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The Case Against Currency Boards

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The Case Against Currency Boards: Debunking 10 Myths about the Benefits of Currency Boards by Nouriel Roubini
There is currently a broad debate among economists and policy makers about the benefits and costs of currency boards (CB). In recent times, they have been adopted by countries such as Hong Kong (1983), Argentina (1991), Estonia (1992), Lithuania (1994) and Bulgaria (1997). Also, a number of Asian countries (Indonesia in particular, but also Thailand and Malaysia) are considering adopting a currency board system. The talk of currency boards is also widespread in Latin America where countries such as Venezuela, Brazil and Mexico are considering whether to follow the successful experience of Argentina. I will argue that, in spite of their current popularity, currency boards are overall a very bad policy idea. What matters for an economy is to have stable, sensible and credible economic policies, not a currency board. We will present the arguments against currency boards by considering 10 myths about the alleged benefits of currency boards. Our analysis analysis will suggest that the case for currency boards is very weak and the experience with them a mixed bag. There are countries in which they seem to work for a while; however, these countries are successful not because of the CB system itself but rather because they follow macroeconomic policies and structural liberalization policies that are consistent with the maintenance of fixed rates. Fixed rates and currency boards without these good policies lead to currency collapse and economic disaster. Conversely, if you do follow the right economic policies you do not need a currency board: you will do as well without one and adopting one may only hurt you when truly exogenous shocks require an adjustment of your nominal exchange rate parity. There are of course some marginal benefits of CB that one can point to: short-run credibility when you start from an hyperinflation (like in Argentina), stronger incentives not to monetize and run budget deficits under some conditions. But those are all results that a country can achieve without a CB and therefore avoid the other costs of having one. While these days CBs are being proposed as the Holy Grail that will cure every ill and give bliss to a country, their shortcomings are serious and their adoption may actually harm a country rather than improve its economic long-run performance. Let us then consider the arguments, or myths, about currency boards in more detail. Myth 1. Speculative attacks against a currency do not occur in a currency board system because you are credibly committed to fixed exchange rates. One of the main myths about CBs is that speculative attacks against a currency cannot occur in a currency board because you are committed fixed exchange rates. The empirical truth is that CBs do not prevent speculative attacks on a currency. The fact that currency boards do not prevent speculative attacks is evident from the recent experience of Argentina and Hong Kong (HK). As the Mexican peso collapsed in 1994 and the Asian currencies collapsed in 1997, the currencies of Argentina (in 1995) and HK (in 1997) were also subject to speculative attacks. While it is true that these currencies did not collapse (so far), these attacks had very large economic costs. Since the attack implied that investors perceived that the probability of devaluation was positive and high, the monetary authorities of these countries had to cut the money supply (as a capital outflows leads to an automatic cut in the monetary base in a mechanical CB) and increase dramatically the domestic interest rates (as high as 20% in real terms in both countries). This huge increase in interest rates pushed Argentina in a severe recession in 1995 with output collapsing 6% and unemployment rising to 18%. In the rhetoric of the defenders of a currency board, an attack should never occur and therefore domestic interest rates should remain at the level of the country to which you peg (i.e. 5% as they both peg to the US dollar). That turned out to be false and the expectation of a devaluation forced the monetary authorities to sharply increase interest rates. Since a CB does not mean that a devaluation will not occur (it is just a more strict form of fixed
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exchange rates), the possibility of a devaluation implies that when an attack occurs, the domestic authorities have to push up interest rates to credibly show that they are committed to the peg parity. These high interest rates can bankrupt domestic banks, domestic firms and lead to a big recession. It happened in Argentina in 1995 and it will happen in HK this year: high interest rates are already destroying growth in HK in 1998. Compare instead the behavior of HK with that of Taiwan and Singapore who did not have a CB an let their fixed parity to the US$ to be abandoned when their currencies were attacked: their currencies devalued somewhat but they avoided a bigger crisis. Growth in Taiwan and Singapore will be better than in HK this year as they did not have to increase interest rates as much and their real exchange rate was allowed to depreciate. Myth 2. Currency boards are good for the stability of the banking and financial system The reality is opposite: a monetary tightening and interest rates increase when a CB is subject to a speculative attack can bankrupt the domestic financial system and the domestic banks; tight base money mans that, given required reserve ratios, banks are forced to recall loans and firms are going to go bankrupt. This is why it is very dangerous to introduce a CB in a country like Indonesia right now when a major financial crisis is occurring and banks are on the verge of collapse even without a CB. Everything else equal, the fragility of the banking system is an important factor to consider when deciding whether to introduce a CB: the weaker the banks the more dangerous a CB. The concern with the collapse of the banking system is also the reason why a CB is often implemented with some degree of cheating. When Argentina came under attack in 1995 the rules of a strict CB should have force the country to reduce the monetary base by an amount equal to the large capital outflow. Since this mechanical CB would have led, through the money multiplier in the banking system, to a sharp contraction of bank loans and deposits and banking collapse, the monetary authorities cheated: they cut the monetary base but then they significantly reduced the required reserve ratios of the banks to avoid a sharp fall in the money supply, loans and deposit. This is not what a CB should be and, therefore, during an emergency the role of lender of last resort of the central banks, that should have been eliminated by the CB, was restored. One should certainly approve the Argentinean policy of easing the monetary tightening by changing reserve ratios: the alternative would have been even higher real rates, banking collapse and a even bigger recession than the one that occurred with the monetary squeeze in 1995. However, the Argentinean easing of the reserve ratios proves the point: a true CB does not work because if you let it work as it should, when there is an attack the country and its banking system would go bankrupt. Some role of lender of last resort is always useful to have and a strict CB would eliminate such a role and cause more harm than good when a financial crisis is occurring. Myth 3. Fixed exchange rate regimes, and CBs in particular, work better than more flexible exchange rate regimes The experience of the 1990s suggests that rigidly fixed exchange rate are the cause of currency crisis, not flexible exchange rates. Currencies collapse when they are fixed for too long to parities that are not consistent with the equilibrium fundamental value of a currency. The ERM crisis in 1992-93, the Mexican peso crisis and Tequila effect in 1994-95 and the Asian of 1997-98 were caused by the fact that the countries were on a fixed exchange rate system, not because flexible exchange rate systems. People forget that the big currency crises of the 1990s occur with fixed rate regimes (a close cousin of currency boards), not under more flexible exchange rate regimes. The lessons of Latin America (see Chile) is that you should avoid the real appreciation often associated with fixed exchange rates (or CB's) : you should rather target the real exchange rate and introduce capital controls on inflows to avoid hot money capital flow leading to nominal and real appreciation of your currency and competitiveness loss. A CB, like most fixed rate regimes, is just a recipe for disaster: in the short-run things look good until the regime collapses with major real economic costs. One should also observe that the historical experience with dozen of CB's experiences suggests almost all CB's eventually collapse or are phased out (this is what Lithuania and Estonia are trying to do now after mistakenly opting for a CB in the early 1990s). Myth 4. Currency board are good for countries exporting world commodities priced in foreign currency because such countries cannot use the exchange rate to affect their real exchange rate

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This argument is made in countries such as Venezuela where some political groups are currently recommending the adoption of a currency board. The argument is that in a country such as Venezuela most exports are oil and other primary commodities whose prices cannot be affected by a devaluation. It is true that in the case of a country where a large fraction of exports are set in world markets, the ability to use the exchange rate to lead to a real devaluation that stimulates exports is limited. However, even limited exchange rate flexibility may be useful. In fact, the country also produces and sell non-traditional and non-oil manufactured exports whose demand depends on the nominal and real exchange rate. As Dutch disease phenomenon has already hurt these non-oil exports, you do not need to make things worse by adopting a CB that will lead to even more real appreciation and loss of competitiveness in these goods. Also, since such a country is always going to be subject to terms of trade shocks that negatively affect demand and growth, some exchange rate flexibility is necessary. For example, Texas has a CB (or more precisely a monetary union with the rest of the US). When the price of oil collapsed in the mid 1980s, oil-producing states such as Texas (and Louisiana) went into a deep recession. Suppose that Texas had had its own Texas dollar; then nominal and real depreciation of the Texas dollar relative to the US would have reduced the recessionary effect of a fall in the price of oil. Since your terms of trade are dominated by oil, a fixed exchange rate relative to the US is not optimal: i.e. Venezuela and US do not make an optimal currency union as their economies and the shocks to their productivities are completely different and there is not enough factor mobility across these two countries. There is no good reason to have a fixed parity to the US (either in the form of fixed rates or in the form of a CB or in the form of a monetary union) for a country with large exports of primary commodities subject to large terms of trade shocks. When a shock to the terms of trade occurs, the market will attack this country as the equilibrium nominal parity becomes lower; then the country will either not be able to survive the attack even if they had a CB or will survive the attack paying a larger costs in terms of output loss. Also, in the case of Latin America, there is some likelihood that fixed rate parities in Latin America may collapse in the near future. The Brazilian currency is misaligned in real terms and a major devaluation may occur (especially after the current president is reelected). If the Brazilian currency falls, the Argentinean peso CB will collapse too. At that point, any other country in Latin America considering the adoption (such as Venezuela) and implementing a currency board will be in trouble and be attacked too. More in general, in any country with large exports of primary goods, a CB is a bad idea. The high volatility of the terms of trade and the high dependence of the economy on primary exports requires a central bank that is able to sterilize capital flows. A currency board would introduce such large fluctuations in the monetary base of the economy that would have a deeply destabilizing influence. At least in the case of Texas one could make the arguments that Texas and the rest of the US satisfy the conditions for an optimal currency union: while their productivity shocks are not synchronized, at least, the degree of labor of capital mobility between Texas and the rest of the US is very large. As the negative oil shock hit Texas, people and capital left Texas for other states and this dampened the real effect of the shock; high capital and labor mobility helps the adjustment to a terms of trade shocks. The same cannot be said of other countries considering a currency board with parities pegged to the US dollar. They cannot respond to a large terms of trade shocks by sending their workers to the US. Myth 5. Currency boards are better than monetary unions The argument for a CB over a monetary union is based on the argument that a country would lose seigniorage revenues (a source of revenue for the government) by giving up its domestic currency. However, under a CB system, the seigniorage that a country can collect is close to zero as monetary growth is very limited and the monetary is very small (relative to GDP) in economies with a developed financial system. If a country really wants to have truly credible fixed exchange rates, it might as well give up altogether its national currency ad go the extra step: form a monetary union. In the case of your country, this would be mean forming a monetary union with the US. A monetary union is much more credible than a currency board. Myth 6. Currency boards avoid destabilizing international capital flows. The contrary appears to be the case. Large capital inflows (in optimistic periods) or outflows (like in Argentina and Hong Kong) when a speculative attack occurs so occur regardless of whether a country has a currency board or not. However, a CB makes the task of managing these destabilizing capital flows much harder. In fact, a currency board introduces very large fluctuations in the monetary base of the economy that can have a deeply destabilizing influence. In a currency board the central bank is not allowed to sterilize the effects of large capital flows on the
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monetary base and this is destabilizing: when capital flows out, base money falls, interest rates are forced to dramatically increase, the banking system comes under strain and a major recession may ensue. Conversely, when there are large capital inflows, the central bank is not allowed to sterilize their effects on the money supply. Excessive monetary growth then may lead to overheating and higher inflation.

Myth 7. Currency boards prevent real appreciations and loss of competitiveness This is a myth because the empirical evidence suggest the contrary: fixed exchange rate regimes, and currency boards in particular, are associated with real exchange rate appreciation, loss of competitiveness, worsening of the trade balance and current account. That is why CBs end up to be subject to attack and they often collapse. In general, we know that a real exchange rate appreciation (from large capital inflows or any other reason) may cause a loss of competitiveness and a structural worsening of the trade balance which makes the current account deficit less sustainable. Thus, the current account deficit may be less sustainable when accompanied by a real exchange rate appreciation that leads to a misaligned currency value. In the case of Asia, the real appreciation was partly the consequence of the choice of the exchange rate regime, essentially a fixed peg to the U.S. dollar (that is a looser variant of a currency board) . The consequence of such a peg were two; first, they led to large capital inflows attracted by favorable interest rate differentials and the expectation of low exchange rate risk given the policy of stable currency values. Such inflows prevented currency depreciations even if domestic inflation was higher than world inflation and, at times, even led to nominal currency appreciation; this, in turn, led to a real appreciation that was partly the cause of the large and growing current account imbalances. Note that in Asia in the 1990s, the official exchange rate policy of many countries was one of pegging to the U.S. dollar. While Hong Kong had actually a currency board with the parity tied to that of the US dollar, other countries were formally pegging their exchange rate to a basket of currencies; however, the effective weight of the US dollar in the basket was so high that their policy can be characterized as an implicit peg to the US currency. While such policy of pegging the exchange rate ensured in many Asian countries ensured the stability of the nominal exchange rate relative to the US currency, it also had the consequence that change in the nominal and real value of the dollar relative to the Japanese Yen and the European currencies had the consequence of affecting the real exchange rate of the Asian currencies pegged to the US dollar. Specifically, the dollar was on a downward nominal trend relative to the yen and mark between 1991 and 1995 reaching a low of 80 yen per dollar in the spring of 1995. During that period, the Asian currencies pegged to the U.S. experienced a real depreciation of their currencies, as they were depreciating relative to the Japanese and European currencies. However, after the spring of 1995, the dollar started to rapidly appreciated relative to most world currencies (the yen/dollar rate went from 80 in the spring to 1995 to over 125 in the summer of 1997, a 56% appreciation). As a consequence, the Asian currencies that were tied in nominal terms to the dollar also experienced a very rapid real appreciation. Note also that the real exchange appreciation was the largest in Asia in the country that has a currency board, Hong Kong: between 1990 and 1997 the Hong Kong dollar appreciated in real terms by over 30%, twice the rate of average real appreciation of the other currencies in the region. Note also that a real appreciation of the currency will occur when the exchange rate is pegged and used as a nominal anchor for monetary policy (as it has been in most Asian countries) if the initial domestic inflation rate is above the world one and it does not converge rapidly to the world inflation rate. In fact, while fixing the exchange rate is a fast way to disinflate an economy starting with a higher inflation rate, pegging the exchange rate will not reduce the inflation rate instantaneously to the world level. The reasons why inflation will not fall right away to the world level are several; 1) PPP does not hold exactly in the short tun since domestic and foreign goods are not perfectly substitutable. So domestic firms will reduce the inflation rate when the exchange rate is pegged but may not push it immediately down to the world level. 2) Non-tradable goods prices do not feel the same competitive pressures as tradable goods prices, thus inflation in the non-traded sector will fall only slowly. 3) Since there is significant inertia in nominal wage growth, wage inflation might not fall right away to the world level. Many wage contracts are backward looking and the adjustment of wages will occur slowly. Also, in countries where there is formal indexation of nominal wages, wage inflation is based on past (higher) inflation rather than current (lower) inflation; so this inertia in the wage setting in the economy means that wage inflation will remain above the world rate. If domestic inflation does not converge immediately to the world level when the exchange rate parity is fixed, a real appreciation will occur over time. This appreciation of the real exchange rate implies a loss of competitiveness of the domestic economy: exports become more expensive relative to imported goods; this worsens the trade balance
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and the current account over time. Even small differentials between domestic and foreign inflation rates can compound rapidly into a substantial real appreciation. Therefore, the problem of anti-inflation stabilization policies (such as the adoption of a currency board or a hard fix peg) that use the fixed exchange rate as the policy tool to fight inflation is that fixed rates lead to a real exchange rate appreciation and to a significant worsening of the current account. While the Asian countries had not experienced the large inflation rates of some Latin countries, their inflation rates were usually above those of the OECD group; therefore a policy of pegged parities (or currency boards) might have contributed to the real appreciation observed in the 1990s throughout Asia. The above arguments are confirmed by the experience in transition economies such as Estonia that adopted a currency board in 1992 and Lithuania that adopted a currency board in 1994. In both countries, the move to a peg has been associated with a large real appreciation of their currency. In Estonia and Lithuania, the slowdown in inflation was not been as large as hoped for following the adoption of a currency board: in spite of the currency board inflation remained in the mid teens in both countries until 1996. As a consequence, in Estonia the real appreciation of the currency since the adoption of the currency board in 1992 has been equal to over 70%. In Lithuania, the real appreciation has been 59% since the adoption of the currency board in 1994. Lithuania entered the currency board in 1994 with an exchange rate that was undervalued in real terms so that some real appreciation was expected to occur . However, even considering the initial undervaluation, there has been a significant real appreciation since 1994. These real appreciations have had dramatic effects on the competitiveness of exports of these countries and have been confirmed by recent current account data. Firms in Estonia and Lithuania complain that they are unable to compete in international markets. In 1992, Estonia ran a current account surplus equal to 3.4% of GDP; this had turned into a current account deficit of 6.8% of GDP in 1996 and was expected to be almost 14% of GDP in 1997. In Lithuania, a current account deficit of 3% of GDP in 1994 has turned into a current account deficit of about 10% of GDP in 1996 and 1997. Given the poor performance of the currency board and the serious misalignment of the real exchange rate, the monetary authorities in Lithuania have been considering the idea of phasing out the currency board in 1998. While they argue that a fixed parity would be maintained even without a currency board, it is now likely that a currency devaluation will be required to reverse some of the loss of competitiveness suffered since 1994. The experience of Estonia and Lithuania also suggests some skepticism about the future of the currency board adopted by Bulgaria in 1997. While the loss of fiscal and inflation credibility of Bulgaria in recent years had been a strong argument in favor of the binding constraints of a currency board, there are at least two problems with such a step. First, a real appreciation might occur over time and lead to a destabilizing loss of competitiveness over the medium term. Second, the exchange rate parity chosen when Bulgaria adopted the currency board may not be correct. The Bulgarian leva depreciated dramatically in 1996 (by more than 600%) to a parity of about 1600 leva per German Mark (DM) However, after the 1997 election there were large inflows of capital and the currency rapidly appreciated to 1000 leva per DM, the rate at which the leva entered into a currency board in July 1997. While a rate of 1600 represented a significant real undervalution of the leva, a rate of 1000 implied a significant real overvaluation (relative to the 1995 values) given that the past depreciations had fed into the price system in 1997. Entering in a currency board at the wrong parity, as it is likely that Bulgaria did, is likely to have serious competitiveness consequences in the medium-run: it appears that the currency board was introduced at the then existing exchange rate without serious consideration of its relationship to equilibrium and the long-term competitiveness consequences of such a parity. This is a typical problem with currency board. Usually, such CBs are adopted after a sharp depreciation has led to high inflation and a higher price level. Then, the expectation of the adoption of a CB leads to a sudden capital inflow that rapidly appreciates the currency to a level that may not be consistent with the fact that the previous depreciation has already fed into the domestic price level. Then, the currency board get started by locking the parity at an artificially parity level, something that turns out to be a serious problem as competitiveness is eroded over time. In summary, the experience therefore suggests that the currency crises in Asia occurred not because of flexible exchange rate regimes but rather because of fixed exchange rates regimes. Locking yourself for too long to a misaligned nominal parity is bound to lead to a speculative attack and the final collapse of your currency. I.e., paradoxically, it is fixed rates and currency boards that cause currency crises and their collapse, not floating exchange rate regimes. Myth 8. Currency boards cannot collapse because the monetary base is fully backed by the foreign reserves of the country

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The argument that currency boards cannot collapse because the monetary base is fully backed by the foreign reserves of the country is patently incorrect. If an attack on the currency occurs, domestic residents may try to get rid of domestic financial assets and buy foreign assets by running down the foreign reserves (FX) of the central bank. The domestic financial assets that may be used to buy foreign currency are not limited to the monetary base (that is fully backed by foreign reserves in a CB) but rather the entire stock of liquid monetary assets that is usually a large multiple of the monetary base. A better indicator of reserves adequacy is therefore the ratio of money assets to foreign reserves because, in the event of an exchange rate crisis or panic, liquid money assets can be converted into foreign exchange. Calvo (1995) suggests the use of the ratio of a broad measure of liquid monetary assets to foreign reserves and Sachs, Tornell and Velasco (1996) use the ratio of M2 to foreign reserves. We should therefore look at the data both on the M1/FX ratio and M2/FX ratio rather than just monetary base (M0/FX). To compare the Asian experience with that of Latin America, note that the M2 to reserve ratio in Mexico right before the Peso crisis (November 1994) was 9.1 while Brazil and Argentina, the two countries that were most affected by the Mexican peso 'tequila effect', had a ratio of M2 to reserves of 3.6 in November 1994. In most Asian countries these ratios were very high in 1996-97. In Korea, the M2/ FX ratio was 6.5 by the end of 1996 and rose to almost 7 in the first quarter of 1997; in Indonesia the ratio was 6.5 by the end of 1995 after rising through the 1990s'; in Malaysia, the ratio was lower but went from 2.8 in 1990 to 3.3 at the end of 1996. In the Philippines the ratio fell from 4.8 in 1991 to 4.5 in 1996. In Thailand the ratio went from 4.5 in 1990 to 3.9 in 1996. In Singapore, the ratio was a low in 1990 (1.2) and fell further to 1.01 in 1996. In Hong Kong, the ratio was at 4.2 in 1996 while equal to 8.5 in China. The figure for the M1 to foreign reserves are much smaller as a large fraction of M2 is "Quasi Money", a much larger figure than M1. At the end of 1996, the M1 to reserve ratio was above unity in China (3.4), Korea (1.4), Indonesia (1.2), Malaysia (1.08) and below unity in Singapore (0.24), Hong Kong (0.35), Thailand, (0.44), the Philippines (0.88). Note that while China has the highest ratios, the ability of Chinese resident to convert domestic liquid assets into foreign currency is severely limited by widespread capital controls that are absent in most of the other countries in the region. The above numbers suggests that a currency board where base money (M0) is fully backed by foreign reserve would not be able to prevent a speculative attack from succeeding because in the event of an exchange rate crisis or panic, all liquid money assets (such as M1 and M2) can be converted into foreign exchange and they are an order of magnitude larger than foreign reserves. Myth 9. Currency boards leads to lower inflation rates than flexible exchange rates The argument is very simple. Inflation is usually a monetary phenomenon caused by excessive rates of growth of the money supply. Since the hands of monetary authorities are tied in a currency board and excessive monetary growth cannot occur, inflation will remain low. Also, the credible fixed exchange rate prevent nominal depreciations from leading to higher inflation. A credibly fixed exchange rate, like a currency board, therefore leads to permanently low inflation. The incentive of monetary authorities to have high monetary growth is often argued to derive from the time inconsistency of monetary policy. The idea is that the inflation process is the outcome of a credibility game between governments and the private sector. In a seminal contribution, Barro and Gordon (1983) applied the Kydland and Prescott (1977) problem of the time inconsistency of optimal plans to the issue of inflation. If the government target level of output or unemployment is higher than the private sector one, the announcement by the government of a zero inflation policy will not be credible or time consistent. The private agents, in forming their rational expectations of inflation, will realize that the government has an incentive to try to engineer unexpected inflation in order to stimulate output. In a time consistent equilibrium, rational inflationary expectation are such that no surprise inflation occur and output remains at its natural level. However, such a time consistent equilibrium is characterized by a positive rate of inflation that is higher than what is socially optimal. The implications of such models of inflation are as follows: inflation should be lower in countries with independent central banks (Rogoff (1985)) and in countries that credibly fix their exchange rate to a low inflation country (Giavazzi and Pagano (1985)). The suggestion that low inflation might be associated with credible and independent central banks has been confirmed in a number of empirical studies: there is strong evidence that low inflation rates are associated with independent central banks. Most of these studies, however, beg a fundamental causality issue: does central bank independence lead to low inflation or is it that countries that decide to rely less (more) on seigniorage and inflation will choose more independent (dependent) central banks ? While it is true that institutions, once formed change only slowly over time
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so that there is some institutional inertia deriving from choosing an independent central banker, it is also true that countries that decide to rely heavily on seigniorage taxation will also decide to have a weak central bank that will monetize deficits on command by the government. In this sense, it is the need of seigniorage taxes and inflation that causes the choice of weak central banks in many developing countries rather than dependent central banks being an exogenous cause of inflation. Moreover, for countries that heavily relied on seigniorage revenues for government financing purposes (such as Argentina, Brazil, Chile, Peru and Bolivia in various time periods), the idea that inflation could have been reduced to zero if they had only chosen an independent central bank and adopted a currency board appears ingenuous. These countries needed a dependent central bank and currency depreciation in order to raise seigniorage revenues. For similar fiscal reasons, it does not look reasonable to try to explain the very high inflation rates of many countries on the basis of a credibility story by assuming that the government is trying to surprise private agents, reduce real wages and stimulate output. Do we really think that inflation rates over 100% in countries such as Brazil, Bolivia, Chile and Argentina were due a benevolent government trying to stimulate output above the natural rate ? In this respect, some preliminary evidence in Cukierman, Webb and Neyapti (1991) confirms that the causality between central bank independence and inflation rates might be going both ways: while there is an effect of independence on inflation, causality tests performed by these authors also imply that high inflation might cause lack of central bank independence. The above discussion suggest that one should use caution in using measures of central bank independence and the choice of a fixed exchange rate regime as determinants of cross-country differences in inflation rates. Similarly, in the context of studies of the European monetary system, it has been suggested that one way to solve the credibility problem for a government with an inflation bias it to fix the exchange rate of the country to the one of a country (such as Germany) credibly committed to low inflation. In this sense, credible fixed exchange rate regime should be associated with low inflation. While the empirical evidence from the EMS on such an hypothesis is quite weak, its major weakness is theoretical: And why should a fixed exchange rate regime be more credible than the announcement of monetary targets if the country suffers of a "inflation credibility bias" in the first place? The above models just assume that the announcement of a fixed regime is credible while the announcement of a low inflation monetary rule is not credible. Such an asymmetry is arbitrary and unwarranted unless one can explain why the cost of reneging on the commitment to fixed rates are higher than those of reneging on a monetary rule announcement. Moreover, the apparent relation between fixed exchange rate regimes and low inflation suggested by the Bretton Woods and the EMS experience might also suffer of a serious causality issue: Is a fixed exchange regime an exogenous nominal anchor that can be chosen to nail price expectations or is a fixed (flexible) exchange rate regime chosen by country that decides to rely less (more) on seigniorage taxation and inflation ? The fiscal model of inflation presented by Grilli and de Kock (1989) suggests that the choice of the exchange rate regime, fixed or flexible, is not exogenous and does not determine inflation. Countries that need to rely heavily on seigniorage taxation because of fiscal shocks will switch from fixed exchange rate to flexible exchange regimes; in this sense the association of low (high) inflation with fixed (flexible) exchange rates does not imply that the exchange rate regime causes the level of inflation but rather that the policy chose level of inflation and seigniorage leads to the choice of the exchange rate regime that is compatible with the fiscal needs of the country. The above discussion suggests that one should be careful in using the independence of the central bank seen in currency boards and fixed exchange rate regime characteristic of a CB as an exogenous determinant of country differences in inflation rates. While the above variables appear to be empirically correlated with inflation rate differentials, the correct causal nexus between them and inflation has not been satisfactorily addressed. Myth 10. Currency boards lead to more fiscal discipline than flexible exchange rate regimes As discussed above, inflation is usually a monetary phenomenon caused by excessive rates of growth of the money supply. As the argument goes, since the hands of monetary authorities are tied in a currency board and excessive monetary growth cannot occur, inflation will remain low. Moreover, as monetization of fiscal deficits is not possible under a currency board, the incentive to have large budget deficits should be reduced: if the fiscal authorities know that a fiscal deficit will not be monetized by the central bank, their political incentives to spend a lot and have large deficits will be reduced. Experience shows that in the 1980s, Argentina, Bolivia, Brazil, and Israel experienced very large inflation rates, all over one hundred percent a year and some over a thousand. But why was inflation high and currency depreciation rapid in the first place? If the relation between money growth and inflation is so clear, why these countries did not
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simply print less money and stop depreciating their currency? If only it were so easy! The real problem most of these countries had was large structural fiscal deficits and they needed to monetize these deficits by printing money. Let's think how that influences monetary policy and exchange rates. If a government is running a deficit, then it must issue iou's of some sort to pay for it. Roughly, speaking, they may issue money (dollar bills or their local equivalent) or interest-bearing debt (treasury bills and notes) denoted with the variable B. Mathematically we can express this as Pt (Gt - Tt) = dMt + dBt, or Gt - Tt = dMt / Pt + dBt / Pt where the two terms on the right are issues of new money (dM) and new interest-bearing debt (dB), respectively. This is an example of a government budget constraint: it tells us that what the government doesn't pay for with tax revenues, it must finance by issuing debt of some sort. So why do these countries increase the money supply? The problem, typically, is that a political impasse makes it nearly impossible to reduce the deficit. Given the government's budget constraint, it must then issue debt. Now for US debt there is apparently no shortage of ready buyers, but the same can't be said for Argentina or Russia. If they can't issue debt and they can't reduce the deficit, the only alternative left is to print money: in short, when they can't pay their bills any other way, they pay them with money, which is easy enough to print. The effect of this, of course, is that these countries experience extremely high rates of inflation. Note that whenever a central bank prints "fresh money" it can obtain goods and services in exchange for these new pieces of paper. The amount of goods and services that the government obtains by printing money in a given period is called "seigniorage". In real terms, this quantity of goods and service is given by the following expression: Seigniorage = dMt / Pt = New bills printed during the period / Price level during the period. The monetary aggregate that the central banks control directly is the "monetary base", consisting of currency in the hands of the public and reserves of the commercial banks deposited in the central bank. Thus, when we refer to a central bank as "printing more money", we mean increasing the monetary base. Note that since the government, by printing money, acquires real goods and services, seigniorage is is effectively a tax imposed by the government on private agents. Such a seigniorage tax is also called the inflation tax. The reason is the following. From the definition of seigniorage: Seigniorage = dMt / Pt = (dMt / Mt ) (Mt/Pt) Since the rate of growth of money (dM/M=m) is equal to inflation (p) (assuming, for simplicity, that the rate of growth of output y is zero), we get: Seignoraget = pt (Mt/Pt) In other terms the inflation tax is equal to the inflation rate times the real money balances held by private agents. This makes sense: the inflation tax must be equal the tax rate on the asset that is taxed times the tax base. In the case of the inflation tax, the tax base are the real money balances while the tax rate at which they are taxed is the inflation rate. In other terms, if I hold for one period an amount of real balances equal to Mt/Pt, the real value of such balances (their purchasing power in terms of goods) will be reduced by an amount equal to pt (Mt /Pt) after one period. The reduction in the real value of my monetary balances caused by inflation is exactly the inflation tax, the amount of real resources that the government extracts from me by printing new money and generating inflation. The thing I like about this analysis is that it gives a strange twist to Friedman's quote: inflation might be a monetary phenomenon, but the money is a reflection of bad fiscal policy, not monetary policy. We might say instead: "Inflation is always and everywhere a fiscal phenomenon."

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To understand better why inflation is a fiscal phenomenon, note again that a government with a budget deficit can finance it either by printing money (that leads to seigniorage or the inflation tax) or by issuing public debt: P (G-T) = dM + dB = p (M) + dB Note also that countries such as Argentina, Bolivia, Brazil and Israel had very high inflation rates in the 1980s. Now, if inflation and currency depreciation was purely a monetary phenomenon caused in the first place by an exogenous excessive rate of growth of money, these countries could have reduced inflation quite fast by printing less money, reducing the growth rate of the money supply and adopting fixed exchange rates. Instead, all these countries had a really hard time in reducing their inflation rates. So, if inflation was due to an exogenous high growth rate of money, why didn't these countries print less money? The main problem is that these countries had large structural budget deficits and printed money to finance it. In this sense, the excessive growth rate of money that led to seigniorage and caused inflation was not exogenous but rather endogenous and caused itself by the need of these governments to finance their budget deficits. Note, however, that these countries could have in principle avoided the high inflation if they had cut their budget deficits (thus reducing the need for seigniorage revenues) and/or if they had financed their budget deficits by issuing bonds rather than by printing money. This leads to the further question: why weren't the deficits reduced and/or why weren't the deficits financed by issuing bonds? Budget deficits are often very hard to reduce for political and structural reasons: cutting deficits implies reducing government spending and/or increasing taxes and both policies are politically unpopular. Also, in countries with inefficient tax collection systems and where there is a lot of tax evasion, it is hard in the short-run to reform the tax system so as to increase (non-seigniorage) revenues. Conversely, increasing seigniorage revenues is much easier as it implies printing new money, an executive action rather than a legislative action as in the case of traditional taxes. Of course, seigniorage is as much of a tax as regular taxes but it is politically more hidden (at least at low levels of inflation) as the effect of higher money growth leads to higher inflation only slowly over time. For what concerns the possibility of (non-inflationary) bond financing rather than (inflationary) monetary financing of the deficits, there are several obstacles to such a policy option in many developing countries. First, bond markets are not very well developed (and in some cases altogether absent) in many countries. Second, citizens are concerned about buying nominal long-term bonds issued by the domestic government because an unexpected increase in inflation by the government would lead to a fall in the real value of these bonds (that is equal to a wealth tax on the public holdings of such bonds). Third, bonds indexed to inflation and/or short-term bonds that pay returns close to current market rates are still subject to default risk if the government decide to renege on its obligations. Fourth, the ability to borrow abroad and/or issue bonds denominated in foreign currency in international capital markets may also be limited by the default risk of the country. Fifth, even when some bond borrowing may be available either domestically or abroad, governments may not be willing to issue such bonds. In fact, bond financing is more expensive than monetary financing (seigniorage) since governments do not pay interest on their monetary liabilities while they have to pay interest (high ones if inflation is high) on their borrowing. Sixth, borrowing by issuing debt means that the stock of debt goes up every year by the amount of the the flow debt financing: Bt+1 = Bt + dBt. This growth of debt may be very costly and not be sustainable in the long-run. In fact, if the public debt grows a lot (relative to GDP), at some point private agents might become unwilling to buy new debt (or even roll-over old debt that comes to maturity) as high debt increases the probability that the government might at some point default on its debt obligations. So, if such a panic occurs and the private sector refuses to buy new debt and/or renew the old one, a government with a structural budget deficit will eventually be forced to start printing money and thus create inflation. Therefore, in face of a structural deficit, trying to reduce inflation today by issuing bonds rather than printing money will just lead to higher debt in the future that will eventually force the government to monetize the deficit (when the debt constraint is hit) and thus will cause inflation in the future. Again, inflation is a fiscal phenomenon and there is no escape from it if the underlying deficit problem is not solved: attempts to reduce current inflation by issuing bonds only implies that future inflation will be higher when the ability to issue debt is exhausted and the government is forced to switch to a monetary financing of the deficit. Therefore, while the near proximate cause of high inflation is always monetary as inflation is associated with high rates of growth of money, the true structural cause of persistent high inflation is most often a fiscal deficit that is not eliminated with cuts in spending and/or increases in (non-seigniorage) taxes. The above analysis also suggests that the choice of the exchange rate regime, fixed or flexible, currency board or

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not, is not exogenous and does not determine inflation and fiscal deficits. Countries that need to rely heavily on seigniorage taxation because of fiscal shocks (transitory or structural) will switch from fixed exchange rates to flexible exchange regimes and rely on high seigniorage taxation; in this sense the association of low (high) inflation with fixed (flexible) exchange rates does not imply that the exchange rate regime causes the level of inflation but rather that the policy chose level of inflation and seigniorage leads to the choice of the exchange rate regime that is compatible with the fiscal needs of the country. The above discussion is important because it suggests that introducing a currency board is not, by itself, sufficient to reduce inflation and eliminate budget deficits. Instead, a country needs to pursue structural fiscal reforms such as a cut in government spending and a reform of the tax system (that leads to greater non-seignorage revenues) to eliminate fiscal deficits and reduce the reliance on seigniorage revenues. If such fiscal reforms are made, seigniorage needs will fall, budget deficits will be lower and inflation and depreciation will sharply fall regardless of whether a country is under a fixed or a flexible exchange rate regime. The experience of Argentina and Israel confirms this. Both countries had very high inflation in the 1980s and rely on seigniorage revenues to finance budget deficits. Both countries introduced structural fiscal reforms (starting in 1985 in Israel and in 1990 in Argentina). While Argentina also introduced a currency board, Israel did not; the latter country, instead, followed a flexible exchange rate policy aimed at avoiding the real appreciation of the currency and allowing the currency to depreciate over time. Both countries were successful in reducing inflation and budget deficits because of their fiscal reform. The adoption of a currency board in one country and a flexible exchange rae policy in the other had very little to do with their success in controlling budget deficits. It was rather the political will to address the fiscal root causes of inflation that led to the reduction in fiscal deficits. This is why a country without a currency board such as Israel was successful in controlling fiscal deficits and inflation. There are also other reasons to believe that fixed exchange rates may have perverse negative effects on budget deficits. There are at least two points to be made in this regard. First, note that the argument that currency board will lead to fiscal discipline is based on the following logic. Suppose that a fiscal deficit is due to political distortions of various sorts that lead fiscal policy makers to spend too much and tax too little. Then, if fiscal authorities know that the automatic monetization of fiscal deficits is not possible under a currency board, the incentive to have large budget deficits should be reduced. I.e., if the fiscal authorities realize that a fiscal deficit will not be monetized by the central bank, their political incentives to spend a lot and have large deficits will be reduced. This was, for example, the logic behind experiments such a the "divorce" between Treasury and Central Bank adopted by Italy in the early 1980s. The "divorce" implied that the Central Bank was not forced any more to passively finance fiscal deficit by printing money. This should have lead to more discipline imposed on the fiscal authorities. The consequence of this divorce on the fiscal deficit were, however, quite different from those expected from theory. Such a divorce did not reduce the political bias of the fiscal authorities (at least until the late 1980s) as the deficits were caused by structural political distortions. Instead, as seigniorage revenues sharply dropped after the divorce, fiscal deficits remained high and were instead more bond-financed rather than seignioragefinanced. As a consequence, the Italian public debt that had remained constant (as a share of GDP) in the 1970s thanks to seigniorage revenues, exploded in the 1980s: the fiscal deficits were financed by debt rather than money and the public debt to GDP ratio increased from about 50% to over 120% in the early 1990s. Again, the lesson is that fixed rules such a fiscal-monetary divorce or a currency board do not, by themselves, impose a fiscal discipline. If the political biases or structural causes of deficits remain, less monetization of deficits will lead to greater reliance on debt-financing of such deficits. A currency board, by itself, cannot solve such political biases. Second, one could make an argument (originally advance by Velasco and Tornell (1996)) that fixed exchange rates may actually lead to less fiscal discipline, not more, compared to flexible exchange rate regimes. The argument is as follows. Flexible exchange rates provide more discipline because, under such regime, any bad fiscal policy leads, right away, to a punishing currency depreciation. If currency depreciation is politically costly, under flex rates anytime a fiscal deficits is increased and monetized, markets will instantaneously punish you by having your currency devalue. Such punishment by currency trader vigilantes can be a reasonable deterrent to politicians trying to pursue loose fiscal policies. Under fixed exchange rates, instead, the politicians do not pay right away the costs of bad fiscal policies. As the currency is pegged, an expansionary fiscal policy does not immediately lead to a humiliating currency depreciation. Instead, the deviant fiscal behavior can for a while be hidden behind a bond-financing of the deficits with no devaluation or with a loss of foreign reserves if the deficit is financed through a monetary increase in domestic credit. Either way, the market disciplined against fiscal deficits is loosened. As long as politicians have a short-term horizon - maybe because the know they may not be in power in the medium term - they may prefer to avoid paying the political costs of a depreciation following deviant fiscal behavior by adopting a fixed exchange rate

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regime that - in the short-run - prevent the currency from falling following bad economic policies. Then, fiscal discipline and, more in general, good economic policy discipline may be lessened under a regime of fixed exchange rates compared to a regime of flexible exchange rates.

In conclusion, our analysis suggests that the case for currency boards is very weak and the experience with them a mixed bag. There are countries in which they seem to work for a while; however, these countries are successful not because of the CB system itself but rather because they follow macroeconomic policies and structural liberalization policies that are consistent with the maintenance of fixed rates. Fixed rates and CBs without these good policies lead to currency collapse and economic disaster. Conversely, if you do follow the right economic policies you do not need a Currency Board: you will do well without them and adopting one could only hurt you when truly exogenous shocks require an adjustment of your nominal parity. There are of course some marginal benefits of CB that one can point to: short-run credibility when you start from an hyperinflation (like in Argentina), stronger incentives not to monetize and run budget deficits under some conditions. But those are all benefits that a country can achieve without a CB and therefore avoid the other costs of having one. While these days CBs are being proposed as the Holy Grail that will cure every ill and give bliss to a country, their shortcomings are serious and their adoption may actually harm a country rather than improve its economic long-run performance. Copyright: Nouriel Roubini, Stern School of Business, New York University, February 1998. Back to my Asian Crisis Homepage

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