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Hammers Where No Nails Exist

Abraham Maslow, the American psychologist, once observed that if one only has a hammer, all problems look like nails. Professor Steve Hanke has a hammer. It is the currency board. It is offered as the cure for emerging market woes.

Earlier this year, Indonesia briefly flirted with Hanke's currency board proposition before rejecting it. Hanke has recently renewed his claim that a currency board is Russia's only salvation. But is it ?

Currency boards are a special variant of a fixed exchange rate regime. A board has two distinguishing features. First, all notes and coins in circulation are backed by holdings of foreign currencies. In this regard, a currency board is similar to the old gold standard. But rather than gold, officials back their currency with the currency of another country, usually the U.S. dollar.

Second, under a currency board arrangement, officials foreswear the power to create domestic credit, either for the banking system or for the government. This prevents both the printing of money to finance government expenditures -- and the ability to become the lender of last resort.

Taken together, these features mean that the monetary base is driven solely through the balance of payments. A surplus on the balance of payments allows money supply to expand. A deficit tightens monetary conditions. Interest rates tend to follow those of the reserve currency, plus a market-determined risk premium.

In effect, when a country adopts a currency board arrangement, it abdicates the power to pursue an independent monetary policy. Doing so has served chiefly as a means to enhance the credibility of a country's policies and has proven fairly successful where it has been adopted. For the most part, small and relatively open economies such as Hong Kong (1983), Estonia (1992), Lithuania (1994) and Bulgaria (1997) have adopted currency boards. Argentina, which is a larger and less open economy, adopted a currency board in 1991. In each of these cases, the resulting stable currencies have helped dampen inflation pressures and encourage foreign investment.

The one obvious prerequisite for a currency board is sufficient reserves. The precise rules and extent of the backing varies from country to country. Argentina, for example, backs 100% of its monetary base with dollars. In Hong Kong, 100% of the certificates of indebtedness issued to the note-issuing banks are backed by dollars. This is equal to almost four times the narrow measure of money supply.

There are other prerequisites for a credible currency board that often get played down by currency board advocates. The onerous nature of these requirements goes a long way toward explaining why Indonesia earlier this year, and Russia now, did not adopt currency boards.

First, a strong banking sector is required. As the monetary base expands and contracts with the inflow and outflow of the reserve asset at the central bank, the financial system suffers strains. In particular, when experiencing large capital outflows, domestic liquidity conditions can tighten sharply. Argentina's bank deposit base fell almost 20% in just six weeks in early 1995, following the Mexican peso crisis. Unfortunately, a healthy banking sector -- or even an unequivocal commitment to banking reform -- is often lacking.

The second prerequisite is for a sustainable balance of payments position. This is important because this means that there will be adequate reserves to credibly back up the country's commitment and provide the monetary conditions for sustained growth. It also implies that capital flight will be limited. It is not clear that Russia (or Indonesia, for that matter) can satisfy this requirement.

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Third, a currency board requires flexible market structures. Interest rates and the foreign exchange value of a currency absorb the shocks generated by the imbalances that are part of the modern economy. If these shock absorbers are not allowed to work, then something else will have to bear the burden of the adjustment.

The fixed value of the Hong Kong dollar means that prices for financial instruments, equities, real estate and wages must fall to relieve pressure, for example. Flexible goods and factor markets are essential for the smooth functioning of a currency board. Here again, Hanke and others want to hammer where there may be no nail.

The advocates of a currency board rarely address the practical difficulties of their plans and therefore often reflect a certain political naivete. For example, is it really practical for Russia, which after all has been an adversary of the U.S. for at least a generation or two, to surrender its monetary policy to the

Federal Reserve

, which is what a currency board arrangement that is pegged to the dollar effectively entails?

Some countries, like Argentina, may be willing to accept complete dollarization of their economies, but this is not going to be generally acceptable to most countries, almost regardless of the case the economists may make. There is something profoundly antidemocratic about depoliticizing monetary policy.

There is another practical difficulty, even if all the prerequisites are met. What currency should be used as the anchor? Hanke has argued that the dollar is the most appropriate currency for both Indonesia and Russia. However, this is not self-evident, even if one were sympathetic to currency board arrangements. Hong Kong, for example, experienced inflation problems in the early 1990s as a result of the low nominal interest rates imported from the U.S., while China's strong growth was fueling an economic boom.

Countries with limited trade with the reserve currency country are particularly exposed to such shocks. Hanke's prescription for Russia risks killing a weak patient. If the dollar appreciates markedly against the new euro currency, a Russian currency board pegged to the dollar risks pricing Russian goods out of the biggest foreign market for its goods.

As a variant of a fixed exchange rate regime, a currency board arrangement shares many of its drawbacks. It is not clear that in a world of highly mobile capital, fixed exchange rate regimes are truly desirable. On the contrary, the movement has been away from such rigid currency regimes in recent years.

There is no such thing as a free lunch. The price of the operational simplicity of a currency board is less flexibility. It also entails the erosion of sovereignty (over monetary and perhaps fiscal policy), which is not exactly subject to cost-benefit analysis.

Marc Chandler is vice president and senior currency strategist at Deutsche Bank Securities. The thoughts reflected in his writings here are his own and not necessarily those of DBS. His column appears Wednesdays.