatexpectation, a fact acknowledged inthe IMF’s (2001f) most recent editionof the World Economic Outlook: &dquo;a

currency board tends to discouragepersistently large fiscal deficits andthe use of the inflation tax&dquo; (p. 131).The resurgence has not gone

unchallenged, however. Indeed, a cot-tage industry housing passionateopponents of currency boards hasdeveloped over the past decade. Theworks they produce, much like thosein development economics, have beenpromoted by &dquo;the disregard for con-trary opinions&dquo; (Bauer 1976, 231).Indeed, they suffer from parasiticcitation loops in which opponentsexclusively cite other opponents. Asfor the empirical evidence, it is sweptaway like flies. Indeed, the opponentsuse as their method &dquo;nirvana eco-

nomics&dquo; in which the ideal of central

banking is compared to the actualoperation of currency boards.

But, why all this opposition? Themost charitable answer to this phe-nomenon was given by MichaelPolanyi (1958). He wrote that it is&dquo;the normal practice of scientists toignore evidence which appearsincompatible with the accepted sys-tem of scientific knowledge&dquo; (p.138).

Be that as it may, there are a num-ber of objections that were antici-pated and refuted in a chapterdevoted to that task (Hanke andSchuler 1994a). Unfortunately, theseobjections have become little morethan clich6s (Williamson 1995) andmerit comment, once again.The most common clich6 that has

been propagated by the opponents ofcurrency boards is the notion thatcertain preconditions must be satis-fied before currency boards can be

adopted. It was embraced by theCouncil of Economic Advisers (1999),which wrote, &dquo;A currency board is

unlikely to be successful without thesolid fundamentals of adequatereserves, fiscal discipline and astrong and well-managed financialsystem, in addition to the rule of law&dquo;(p. 289).

This statement is literally fantas-tic and demonstrates how far off base

professional economists can getwhen they fail to carefully study thehistory, workings, and results ofalternative real-world institutions.After all, none of the successful cur-rency boards of the 1990s wasinstalled in a country that came closeto satisfying even one of the allegedpreconditions.

100

The second oft-cited criticism of

currency boards asserts that they arerule bound and rigid. Consequently,countries that employ them are moresubject to external shocks than arecountries with central banks. If thiswere true, the variability of growthmeasured by the standard deviationsin growth rates in currency boardcountries would be larger than incentral banking countries. The factsdo not support this thesis (Hanke1999). Indeed, the variability ofgrowth rates between the two sets ofcountries is almost identical. This

suggests that while currency boardcountries are subject to externalshocks, central banking countries aresubject to internal shocks, and theirmagnitudes are almost the same.The currency board shock argumentis, therefore, little more than a strawman.

The inability of a currency boardto extend credit to the banking sys-tem, or what is referred to as thelack of a lender of last resort, consti-tutes a third criticism. As the UnitedNations Conference on Trade and

Development (2001) put it, &dquo;a cur-

rency board regime makes paymentscrises less likely only by makingbank crises more likely&dquo; (p. 117). Thisis another straw man argument. Themajor banking crises in the worldhave all occurred in central bankingcountries in which the lender of lastresort function was practiced withreckless abandon (Frydl 1999). Incontrast, currency board countrieshave not only avoided banking crises,but their banking systems-knowingthey would not be bailed out by alender of last resort-have tended to

strengthen over time. Bulgaria is but

one example. The 1999 Organizationfor Economic Cooperation and Devel-opment (OECD) Economic Survey ofBulgaria stated, &dquo;By mid-1996, theBulgarian banking system was dev-astated, with highly negative networth and extremely low liquidity,and the government no longer hadany resources to keep it afloat&dquo;

(p. 60). However, the OECD alsoobserved, &dquo;By the beginning of 1998,the situation in the commercial

banking sector had essentially stabi-lized, with operating banks, onaggregate, appearing solvent andwell-capitalized&dquo; (p. 59).A fourth clich6 states that compet-

itiveness cannot be maintained afterthe adoption of a currency board.Hong Kong contradicts this conven-tional wisdom. Since its currencyboard was installed in 1983, it hasretained its rank as the most compet-itive economy in the world (Gwart-ney and Lawson 2001). Moreover,countries that adopted currencyboards in the 1990s have maintainedtheir competitiveness measured byexports as a percent of GDP (seeTables 5-8). Argentina is of particu-lar interest because virtually everyreport about the current problems inArgentina contains an assertionabout how the currency board-likesystem has made Argentina uncom-petitive. What nonsense. Exports arethe only bright spot in Argentina’seconomy. Indeed, the value of exportsin the first half of 2001 grew by3.2 percent compared to the firstsix months of 2000 (Dow JonesNewswires 2001).A fifth assertion made by oppo-

nents of currency boards is that theyare desirable only in small, if not tiny,

101

economies. It is true that most cur-

rency boards today are in relativelysmall economies (see Table 1). How-ever, Argentina and Hong Kong arenot small. Indeed, Argentina andHong Kong rank as the seventeenthand twenty-fourth largest economiesin the world, respectively (WorldBank 2001). If the size of Argentina’seconomy is the standard, then 115countries-including every one inAfrica-would qualify for currencyboards because their economies aresmaller than Argentina’s (WorldBank 2001).A sixth concern expressed by econ-

omists is that currency boards arenot suitable for most countriesbecause the prospective currencyboard country is not in an optimumcurrency area with the anchor cur-

rency country. An optimum currencyarea is an artificial construct withinwhich exchange rates should be fixedand between which exchange ratesshould be flexible. The problem isthat the facts on the ground contra-dict the economists’ notion of an opti-mal currency area. For example,Argentines have voluntarily chosento hold most bank deposits and makemost bank loans in dollars, and thevalue of the dollar notes (papermoney) held in Argentina exceedsthe value of the peso notes held.

Therefore, Argentines have them-selves determined that the dollar isthe best currency, no matter what the

optimal currency area theorists haveconcluded.

A seventh argument designed tostir populist ire concerns sovereignty.It is argued that monetary sover-eignty is lost by the adoption of a

currency board. An independentmonetary policy is given up. True.After all, a currency board has nomonetary policy. However, nationalsovereignty over a country’s mone-tary regime is retained. Indeed, his-tory has shown that many countriesthat once had currency boards have

unilaterally exited from those rule-bound systems, albeit to their peril.

In closing, one final comment mer-its attention because it reveals justhow confused and confusing the de-bate about the desirability of a cur-rency boards is. Has the IMF been foror against currency boards? Well, itdepends on when you ask. Lx antethe IMF has generally been opposedand has employed many of the clich6smentioned. The most notable casewas in 1998 when the IMF vehe-

mently opposed the establishment ofa currency board in Indonesia(Hanke 2000b; Culp, Hanke, andMiller 1999). This prompted RobertMundell (cited in IMF 2000b), the1999 Nobel Laureate in Economics,to chastise the IMF at an IMF eco-nomic forum, where he said,

I have been very disappointed in the waythe IMF has treated currency board ar-rangements, by and large. I think theyshould have grasped onto it. After all,let’s suppose that apart from the fact thatthe United States dollar would be at thecenter of this thing, you could imagine aworld of currency boards, where all cen-tral banks operate like currency boards-not currency boards, but currency boardsystems. After all, that’s what the goldstandard was-it was what people nowa-days call a currency board system. That’swhat the adjustment mechanism was. Itwas automatic until countries decided inthe 1930s to go off on independent mone-

102

tary policies; then they got off on thewrong track.

Ex post the IMF has had nothingbut praise for the five currencyboards installed in the 1990s, as wellas Hong Kong’s (IMF 2000a, 2001a,2001b, 2001c, 2001d, 2001e). Accord-ing to the IMF, they have strength-ened fiscal discipline and the bank-ing systems, have motivated reforms,and have been the linchpins forgrowth.

ARGENTINA

Even though one might agree thatthe opponents of currency boardshave ignored the evidence and putforward a wide variety of nonsensicalarguments, the current travails inArgentina might cause one to pausebefore embracing the currency boardidea. Just how did Argentina becomeembroiled in yet another financialturmoil? After all, it has a currencyboard-like system.

Even though Argentina emergedintact from Mexico’s tequila crisis of1995 and its GDP grew by 5.5 percentin 1996 and 8.1 percent in 1997, itseconomy ran into trouble in 1999,after Brazil’s devaluation and beforeits own presidential elections.

The inauguration of Fernando dela Rua as president in December1999 engendered some economicoptimism, but the de la Rua govern-ment was a weak left wing coalition.It quickly proved incapable ofreforming the supply side of the econ-omy and bringing order to Argen-tina’s fiscal affairs. A crisis of confi-dence ensued.

Earlier this year, de la Rua was

forced to appoint Domingo Cavallo ashis economic czar. Cavallo designedArgentina’s unorthodox currencyboard, which killed the country’shyperinflation. But this time around,Cavallo has made missteps that haveworsened Argentina’s predicament.

In June, Cavallo introduced adual-currency regime. Under thissetup, all exports (excluding oil) takeplace with a devalued peso, all

imports with a revalued peso. Allother transactions take place at apeso-dollar rate of 1:1. Then a lawwas passed in which the peso’sanchor will switch from the dollar toa basket of 50 percent euros and 50percent dollars once the euro reachesparity with the dollar.

Not surprisingly, these changeswere viewed by the markets as movesby Argentina to abandon its currencyboard. Interest rates shot up in antic-

ipation of a devaluation.This raises the issue of whether,

and how, to drop an exchange rateregime. Countries that exited frompegged regimes and adopted cur-rency boards in the 1990s have allseen dramatic improvements in theirmacroeconomic indicators. Indeed, ashift from a soft regime to a hard onehas always ended currency crises.But not so with shifts from hard

regimes to soft. Recall Hong Kong’sexit from its currency board inNovember 1974.

Domingo Cavallo should under-stand that merely talking about theidea of abandoning a hard regime inthe middle of a crisis is playing withdynamite. In July, the dynamiteexploded. Military history teachesthe same lessons about the dangers

103

of discussing exit strategies. In hisnew book, Waging Modern War, Gen-eral Wesley Clark showed that everytime the U.S. Department of Defensespoke about exit strategies for U.S.troops in Bosnia, the Bosnian Serbswould intensify their efforts, causingno end of problems for the allies(Clark 2001).

THE WAY FORWARD

What is the way forward for cur-

rency boards? The analytical povertyof nirvana economics must be elimi-nated. Hypothetical ideals are opera-tionally irrelevant. Within the feasi-ble subset of real-world options, therelevant test should be whether analternative can be described that canbe implemented with expected gains.It is this remediableness criterionthat should be adopted.When that criterion is applied,

currency boards stand head andshoulders above central banks for

many developing countries. Just howmany pass the test? According to theWorld Bank, average annual infla-tion has exceeded 10 percent in sixty-one countries with central banks

during the past decade (World Bank2001). As a rough estimate, then,sixty-one new currency boards couldpass the remediableness test.

Indeed, for these countries, centralbanks are an expensive luxury theycan ill afford.

References

Bauer, Peter. 1976. Dissent on develop-ment. Rev. ed. Cambridge, MA: Har-vard University Press.

Central Intelligence Agency (CIA). 1999.U.S. Central Intelligence Agency, CIAworld factbook. Retrieved from http://www. odci.gov/cia/publications/factbook/index.html.

Clark, Wesley. 2001. Waging modern war.New York: PublicAffairs.

Council of Economic Advisers. 1999. Theannual report of the Council of Eco-nomic Advisers. Washington, DC: Gov-ernment Printing Office.

Culp, Christopher L., Steve H. Hanke,and Merton H. Miller. 1999. The casefor an Indonesian currency board.Journal of Applied Corporate Finance11 (4): 57-65.

Dow Jones Newswires. 2001. Argen-tina’s July imports fall 20% on year.31 August.

Frydl, Edward J. 1999. The length andcost of banking crises. IMF workingpaper no. WP/99/30. Washington, DC:International Monetary Fund.

Ghosh, Atish, Anne Marie Gulde, andHolger Wolf. 1998. Currency boards:The ultimate fix? IMF working paperno. WP/98/8. Washington, DC: Inter-national Monetary Fund.

Gwartney, James, and Robert Lawson.2001. Economic freedom of the world:Annual report 2001. Vancouver,British Columbia, Canada: FraserInstitute.

Hanke, Steve H.1996/1997. A field reportfrom Sarajevo and Pale. CentralBanking 12 (3): 36-40.

&mdash;. 1999. Some reflections on cur-

rency boards. In Central banking,monetary policies, and the implica-tions for transition economies, editedby M. Blejer and M. Skreb, 341-66.Boston: Kluwer.

&mdash;. 2000a. Indonesia’s central bank

goes bust. Asian Wall Street Journal,16 February.

&mdash;. 2000b. Reforming the IMF: Les-sons from Indonesia. Central Banking11 (2): 38-44.

104

&mdash;. 2001. IMF early warning shouldstart on the Web. Wall Street Journal,1 May.

Hanke, Steve H., Lars Jonung, and KurtSchuler. 1992. Monetary reform for afree Estonia. Stockholm: SNS Forlag.

&mdash;. 1993. Russian currency and fi-nance. London: Routledge.

Hanke, Steve H., and Kurt Schuler.1991a. Banco central o caja de conver-sion? Buenos Aires, Argentina:Fundacion Republica.

&mdash;. 1991b. Teeth for the Bulgarianlev: A currency board solution. Wash-

ington, DC: International FreedomFoundation.

&mdash;. 1994a. Currency boards for devel-oping countries. San Francisco: Insti-tute for Contemporary Studies.. 1994b. Valiutu Taryba:

Pasiulymai Lietuvai. Vilnius, Lithua-nia : Lietuvos Laisvosios RinkosInstitutas.

Hicks, John. 1967. Critical essays in mon-etary theory. London: Oxford Univer-sity Press.

Horv&aacute;th, Balazs, and Istvan P. Sz&eacute;kely.2001. The role of medium-term fiscalframeworks for transition countries:The case of Bulgaria. IMF working pa-per no. WP/01/11. Washington, DC: In-ternational Monetary Fund.

International Monetary Fund (IMF).2000a. IMF concludes article IV con-sultation with Argentina. Public infor-mation notice no. 00/84. 3 October.

&mdash;. 2000b. One world, one currency:Destination or delusion? Transcript ofeconomic forum, 8 November. Avail-able from www.imf.org.

&mdash;. 2001a. IMF completes finalBosnia and Herzegovina reviews, ap-proves US$18 million credit tranche.News brief no. 01/46. 25 May.

&mdash;. 2001b. IMF concludes article IVconsultation with Bulgaria. Public in-formation notice no. 01/33. 3 April.

&mdash;. 2001c. IMF concludes article IVconsultation with Estonia. Public in-formation notice no. 01/62. 9 July.

&mdash;. 2001d. IMF concludes article IVconsultation with Lithuania. Publicinformation notice no. 01/6.22 January.

&mdash;. 2001e. People’s Republic ofChina&mdash;Hong Kong special adminis-trative region: Selected issues and sta-tistical appendix. IMF country reportno. 01/146. August.

&mdash;. 2001f. World economic outlook.

Washington, DC: International Mone-tary Fund.

James, Harold. 2001. The end of global-ization: Lessons from the Great De-pression. Cambridge, MA: HarvardUniversity Press.

Kenen, Peter B. 1978. The role of mone-tary policy in developing countries. InThe role of monetary policy in develop-ing countries: Theoretical perspectiveand institutional framework, editedby Research Department, CentralBank of Gambia, 9-13. Banjul: CentralBank of Gambia.

Klamer, Arjo. 1989. An accountant amongeconomists: Conversations with SirJohn Hicks. Journal of Economic Per-spectives 3 (4): 167-80.

Marsh, David. 1992. The Bundesbank:The bank that rules Europe. London:Mandarin.

Organization for Economic Cooperationand Development (OECD). 1999.OECD economic surveys: Bulgaria.Paris: Organization for Economic Co-operation and Development.

Polanyi, Michael. 1958. Personal knowl-edge. London: Routledge.

Schuler, Kurt. 1996. Should developingcountries have central banks? Cur-

rency quality and monetary systems in155 countries. IEA research mono-

graph no. 52. London: Institute of Eco-nomic Affairs.

Tignor, Robert L. 1998. Capitalism andnationalism at the end of empire.

105

Princeton, NJ: Princeton UniversityPress.

United Nations Conference on Trade and

Development. 2001. Trade and devel-opment report, 2001. Geneva, Switzer-land : United Nations.

Walters, Alan, and Steve H. Hanke. 1992.Currency boards. In The new Palgravedictionary of money and finance,vol. 1, edited by P. Newman, M. Mil-

gate, and J. Eatwell, 558-61. London:Macmillan.

Williamson, John. 1995. What role forcurrency boards? Washington, DC: In-stitute for International Economics.

Williamson, Oliver E. 1996. The mecha-nisms of governance. New York: Ox-ford University Press.

World Bank. 2001. World development re-port 2000/2001: Attacking poverty.New York: Oxford University Press.