The dramatic events in Asia, Russia and Brazil have generated a torrent of comment about exchange rates, hot money, exchange controls, currency boards, “dollarization” and the need for a new global financial architecture, most of it half-baked or dead wrong. Let’s try to unravel the good from the bad.
Follow Friedman
If only developing countries could produce sound money, hot money would cool down and become less volatile. Exchange-rate crises of the type that have battered emerging markets during the past two years would find their way into the dustbin. In his 1972 Horwitz Lectures, Nobel prize-winner Milton Friedman presented a clear diagnosis of the currency problem facing developing countries and a correct prescription.
Friedman concluded that any developing country with a central bank was doomed. He recommended dumping central banking and either unifying a national currency with a strong currency via an orthodox currency board system or via official “dollarization”.
The evidence supports Friedman. I recently evaluated data from 98 developing countries during the period 1950 to 1993. The countries were separated into two groups: those with central banks and those that were either operating with currency boards or were dollarized. The former group had the capacity to engage in discretionary monetary policy; the latter group did not. Countries without central banks had average GDP per capita growth rates that were 54% higher than growth rates in countries with central banks. Moreover, the variability of those growth rates (as measured by their standard deviations) was virtually identical, indicating that the lack of discretionary monetary policy resulted in no greater incidence of or vulnerability to economic shocks. As for inflation, the performance of countries with central banks was also inferior, with average inflation rates being 4.9 times higher and 4.2 times more variable than in countries without central banks. Budget deficits were on average 65% higher in the central-banking countries.
As we enter the 21st century, we can either follow the advice of the wags in Washington or follow professor Friedman. If we listen to the wags, we run the risk of more monetary nationalism and the type of chaos the world encountered after World War I. The alternative is for developing countries to unify their currencies with stronger ones. This can be accomplished by either establishing a currency board or by replacing a national currency with a strong foreign currency (official dollarization).
An orthodox currency board is a monetary institution that issues notes and coins. These notes and coins are backed with a minimum of 100% (up to a maximum of 110%) of foreign reserve currency, and they are fully convertible into the reserve currency at a fixed exchange rate on demand. In addition, an orthodox currency board cannot act as a lender of last resort, does not regulate reserve requirements for commercial banks, earns seigniorage only from interest on reserves and does not engage in forward exchange transactions.
Hong Kong’s currency board and those established in the 1990s all deviate in important respects from orthodoxy. Although these currency board systems have performed well something even the sceptics have admitted this they are not trouble-free. For example, even though Argentina weathered the storms of 1995, the spread between interest rates on Argentine 30-day loans in pesos and dollars has varied between 0.5% and 4.4% during the past year. If the peso-dollar fixed exchange rate was fully credible, these spreads would have been close to zero. The peso-dollar interest rate spreads are not zero because the Argentine currency board system deviates from orthodoxy. It engages in lender-of-last-resort activities; it regulates reserve requirements for commercial banks; and up to one-third of the dollar-denominated reserves, which it holds to back its monetary liabilities, can be held in the form of bonds issued by the government.
Peso-dollar swap
To make Argentina’s currency unification with the dollar perfect, president Carlos Menem has suggested that Argentina replace the peso with the dollar. This official dollarization would eliminate the peso-dollar interest-rate spreads. In addition, peso notes would no longer circulate and Argentina would no longer earn seigniorage from its currency board (about 0.22% of GDP). Argentina could easily implement official dollarization by exchanging its dollar reserves for outstanding peso notes and coins and by declaring that all peso prices, assets and liabilities in Argentina be denominated in dollars.
The major benefit of dollarization would be reduced interest rates in Argentina. With no peso-dollar exchange rate, currency risk would be eliminated and the spread in interest rates between pesos and dollars for loans within Argentina would be eliminated. In consequence, Argentina’s trend rate of growth would be higher with dollarization than with its currency board-like system. A government memorandum estimates that lower interest rates resulting from dollarization would add 2% to Argentina’s annual growth rate. Argentina would be an investor’s paradise.
At least 120 countries have officially used the currency of another country at some time. The best-known today is Panama, which has been dollarized since 1904. However, there are 27 other countries and dependent territories that currently don’t have a national currency and use a foreign one instead. If Menem has his way, Argentina will be added to this list.
On February 10 I presented Menem with A dollarization blueprint for Argentina, which I co-authored with monetary economist Kurt Schuler. We recommended unilateral dollarization for Argentina. This would require Argentina to dump its central bank and the peso. All other currencies would be given legal-tender status.
This liberal form of dollarization would allow Argentina to retain its political sovereignty on money matters, as it wouldn’t have to answer to the US, something a monetary treaty would require. And, more important, it would allow consumers to freely exercise their sovereignty. Given president Menem’s record for delivering on economic reforms, odds favour a competitive currency regime in Argentina before the president’s current term expires in December.
Steve H Hanke is professor of applied economics at Johns Hopkins University in Baltimore and president of Toronto Trust Argentina
