Currency Boards: A Bad Idea That Just Won't Go Away

One curiosity of the Asian financial crisis is the vogue for a quirky idea--the currency board. In Indonesia, President Suharto is proposing that the rupiah be pegged to the U.S. dollar, with a politically insulated currency board empowered to set and defend its fixed exchange rate. He is abetted by a U.S. economist, Steven Hanke at Johns Hopkins University, who promotes currency boards as a monetary panacea.

Hanke's plan pegged the rupiah at 5,000 to the dollar--about twice its current worth. The rupiah briefly rallied when it was first suggested. Then, wiser heads prevailed. To put it less politely, the International Monetary Fund and the Western powers warned the old dictator that if he persisted, there would be no IMF aid. It may be the IMF that backs down. Suharto appears to be proceeding.

Currency boards and rigidly pegged exchange rates leave weak economies with an inelastic monetary system that is hostage to someone else's currency. To fortify a weak currency with a pegged exchange rate against speculative assault, there is only one policy instrument. The board must raise domestic interest rates so high that traders start buying the currency rather than shorting it. In the meantime, the high interest rates savage the local economy.

Currency boards and pegged rates have worked in very special circumstances, such as Hong Kong and Argentina. The former is a city-state with a very strong banking system. The latter suffered from hyperinflation and turned to a currency board as part of a package of wide reforms of the sort Suharto has no appetite for implementing.

OVERBURDENED. If currency boards became generalized, the result would be a more rigid version of the fixed-exchange-rate system that prevailed during the Bretton Woods era, until 1973. At that point, the U.S. dollar could no longer anchor the world's monetary system without producing inflation at home. America shifted to a system of floating rates, widely praised as more "marketlike." But if the U.S. economy, which was relatively more prominent in 1971, could not undergird the global money system then, it can hardly do so today.

What is also peculiar is that monetary conservatives, led in this case by The Wall Street Journal editorial page, love currency boards. However, if all prices are optimized when they are set by free markets, shouldn't that logic also apply to exchange rates? Evidently, there are times when market forces are perverse. Otherwise, why saddle currencies with fixed exchange rates?

What explains this muddle of first principles by cheerleaders for the genius of the market? It turns out that champions of currency boards hate governments even more than they love markets. The vogue for currency boards is a close cousin to the longing for a gold standard, and to Milton Friedman's call for a "fixed monetary rule." Namely, central banks should stop meddling and put monetary policy on automatic pilot.

STABILITY AND ELASTICITY. Central banks, of course, are already supposed to be insulated, but to some true believers, they are not insulated enough. They come under political pressure to print money. With a currency board and a pegged rate, printing money doesn't help because there must be offsetting hikes in the interest rate to defend the watered-down currency. So interfering in the market by pegging rates paradoxically forces countries to bend to the judgment of markets--in this case speculative financial markets. That can indeed introduce draconian monetary discipline. But the cure is often worse than the disease.

Ironically, it was Keynesians--the fathers of Bretton Woods--who appreciated that the monetary system needs a blend of stability and elasticity. That requires government intervention, shelter from speculative pressure to deflate, and infusions of credit to needy cases--not a procrustean fixed rule.

The Bretton Woods system pegged rates and discouraged speculation. It included a collective defense of fixed rates, lubricated by IMF credits. A currency board, in contrast, leaves a weak economy at the mercy of speculators, with all the rigidities of fixed rates and little collective support.

One would welcome more stable exchange rates--in the context of an elastic monetary system that promoted growth. Supporters of this middle ground have proposed a variety of remedies, from "crawling pegs" (fixed rates that are adjustable) to taxes on currency speculation to regional regimes of managed stability, such as the European Monetary System. But the gold bugs and their currency- board cousins propose exactly the wrong combination of free markets and rigid control.

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