Guest Lecture on Currency Boards
Jude Wanniski
July 28, 2000


To: SSU Students
From: Jude Wanniski
Re: Guest Lecture on Currency Boards

One of my favorite websites, one I visit every day, is, launched only four months ago by Cedric Muhammad, a 29-year-old African-American who is one of the prized pupils of Supply-Side University. Cedric, a member of the Nation of Islam, began visiting this website three years ago after I contacted him regarding a story he had written for the NOI’s Final Call. He was already interested in political economics in general, money and banking topics in particular. He then devoured The Way the World Works and the SSU lessons, regularly participated in TalkShop, and even scraped together the funds to attend some of our client conferences. It all shows in this interview he conducted with Professor Steve Hanke of Johns Hopkins for his July 10 website column, “A Deeper Look.” Hanke, the foremost advocate of currency boards in the world, has probably never experienced as expert an interview with a financial reporter of print or electronic media as he did with Cedric. It’s quite long, but when you finish, you will know all about currency boards and appreciate Cedric’s skills as I do, and make his site a favorite place to visit:

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There are few economists in the world who are more influential than Steve H. Hanke. Hanke, a Professor of Applied Economics at Johns Hopkins University, is one of the few men in the field of economics who actually implements the theories that he teaches to his students. He is best known for his advocacy of currency boards - a monetary regime whereby one nation's local currency is fully backed by foreign reserves and tied, at a fixed rate of exchange, with the currency of another nation, and where the maintenance of this rate of exchange, every single day, is the sole function of the central bank.

Hanke has advised the governments of Argentina, Bosnia, Bulgaria, Estonia, Indonesia, Lithuania and Montenegro on the implementation of currency boards. His advisory relationship with the Indonesian government and its then leader - President Suharto - created the most controversy in Hanke's illustrious career. Hanke's advocacy for a currency board in Indonesia was met with virulent opposition from the International Monetary Fund (IMF). The ensuing tug-of-war between Suharto and Hanke on one side and the IMF and the West on the other, after many years of relative silence, returned the issue of currency stability to international prominence.

In hindsight, it is very difficult to argue that Indonesia is better off by not having taken Hanke's advice - as of last week the Indonesian rupiah was exchanging with the U.S. dollar at the rate of almost 10,000 rupiah to 1 U.S. dollar. That was the exact same exchange rate in 1998 - at the height of Indonesia's currency crisis - when the IMF forced Indonesia to reject Hanke's currency board plan. Since 1998, Hanke has aggressively advocated that developing countries discontinue the use of their badly inflated currencies in favor of using the currencies of more economically developed countries, such as the U.S. dollar or Germany's deutsche mark. Though any major foreign currency could be used to replace a weak local national currency, the process is popularly known as "dollarization". In 1999 Hanke successfully advised the nation of Montenegro in the implementation of this process. Last year, Montenegro made the German mark legal tender.

Prof. Hanke recently spoke to about his unique philosophy, the impact of his ideas, their possible application in Africa and his combative relationship with the IMF. For the first time in public and only at, Prof. Hanke proposes that the country of Zimbabwe should "dollarize" in an effort to solve its currency woes. Here are excerpts from our exclusive interview.

CM (Cedric Muhammad): What exactly is the main problem, in a nutshell, that you have with the International Monetary Fund (IMF)?

Prof. Hanke: The main problem in a nutshell, is that I think the IMF policies, in general, have caused more damage than they have provided benefit. A lot of their policies are just wrong-headed as a matter of economic principles. This is point number one. Point number two is that almost by definition the IMF has to meddle into the internal politics of countries that are its clients. I have a real problem with that. When you go in and look at a country the key thing of course, in any government's plan, is its budget. You can't have a plan or policies or programs unless you have a budget. And the IMF, of course, is always involved with the budget and the problem with the IMF is that they are interested mainly in intermediating or channeling more savings through the public sector than in the private sector. And I am interested in reducing the amount of savings that gets channeled through the public sector because it is a black hole in most places...a waste of money. If you put a dollar into the government, they grind it up and it comes out and you get something worth about ten cents in value. If you intermediate savings in the private sector, you know that the private sector is going to do it on a profit and loss basis - if you put a dollar in, you know you better get more than a dollar out or the business goes down the tubes and isn't viable. So I would prefer to see more and more savings channeled through the private sector and let private entrepreneurs decide what to do with it, rather than more and more be channeled through the public sector with government bureaucrats deciding what to do (or their cronies in most cases) ...This problem is endemic in Africa. There, most of the money goes to buy weapons. Another share of the money lines the pockets of some autocrat who is running the place and the money goes into some Swiss bank account or Liechtenstein bank account or in real estate in the South of France. The rest goes to the autocrat's cronies. So as far as people go, people don't see any of this money that goes in from the IMF, the World Bank and other multinational organizations who are putting money into these places. The normal people don't get the money, especially the poor people. If you look at the poorest of the poor, they are always nomads or aboriginal type of people and they don't see a penny of any of this - it never even gets close to them. That is one reason why I am generally against these transfers going from essentially middle-class tax payers in the West to the richest of the rich in the underdeveloped countries.

CM: There exists confusion in many circles over exactly what happened in 1998 between you, the IMF and Indonesia. Obviously the IMF was resistant to your idea that Indonesia should enact a currency board but, to me, it appeared to be even more so than the usual resistance that the IMF provides for people who have differing points of view or opposing economic philosophies. Did you in any way feel that there was something special about the manner in which they (the IMF) opposed you?

Prof. Hanke: It was special in the sense that the specific institution that they were upset about was the currency board. I wanted to put a currency board in because Indonesia had to stabilize the rupiah - it had virtually collapsed by the time I arrived in early February of 1998. And inflation was breaking out and it was clear that they were going to have social unrest and everything else that goes with a collapsing currency and very high rates of inflation. Incidentally, the effects of these higher prices and inflation were disproportionately felt by the very poor. We have done work (research) on this, and the poor, particularly the very poor in urban areas, were getting really clobbered by inflation. It was kind of like a deadly cocktail: these high prices with the big burden of it going on the backs of the poorest people, particularly in urban areas. So that is pretty much the way Suharto saw it too (President Suharto - the President of Indonesia at the time) when I first met him and he first diagnosed the situation and said, "Look, we have to stabilize the currency at a reasonable level or else we are going to have all kinds of unrest and instability and God only knows what else is going to happen". And he said to me " I understand that you have some way to do this...I understand that you have stabilized currencies in the past." And I said, " Well I think the currency board would probably work but I have to check the whole thing out and evaluate it and so forth". In the meantime, the IMF and the West, in general, with the U.S. leading the pack, had another view. It was a pretty unified force with some exceptions, Australia, Singapore and Malaysia quite obviously weren't on board. The ones neighboring Indonesia - were a little bit reluctant to follow the IMF recommendations. But everybody else - Germany and all of the Europeans, all of the G-7 came down on a currency board pretty hard...they did not want the currency stabilized because they wanted currency chaos to reign because their objective was really getting rid of Suharto. And this gets into the political meddling part. The proof of that is that in 1997 for example, in Bulgaria where I am the advisor to President Stoyanov, we put in a currency board in July precisely because the West almost demanded it because they wanted to stabilize the situation. And they knew that currency boards always work. There has never been one that has failed. And also in another situation, in the Balkans, in Bosnia in 1998 they put in a currency board because it was mandated in the Dayton Accords. So we had an international treaty that said, "You must have a currency board or you are not going to get any aid."

CM: This is what Secretary Albright advocated?

Prof. Hanke: was in the Dayton agreement and written that they must do this...Then you had Suharto come along and everybody is against currency boards all of a sudden. But then in August 1998 the Russian ruble collapsed and of course (The West) wanted to keep Yeltsin (in power). So the IMF told the Russians, "If you want to put in a currency board we are not going to oppose a currency board." Then, it turns out that the Russians didn't want a currency board.

And now we have evolved a close cousin of a currency board - dollarization or the use of another foreign currency instead of a local currency. In September of 1999 the Deutsch Mark was officially made the legal tender in Kosovo. In November (of 1999) in Montenegro where I am the President's advisor we legalized the Deutsch Mark. And in January of 2000, in East Timor, which really is a UN protectorate of sorts now, the U.S. dollar has become the official currency. East Timor was part of Indonesia but it broke off and has made the U.S. dollar its currency. In March of 2000, the Ecuadorians decided to dollarize (make the U.S. dollar their official currency). So we have evidence before Indonesia and after Indonesia that either currency boards or dollarization (or using another foreign currency) is perfectly acceptable. The whole thing in Indonesia, again, was politically motivated. It did not have anything to do with the currency board directly… indirectly it did because they knew (the West) that if the currency got stabilized it would be very difficult to get Suharto removed. That was the truth behind the story there.

CM: Do you think that it was possible that the IMF was the institution on the point for intelligence agencies or whomever wanted Suharto out of power? Because I am pretty sure that it wasn't just the IMF that would have wanted him out.

Prof. Hanke: Well I think that the IMF was basically the stalking horse for the Clinton administration's policy vis a vis Indonesia. But it wasn't only the United States. As far as I am aware, all of the G-7 were on board and the Prime Minister Hashimoto of Japan (at the time) came down when I was there. The Finance Minister of Germany also came down. All of the heavy weights were going to Jakarta (capital of Indonesia). President Clinton even sent former vice-president Mondale to Jakarta as a special envoy during the period of time that I was working with Suharto.

Suharto had embraced the currency board idea. He gave a "state of the state" speech. We called it "IMF-plus" because he was going to do everything the IMF wanted him to do plus add a currency board on top of it because he knew he couldn't do anything unless he stabilized the currency first. So, it was a great thing for the currency board cause and stable-money cause and the dollarization movement in the sense that it put a big spotlight on it. Before then, currency boards were an obscure thing that had been done in five or six countries in the 1990s but no one exactly knew what it was all about and no one had even heard of a currency board except a few specialists. Some of the British also knew about them because they were essentially a kind-of British institution. Some Africans knew about them because there were lots of them in Africa. Finally, some in the Caribbean knew about them because there were a lot currency boards in the Caribbean area. But generally, if you take American main-line economists before about 1990 you could only find a handful of them who knew about currency boards.

CM: Aren't there variations among the group of you that advocate currency boards, for instance, is there any distinction between the currency board that you advocated in Indonesia and the one that currently exists in Hong Kong?

Prof. Hanke: Well, there are a variety of distinctions, I have always advocated an orthodox-kind of currency board...I discovered, [ through research], that John Maynard Keynes, in 1918, set up the North Russia Currency Board and that was an orthodox currency board. It was a traditional, classical type of currency board which means that the currency board issues local money, the local money is fully backed by some foreign anchor currency reserves and the local money trades at an absolutely fixed rate with the anchor currency. This means that you have 1) a local money - notes and coins 2) that you are always making a profit off the issuance of this money. The local currency doesn't pay any interest and is fully backed with, if it were dollars, bonds denominated in U.S. dollars issued by the U.S. government. You earn interest on the assets backing the monetary liabilities that don't pay any interest on the local notes that circulate. That interest rate spread generates profits for the currency board.

CM: So it is not so much cash reserves as it is bonds that the local country is concerned with...

Prof. Hanke: The rule is that you keep between 110% and 115% in foreign currency reserves and most of that would be in short-term treasury bills. And the currency board doesn't have any other function. I mean, it doesn't regulate commercial bank reserves or anything like that. The amount of money circulating in the economy is a function of the balance of payments. It is very close to dollarization. Dollarization is exactly the same as an orthodox currency board with two exceptions. 1) you don't have a local note circulating around; 2) you don't make money off of the issuance of the notes because the notes are produced by some other central bank and that other central bank is making money [in the process]. The current dollarization bill by Senator (Connie) Mack (R-Fl.) in the U.S. Senate would correct that. If the Mack dollarization bill passed then if a country says, " I want to get rid of my local junk currency and use the dollar as legal tender", then up to 85% of the profits that the Federal Reserve makes on the issuance of those dollars could potentially be transferred to the country that decided to dollarize. So it makes dollarization much more attractive (for that local country). It is about the only form of foreign aid that I've ever thought makes any sense.

CM: You and I spoke recently and I posed the question to you of Zimbabwe going to a currency board and you suggested that dollarization may be more appropriate than a currency board. Why?

Prof. Hanke: The reason that dollarization is easier, in a way, than the currency board, is that dollarization really gets rid of all of the apparatus (associated with) a central bank - you don't need anything to dollarize because the central banking function is something that is really handled by the Federal Reserve. So I like it, particularly in a place like Zimbabwe that is completely corrupt with no rule of law at all. That is why I recommended that Montenegro go to the use of the Deutsche Mark. I originally said that I thought it would be good for Montenegro to go to a currency board, it would be good because then they would make a profit on it - the government does. The advantage to having a currency board now, absent Sen. Mack's dollarization bill, is that you make money on the currency. A currency board always makes a profit. And in a lot of these countries the government is strapped for money. So it is something that you have to consider. If you don't have a currency board then you don't make the money - the Federal Reserve makes all of the money...What I think you should do in a place like Zimbabwe are make several reforms… Specifically, you should dollarize, so you get rid of exchange rate crises - you get sound money right away. And in the banking sector, I am recommending that any bank that takes deposits in from customers must have 100% liquid reserves backing them up. Now, what will a bank be? A bank will be like a money market mutual fund. A money market mutual fund has 100% liquid reserves backing up your assets. And you can take your money out of a money market mutual fund without any fear that there is going to be a bank panic or anything like that.

You have to understand this when it comes to currencies: stability might not be everything but everything is nothing without stability. So, they have a junk currency in Zimbabwe. It has certainly been junk during the Mugabe period. They have to stabilize that situation if they are going to have any kind of economic reform program, if they are going to have a big increase in economic freedom, if they are going to have economic growth and if they are going to have a more equal distribution of income. Now, Zimbabwe literally has everything wrong with it. They would have a terrible economic freedom score, they would have a terrible civil liberties score...they are at the bottom of the barrel in everything. And so I would start with dollarization and then move on to the banks. I would make them run like they were money market mutual funds - any deposit-taking bank would have to have 100% liquid reserves or they couldn't take deposits. Now, why do you do that? You don't have bank panics in a money market mutual fund. Why? Because everyone knows that by law they have to have 100% backing in liquid reserves to back up your deposits. So any time you write a check on your money market mutual fund you know your money is there. That stops bank panics. Then you ask, "Well how are they going to get credit in a place like Zimbabwe?" Well you would have merchant banks supply that. Merchant banks get their savings that they loan credit on from equity or debentures.

CM: Would these merchant banks be both domestic and international?

Prof. Hanke: Yes, you have got to have the same rules of entry for foreign banks and domestic banks. In other words, you can't have the cronies running a bunch of banks and then not letting Deutsche Bank in or Citibank or some foreign bank. You have to have everyone playing by the same rules. And in fact, in the old currency board days in Africa, they had sound money because they had currency boards, most of those were tied to the British pound sterling and also you had most of the banks - they (Africa) had high quality banks because most banks in Africa were branches of London-based banks. So money and banking in Africa really wasn't a problem until the independence movement started and they unfortunately threw the baby out with the bath water. They wanted any vestiges of the imperial powers of colonialism out. The IMF, by the way, played a nasty role in this process because of course, the IMF wanted jobs for the "boys" so the best way you have jobs for the "boys" is to have them set up an independent central bank, then they need all kinds of technical assistance and advice, money and everything else under the sun. And so the IMF was in there fighting, literally, the Bank of England. The Bank of England wanted currency boards retained in most of these places that became independent countries (in Africa).

CM: Actually there are two arguments that I have heard on drawbacks to dollarization and more importantly currency boards. One of these arguments has been raised by Economist Jude Wanniski who definitely agrees with you on the importance of currency stability but he stresses that countries who adopt a currency board are unable to protect themselves from importing the monetary policy errors of the country whose currency they are tied to. They are unable to protect themselves from importing an inflation or deflation of another country...

Prof. Hanke: Yes, there are two points here and this gets into sovereignty. But first let me back up here. Note that none of these underdeveloped countries have even an average quality money. Most of it is a complete disaster. It is really junk currency. So to say that somehow you are worried that the Fed isn't going to do the right thing is just ridiculous. Comparing the South African Rand to any one of the G-7 monies, for example - the euro, the yen, the dollar - whatever you think of them - they are fiat (paper) monies; they aren't backed by any metals or anything like that; but they are far better then the currencies of any of the developing countries. Secondly, addressing this issue of sovereignty, some people say, " Well you would be giving up your sovereignty if you dollarize the country. You wouldn't have your own money; therefore, you would be dependent on the Federal Reserve and the United States is going to jerk you around and so on..." This is only partially true. You would give up your monetary sovereignty if you actually formed a formal monetary union with the United States and you had a treaty arrangement that didn't give you an exit strategy.

What you want, is to do the dollarization unilaterally, not bilaterally under a formal treaty. Have it in a competitive currency regime and don't have a local national money - allow any foreign money to be legally used in the country. So if you have that regime and the dollar goes south on you, then you have consumer sovereignty. So if you are in Zimbabwe and you start with the U.S. dollar and for some reason tobacco farmers and businessmen and other people don't like the U.S. dollar, they are not forced to use it. They may decide to use the South African rand, the euro or the Swiss franc...if you don't enter a formal monetary union with another country, you maintain your sovereignty. This leaves you with Hayek's competitive currency regime where the consumer decides what money he is going to use. The only thing the local government would do is say, “The local government isn't going to produce money.” Currently, in some places like Zimbabwe where you have exchange controls, it is almost like holding a gun to somebody's head and saying, "We are producing this money and you must use this money." What I am saying is that the government would decide not to produce money nationally anymore. It has been a complete unmitigated disaster that has robbed the people of not only their wealth but their economic stability and possibilities for growth. The government should allow the people to use anything they want (for money).

CM: Do you think these merchant banks would be able to supply the same amount of liquidity as commercial banks currently do...or even more?

Prof. Hanke: I think they would provide a lot more. Because now what do commercial banks do in underdeveloped countries? They are really arms of the government. They are almost a part of the finance ministries. The finance ministries sell bonds...the savings that goes into a local bank in an underdeveloped country goes into buying government bonds. Why? The government comes in with a pistol against a banker's head and says, "You have to buy these government bonds". That is the stick - the order to buy the government bonds. The carrot is that the returns are usually very juicy too. It is an incestuous relationship. The bankers are usually the cronies in bed with the guys who are running the place anyway. What you end up with (under my system) is more savings. If you look at some place like Africa at around the 1900s before the first World War, the banking system in Africa was very sophisticated. It certainly wasn't corrupt and they weren't plagued with currency crisis and banking crisis, inflation, bad money and everything else. What I am suggesting is going back to the kind of arrangements that they had that worked very well 100 years ago.

CM: What would be the worst case scenario for a country that is on a currency board or which has dollarized or which uses a foreign currency as its own? Under what circumstances would they be better off not using dollars or a foreign currency in their country?

Prof. Hanke: Well, a perfect example is Hong Kong. Hong Kong had a currency board with the pound sterling as its anchor currency. However, the pound sterling after World War II, and really after the first World War, began to become a second-rate currency. Hong Kong then abandoned it. It just turned out to be a disaster and by 1983 everything was going under. They really went from the frying pan into the fire because they let their currency float. Finally in '83 they put the currency board back in with the U.S. dollar as the anchor, and it worked well. See, the key under a currency board is to have rules that automatically kick in if the anchor currency is bad. These rules would then automatically switch anchors to something else. With a competitive currency regime, the consumers would automatically switch.

CM: Is there anything that the dollar can be anchored to that would be better than itself?

Prof. Hanke: I think that in this competitive currency regime that I have put forward, what you are going to have, I think, are things that are just starting like e-money (electronic money) where you will have private issuers of the various kinds of money that will be backed by various commodities or baskets of services. So I think the situation is changing in such a way that we are already getting, essentially, different kinds of money evolving. If people want to have gold-backed currencies or silver or copper, there will be a market for it. I don't anticipate that there will be a big boom in it but with electronic money and the new technology we have, it makes it all easier. In effect, you will have Citibank money or Solomon Brothers money and if you want to redeem that into whatever the base is, then you will be able to do it.

CM: Are we going back to the days of free banking? In the sense that today there are speculators and banks that are more wealthy than entire nations; so the thought occurred to me as you were talking, of whether, one day, there may be a Citibank or J.P. Morgan currency (or a George Soros currency).

Prof. Hanke: This is coming... and that is why, for one reason, if a country decided to dollarize or even have a currency board, they should do it in a unilateral way with no treaty so that they maintain their sovereignty. They also should do it in a competitive regime so that the people are free to use any kind of money that they want except (a local national money). If you have dollarization, you don't have a national money. The main thing is to get rid of these crummy central banks and the junk money that they have and let the people use anything that they want. If I was in Zimbabwe I would prefer using U.S. dollars or maybe euros. If, however, you were in a business situation where you were doing all of your trade with South Africa and you wanted to keep your books in South African rand, under my scheme it would be perfectly legal. It would also be perfectly legal if Citibank started issuing money that was backed 100% by gold. That keeps the flexibility and consumer sovereignty.