On May 6, 2021, David, freelance journalist based in Paris White House, PhD, conducted an in-depth interview with Professor Steve Hanke, Professor of Applied Economics at Johns Hopkins University in Baltimore.
In this unique interview, Professor Hanke stressed that “developing countries facing increased risks of hyperinflation must consider drastic preventive measures, including currency boards before it is too late. For developing countries, the best way to eliminate the possibility of hyperinflation would be to put their central banks on the back burner and put them in museums.
The following is a reproduction of what is published by Disruption Banking Magazine; the text is prepared by David Whitehouse, PhD.
“Developing countries have two options,” says Hanke. The first is to use a healthy foreign currency and operate without a local currency, a solution often referred to as “dollarization”. Today, dollarized regimes exist in 37 countries, including Montenegro, where Hanke was an adviser in 1999, helping to design the replacement of the high-swelling Yugoslav dinar with the German deutschemark.
The second option is to issue local currency through a currency board, he says. In this case, the local currency trades at an absolutely fixed exchange rate with a strong anchor currency and is backed 100% by strong currency reserves. The local currency effectively becomes a “clone” of its anchor.
Hanke is the architect of the currency boards in Estonia, Lithuania, Bulgaria and Bosnia and Herzegovina. He became convinced of their merits as economic advisor to the government of Yugoslavia in 1990. The fall into war prevented him from implementing his solution to the inflation that rages in Yugoslavia. He became chief adviser to Bulgarian President Petar Stoyanov in Bulgaria, where hyperinflation peaked at 242% in 1997.
When hyperinflation erupted in Bulgaria in 1996, Hanke recalls, the previous resistance to the currency board ideal disappeared. Under a “dollarized” or currency board regime, there are “no printing presses operated by a central bank that generate increases in the money supply,” which is fueling fleeing prices. “Bulgaria’s currency board immediately broke hyperinflation.”
“By 1998, the banking system was solvent, money market interest rates had fallen from triple digits to 2.4% on average, a huge budget deficit had turned into a surplus, a deep depression had turned into Bulgaria’s economic growth and foreign exchange reserves were more than tripled. Thanks to its currency board, according to Hanke, Bulgaria has the second lowest debt-to-GDP ratio in the European Union, behind Estonia.
Lies, damn lies
Hanke subscribes to Milton Friedman’s saying that inflation is “always and everywhere a monetary phenomenon,” resulting from an increase in the amount of money relative to output. Thus, the only effective way to stop inflation is to restrict the rate of growth of the money supply.
This priority has been pushed to the back of the queue in the context of COVID-19. “The response of most countries to COVID-19 has been to push the money supply accelerator to the floor,” Hanke said. With the exception of China and Japan, major monetary measures continue to grow by more than 10% per year in all of the world’s major economies. In the United States, he says, the broadly measured money supply has reached highs not seen since 1943.
“As a result, inflation is accelerating, and contrary to what central bankers tell us, inflation will not be just a temporary phenomenon.” Inflation will be “one of the many serious problems accompanying the post-pandemic era”.
Government statistics fail to capture the reality of inflation, says Hanke. In August 2020, Turkey had an official annual inflation rate of 11.77%, compared to 27% for Hanke’s own measure. He argues that the main reason for the difference is that the basket of goods used by the government includes only 418 items, thus excluding thousands of goods bought and sold in Turkey every day. Hanke’s own measure tries to capture high-frequency prices for anything traded in an economy and then process the data in a purchasing power parity (PPP) model.
The scarcity of events, he says, makes it difficult to predict future events, although war or regime collapse are often prerequisites. Hanke defines hyperinflation as a monthly rate above 50% for at least 30 consecutive days. His research shows that there have been 62 episodes of hyperinflation in world history, beginning in France in May 1795.
The poor are most at risk as the dangers of hyperinflation increase. Hanke notes that the prices of many agricultural products are at or near all time highs. He expects food prices to continue to rise in developing countries. “The poor will pay the price because a large part of their budget is swallowed up by food expenses. “
The Lebanese crisis
The most recent episode of hyperinflation recorded by Hanke occurred in Lebanon, from July 2020. Lebanon therefore joined Venezuela which has been in a state of hyperinflation since 2016. The Lebanese economy has collapsed following the end of the currency peg to the US dollar and the explosion of the port of Beirut.
The banking system has largely ceased to function and the country does not have a fully operational executive authority. Inflation for food and non-alcoholic beverages averaged 254% in 2020 and was a major driver of headline inflation. The World Bank predicts headline inflation of 80% in 2021. Nonetheless, the Economist Intelligence Unit (EIU) predicts that price pressures will ease from 2023 to 2025 to an average of 15.7% per year over time. that the currency stabilizes, that tax rates are raised and that consumption growth resumes.
Some in Lebanon wonder if a currency board is the way to salvation. Nasser Saidi, a former Lebanese Minister of Economy and Trade who also served as the country’s first deputy governor of the country’s central bank, argued during a presentation in February that a currency board would not solve Lebanon’s problems.
Saidi argues that currency boards and fixed exchange rate regimes are associated with real exchange rate appreciation, loss of competitiveness, and deterioration of the trade balance. A currency board where the currency is fully backed by foreign exchange reserves would not, he said, prevent a speculative attack on the currency because, in the context of an exchange rate crisis, all liquid monetary assets, which have an order of magnitude much greater than foreign currency reserves, can be converted into foreign currency.
Flexible exchange rates, he says, offer more discipline because any lax fiscal policy is immediately punished by the depreciation of the currency. “If sound economic policies are followed, there is no need for a currency board,” he says. “Adopting one can hurt when truly exogenous shocks require an adjustment in nominal exchange rate parity. “
Saidi also questions whether central bank independence creates, or simply reflects, greater discipline. According to him, countries that make the political decision to depend less on inflation are more likely to adopt independent central banks.
Hanke rejects these arguments. “The contemporary experience of currency boards contradicts all of the unfounded claims made by Saidi,” he says.
He cites the Hong Kong currency board, set up in 1983 to combat exchange rate instability, as a success. As Sino-UK talks over Hong Kong’s future dragged on, market volatility increased and the Hong Kong dollar collapsed. Stability was quickly achieved once a currency board was established in October. “The board hasn’t missed a beat since,” even during the recent political protests in Hong Kong, Hanke said.
With economist Kurt Schuler, Hanke analyzed the financial data of the 70 currency boards created since the creation of the first in Mauritius in 1849. “We found no instances where an appreciation of the real exchange rate and a loss competitiveness have occurred. “
“There has never been a successful speculative attack on a currency board, primarily because currency boards are, by design, speculative.”
A floating currency, argues Hanke, does little to discourage regimes determined to tax and spend. A depreciating currency is a recipe for inflation. “Flexible exchange rates offer little or no fiscal discipline precisely because they do not impose a strict fiscal constraint. A central bank with a flexible exchange rate can grant credits to the tax authority and therefore, unlike a currency board, does not impose any fiscal discipline.
The peg of the Lebanese currency to the US dollar that lasted from 1997 to 2019 did not prevent the central bank from carrying out financial engineering and discretionary monetary policy, both of which are prohibited under a currency board, Hanke said. Lebanon’s central bank “has no credibility. It will never be fixed. The only way to end Lebanon’s nightmare is to establish a currency board.
David Whitehouse, PhD is a freelance journalist in Paris and editor-in-chief of The Africa Report.
This interview was originally posted here: https://disruptionbanking.com/2021/05/06/steve-hanke-currency-boards-are-needed-to-quash-hyperinflation-risks/