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To Appear In Using Rules Based Fiscal and Monetary Policy to Solve the Debt Crisis


Edited by Steve H. Hanke, John Merrifield, and Barry Poulson.


Cato Institute: Washington, D.C.





A Money Doctor’s Reflections on Currency Reforms and Hard Budget Constraints




Steve H. Hanke, the Johns Hopkins University *



In this chapter, I take a stroll down memory lane. The sights and sounds reveal important lessons, as well as a few surprises, that I have learned about the connections between currency reforms and hard budget constraints in emerging market countries. These lessons were derived from my experience in the operating theater, where I have performed as a money doctor. The patients that I have attended to have been afflicted with a wide variety of economic and financial maladies. These have included balance of payments, banking, currency, debt, and hyperinflation crises. In all of them, these crises erupted because monetary authorities engaged in discretionary monetary policies with reckless abandon. These policies failed to impose hard budget constraints on fiscal authorities. Without such constraints, the fiscal authorities were left to operate with reckless abandon, too. To cure the patients, my prescription has been the imposition of a hard budget constraint via the removal of the possibility for a monetary authority to engage in discretionary monetary activities. This has been accomplished by putting monetary authorities in




  • Steve H. Hanke is Professor of Applied Economics at Johns Hopkins University, Senior Fellow at the Cato


Institute, and Director of Cato’s Troubled Currencies Project. He is also the Founder and Co-Director of The Johns Hopkins Institute for Applied Economics, Global Health, and the Study of Business Enterprise. The author thanks Christopher Arena for his assistance.


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a straitjacket, namely a fixed exchange-rate regime—either a currency board system or “dollarized” system.



My stroll begins in Hong Kong, where the authorities had allowed the Hong Kong dollar to float in November 1974. The floating Hong Kong dollar became wildly volatile and steadily lost value against the U.S. dollar. The volatility reached epic proportions in late September 1983, after the fourth round of Sino-British talks on Hong Kong’s future. It was then that the financial markets and the Hong Kong dollar went into tailspins.



At the end of July 1983, the Hong Kong dollar was trading at HK $7.31 to US $1. By Black Saturday, September 24th, it had fallen to HK $9.55 to US $1, with dealer spreads reported as large as ten thousand basis points. Hong Kong was in a state of panic. People were hoarding toilet paper, rice, and cooking oil. The chaos ended abruptly on October 15th, when Hong Kong reinstated its currency board.



I learned the details of Hong Kong’s currency crisis and the reintroduction of its currency board from my colleague, close friend, and collaborator Sir Alan Walters, who was operating as Prime Minister Margaret Thatcher’s economic guru at the time. Sir Alan conveyed the details to me in real time. The dramatis personae included Sir Alan, Mrs. Thatcher, Milton Friedman, and John Greenwood, the architect of the new currency board (Greenwood 2007). At that time, Hong Kong was still a British Colony; hence, Mrs. Thatcher’s involvement.


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Interestingly, Friedman recounts the importance of the Hong Kong currency crisis of 1983, the installation of the currency board, and the Greenwood-Walters-Friedman involvement in his memoirs Two Lucky People (Friedman and Friedman 1998):



“In 1983, when there was an exchange crisis in Hong Kong, John [Greenwood] was the architect of the monetary reform that led to the Hong Kong dollar being unified with the U.S. dollar. He was able to play the crucial role he did because he had analyzed the Hong Kong monetary system in a series of articles in the Asian Monetary Monitor, pointed out its defects, and sketched possible reforms. During the course of the detailed negotiations that led to the final reform, John was on the phone almost nightly conferring with Alan Walters, then in London as an adviser to Margaret Thatcher, and with me in San Francisco, getting our comments and suggestions on the details of the proposed reform. After he had succeeded in getting his reform adopted—which incidentally has been a great success and achieved the results he had intended—he had three small silver ashtrays made recording the event as mementos for the three of us” (Friedman and Friedman 1998: 326).



I recount the Hong Kong currency crisis of 1983 because it was a turning point in the direction of my primary interests and scholarship—a direction that eventually led to many assignments as a money doctor (Hanke 2016). The house calls were numerous and scattered across the globe. Argentina was the first call in 1989. Then came Yugoslavia (1990), Albania (1991), Russia (1991), Estonia (1992), Lithuania (1994), Kazakhstan (1994), Jamaica (1995), Venezuela (1995), Bulgaria (1997), Bosnia-Herzegovina (1997), Indonesia (1998), Montenegro (1999), and Ecuador (2001). Some of the assignments, like Indonesia’s, were “big,” and some were “small.”


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Some were “long”—lasting the better part of a decade, like Argentina’s—while others were “short.”



What lessons did I learn from observing Hong Kong’s currency crisis and its successful currency board cure? First, if you wish to be a successful money doctor, you must support your prescriptions with research and publishable scholarship, as Greenwood had done. That is why Sir Alan and I began to write about Hong Kong immediately. Some of our findings are contained in the entry “Currency Boards” in the The New Palgrave Dictionary of Money and Finance (Walters and Hanke 1992). Sir Alan and I also wrote many “Point of View” columns in Forbes magazine on currency crises and currency boards. My prescriptions have always been preceded with books, monographs, and articles in which the specific ailments of the patients were diagnosed. Many of these were co-authored with my long-time collaborator Kurt Schuler (Strezewski 2020).



The second lesson I learned from studying the Hong Kong crisis is that currency boards are a free-market solution for currency crises. With currency boards, discretionary monetary policies are not possible. The quantity of domestic money in circulation is solely a function of market forces, namely the demand for the local currency issued by a currency board.



The third lesson learned was that effective, high-quality prescriptions are best produced and administered by yourself or in close collaboration with like-minded, trusted colleagues. Indeed, it is usually a small number of people who make things happen.


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Lastly, and perhaps most importantly, I observed that, with the reintroduction of a currency board in Hong Kong, the currency crisis was snuffed out and stability was established immediately. Subsequent research has shown that this was not an anomaly. Indeed, currency boards have a perfect record of establishing and maintaining stability (Hanke, Jonung, and Schuler 1993). And, when it comes to monetary systems, there is nothing more important than stability. As the former German minister of finance Karl Schiller put it: “stability might not be everything, but without stability, everything is nothing” (Marsh 1992: 30).




So, that’s how I started my journey as a money doctor, my initial lessons, and the patients I attended to. But, when considering the types of exchange-rate regimes to prescribe, what types are available and what are their characteristics? There are three distinct types of exchange rate regimes: floating, fixed, and pegged—each with different characteristics and different results. These are shown in Table 1.


Table 1


Hanke’s Foreign-Exchange Trichotomy


Source of Conflicts Between Balance-of-
Type of Exchange Monetary Exchange Rate Exchange
Monetary Payments
Regime Rate Policy Policy and Monetary Controls
Base Crisis
Floating No Yes Domestic No No No
Fixed Yes No Foreign No No No
Pegged Yes Yes Domestic and Yes Yes Probably



Strictly fixed and floating rates are regimes in which the monetary authority is aiming at only one target at a time. Although floating and fixed rates appear dissimilar, they are members of the same free-market family. Both operate without exchange controls and are free-market mechanisms for balance-of-payments adjustments. With a floating rate, a central bank sets a


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monetary policy but has no exchange rate policy—the exchange rate is on autopilot. As a result, the monetary base is determined domestically by a central bank. With a fixed rate, there are two possibilities: either a currency board sets the exchange rate but has no monetary policy—the money supply is on autopilot—or a country is dollarized and uses a foreign currency as its own. Consequently, under a fixed-rate regime, a country’s monetary base is determined by the balance of payments, moving in a one-to-one correspondence with changes in its foreign reserves. With both of these free-market exchange rate mechanisms, there cannot be conflicts between monetary and exchange rate policies, and balance-of-payments crises cannot rear their ugly heads. Floating- and fixed-rate regimes are inherently equilibrium systems in which market forces act to automatically rebalance financial flows and avert balance-of-payments crises.



Most economists use “fixed” and “pegged” as interchangeable or nearly interchangeable terms for exchange rates. However, they are “superficially similar but basically very different exchange-rate arrangements” (Friedman 1990: 28). Pegged-rate systems are those in a which monetary authority is aiming at more than one target at a time. They often employ exchange controls and are not free-market mechanisms for international balance-of-payments adjustments. Pegged exchange rates are inherently disequilibrium systems, lacking an automatic mechanism to produce balance-of-payments adjustments. Pegged rates require a central bank to manage both the exchange rate and monetary policies. With a pegged rate, the monetary base contains both domestic and foreign components. It is important to note that pegged rates, in fact, include a wide variety of exchange-rate arrangements, including pegged but adjustable, crawling pegs, managed floating, etc.


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Unlike floating and fixed rates, pegged rates invariably result in conflicts between monetary and exchange rate policies. For example, when capital inflows become “excessive” under a pegged system, a central bank often attempts to sterilize the ensuing increase in the foreign component of the monetary base by selling bonds, reducing the domestic component of the base. And, when outflows become “excessive,” a central bank attempts to offset the decrease in the foreign component of the base by buying bonds, increasing the domestic component of the monetary base. Balance-of-payments crises erupt as a central bank begins to offset more and more of the reduction in the foreign component of the monetary base with domestically created base money. When this occurs, it is only a matter of time before currency speculators spot the contradictions between exchange rate and monetary policies and force a devaluation, the imposition of exchange controls, or both.



Of note is the fact that, by the 1990s, many countries were practicing what is often termed managed floating, in which the monetary authority does not promise to maintain any particular level of the exchange rate but intervenes from time to time to influence the rate. Despite having a fluctuating rate, managed floating falls under what I term pegged exchange rates, because the monetary authority aims at more than one target at a time.




As a matter of both principle and practice, I—like my mentors Friedman, Walters, and Greenwood—embrace free-market, exchange-rate mechanisms. But, for emerging market countries, the floating option must be dismissed. In emerging markets countries, floating has never proven to be a solution for a currency crisis and has never offered a stable, sustainable system. So, for this money doctor, the prescription for emerging market countries facing


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currency crises or those attempting to simply establish stability, I have always prescribed fixed exchange-rate systems—either currency boards or official dollarization.



Many controversies in economics stem from ill-defined, vague terminology. Indeed, the debasement of language has gone to such lengths that words—like currency boards—have almost lost their meaning. To avoid any confusion that might be created by problems associated with semantic ambiguity, I present the important features of orthodox currency boards (Hanke and Schuler 1994a)



An orthodox currency board issues notes and coins convertible on demand into a foreign anchor currency at a fixed rate of exchange. As reserves, it holds low-risk, interest-bearing bonds denominated in the anchor currency and typically some gold. The reserve levels (both floors and ceilings) are set by law and are equal to 100%, or slightly more, of its monetary liabilities (notes, coins, and, if permitted, deposits). A currency board’s convertibility and foreign reserve cover requirements do not extend to deposits at commercial banks or to any other financial assets. A currency board generates profits (seigniorage) from the difference between the interest it earns on its reserve assets and the expense of maintaining its liabilities.



By design, a currency board has no discretionary monetary powers and cannot engage in the fiduciary issue of money. It has an exchange rate policy (the exchange rate is fixed) but no monetary policy. A currency board’s operations are passive and automatic. The sole function of a currency board is to exchange the domestic currency it issues for an anchor currency at a fixed rate. Consequently, the quantity of domestic currency in circulation is determined solely by


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market forces, namely the demand for domestic currency. Since the domestic currency issued via a currency board is a clone of its anchor currency, a currency board country is part of an anchor currency country’s unified currency area.



Several features of currency boards merit further elaboration. A currency board’s balance sheet only contains foreign assets. If domestic assets are on the balance sheet, they are frozen. Consequently, a currency board cannot engage in the sterilization of foreign currency inflows or in the neutralization of outflows.



Another particularly important feature of a currency board is its inability to issue credit. A currency board cannot act as a lender of last resort or extend credit to the banking system. A currency board cannot make loans to the fiscal authorities and state-owned enterprises. Consequently, a currency board imposes a hard budget constraint and discipline on the fiscal authorities.



A currency board requires no preconditions for monetary reform and can be installed rapidly. Government finances, state-owned enterprises, and trade need not be already reformed for a currency board to begin to issue currency.




Currency boards have existed in about 70 countries. The first one was installed in the British Indian Ocean colony of Mauritius in 1849. By the 1930s, currency boards were widespread among the British colonies in Africa, Asia, the Caribbean, and the Pacific islands. They have also existed in a number of independent countries and city-states, such as Danzig and Singapore.


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One of the more interesting currency boards was installed in North Russia on November 11, 1918, during the civil war. Its architect was John Maynard Keynes, a British Treasury official responsible for war finance at the time. (Hanke, Jonung, and Schuler 1993).



Countries that have employed currency boards have delivered lower inflation rates, smaller fiscal deficits, lower debt levels relative to gross domestic product, fewer banking crises, and higher real growth rates than comparable countries that have employed central banks. Nevertheless, in the aftermath of World War II, many currency boards were replaced by central banks.



Since Hong Kong reinstated its currency board in 1983, currency boards have witnessed something of a resurgence. Indeed, in the wake of the collapse of the Soviet Union, several countries adopted currency boards. In all of these cases, this money doctor was an attending physician and can report that all the new currency boards were installed rapidly and without any preconditions. In most cases, implementation took a month or less.



The reasons for the post-Soviet adoption of currency boards varied. In Estonia in 1992, the overriding objective was to rid the country of the hyperinflating Russian ruble and replace it with a sound currency (Hanke, Jonung, and Schuler 1992). In 1994, Lithuania desired to put discipline and a hard budget constraint on the government’s fiscal operations (Hanke and Schuler 1994b). Hyperinflation was ravaging Bulgaria in early 1997, and the Bulgarians wanted to stop it. As a result, Bulgaria adopted a currency board in July 1997 (Hanke and Schuler 1996; Hanke and Schuler 1997). In Bosnia and Herzegovina, a currency board was mandated in 1997 by the


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Dayton/Paris Peace Agreement that ended the Balkan Wars (Hanke 1996/97; Hanke and Schuler 1991c).



None of these modern currency boards has failed to maintain convertibility at their fixed exchange rates. Indeed, no currency board has ever failed, and this includes Keynes’s Russian currency board in Archangel. For example, the so-called Russian ruble never deviated from its fixed exchange rate with the British pound, and the board continued to redeem rubles for pounds in London until 1920, well after the civil war had concluded (Hanke and Schuler 1991b).



At present, the following countries and territories use orthodox currency boards: Bermuda, Bosnia and Herzegovina, Brunei, Bulgaria, the Cayman Islands (Hanke and Li 2019), Djibouti, the Falkland Islands, Gibraltar, Guernsey, Hong Kong, the Isle of Man, Jersey, Lithuania, Macau, and Saint Helena (Hanke and Sekerke 2003). Note that Estonia and Lithuania are not included in the list because both transitioned from currency board systems to the Eurozone, in 2011 and 2015, respectively (Hanke and Tanev 2020). This was done with ease because both countries used the euro as their currency board anchor currencies and were, therefore, already unified with the Eurozone via their currency boards.




Even though their performances have been superior, currency boards have been entangled in controversy. Perhaps the most notable episode occurred in Indonesia in 1998, when President Suharto indicated that, on my advice as his chief economic adviser, he was going to adopt a currency board to stop surging inflation and the accompanying food riots. This seemed particularly attractive because the currency boards that I had recently installed in Bulgaria and


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Bosnia and Herzegovina had worked well to stop inflation and establish stability (Hanke 1996/97; Hanke and Schuler 1991d). Both currency boards had been enthusiastically supported by the International Monetary Fund (IMF), and one had been mandated by an international treaty.



But, in Indonesia’s case, the currency board proposal spawned ruthless attacks on the idea and Suharto’s chief economic adviser, namely this money doctor (Hanke 2017a). Suharto was told in no uncertain terms—by both the president of the United States, Bill Clinton, and the managing director of the IMF, Michel Camdessus—that he would have to drop the currency board idea or forgo $43 billion in foreign assistance (Blustein 1998; Camdessus 1998a). Economists jumped on the “trash currency boards” bandwagon, too. Every half-truth and nontruth imaginable was trotted out against the currency board idea. For me, those oft-repeated canards were outweighed by full support for an Indonesian currency board from four Nobel laureates in economics: Gary Becker, Milton Friedman, Merton Miller, and Robert Mundell, as well as Sir Alan Walters (Culp, Hanke, and Miller 1999).



As for the ad hominem attacks on me, they followed an unoriginal, standard formula, one that contained contradictory claims and false fabrications. On the one hand, I was depicted as an obscure economist who had played a minor, or no, role in the currency board reforms of the 1990s; on the other hand, I allegedly had an enormous and corrupting influence in the currency reform sphere. As he often does, it was Nobelist Paul Krugman who took the prize as the king of ad hominem attacks (Krugman 1998; Ebeling 2020)


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Why all the fuss over a currency board for Indonesia? Nobelist Merton Miller understood the great game immediately. As he wrote, the Clinton administration’s objection to the currency board was “not that it would not work but that it would, and if it worked, they would be stuck with Suharto” (Tyson 1999: 2). Much the same argument was articulated by Australia’s former Prime Minister Paul Keating: “The United States Treasury quite deliberately used the economic collapse as a means of bringing about the ouster of President Suharto” (Agence France-Presse 1999). Former U.S. Secretary of State Lawrence Eagleburger weighed in with a similar diagnosis: “We were fairly clever in that we supported the IMF as it overthrew [Suharto]. Whether that was a wise way to proceed is another question. I’m not saying Mr. Suharto should have stayed, but I kind of wish he had left on terms other than because the IMF pushed him out” (Agence France-Presse 1998). Even Camdessus could not find fault with these assessments. On the occasion of his retirement, he proudly proclaimed, “We created the conditions that obliged President Suharto to leave his job” (Sanger 1999: C1).



To depose Suharto, two deceptions were necessary. The first involved forging an IMF public position of open hostility to currency boards. This deception was required to convince Suharto that he was acting heretically and that, if he continued, it would be costly. The IMF’s hostility required a quick about-face from its enthusiastic support for Bulgaria’s and Bosnia and Herzegovina’s currency boards which had been installed in 1997.



Shortly after Suharto departed, the IMF’s currency board deception became transparent. On August 28, 1998, Michel Camdessus announced that the IMF would give Russia the green light if it chose to adopt a currency board (Camdessus 1998b). This was followed on January 16, 1999


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with a little-known meeting in Camdessus’s office at the IMF headquarters in Washington, D.C. The assembled group included IMF top brass, Brazil’s Finance Minister Pedro Malan, and the Banco Central de Brasil’s Director of Monetary Policy Francisco Lopes. It was at that meeting that Camdessus suggested that Brazil adopt a currency board (Blustein 2001).



The second deception involved the widely-circulated story that I had proposed to set the rupiah’s exchange rate at an overvalued level so that Suharto and his cronies could loot Bank Indonesia’s reserves. This take-the-money-and-run scenario was the linchpin of the Clinton administration’s campaign against Suharto. It was intended to “confirm” Suharto’s devious intentions and rally international political support against the currency board idea and for Suharto’s ouster.



The overvaluation story was enshrined by the Wall Street Journal on February 10, 1998 (McDermott, Solomon, and Pura 1998: A13). The Journal reported that Peter Gontha had summoned me to Jakarta and that I had prepared a working paper for the government in which I recommended that the rupiah-U.S. dollar exchange rate be set at 5,500. This was news to me. I did not meet, nor know of, Peter Gontha, nor had I authored any such working paper about Indonesia or proposed an exchange rate for the rupiah.



I immediately attempted to have this fabrication corrected. It was a difficult, slow, and ultimately unsatisfactory process. Although the Wall Street Journal reluctantly published a half-baked correction on February 19th, the damage had been done (Wall Street Journal 1998: A2).


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The Journal’s fabrication (or some variant of it) was repeated in virtually every major magazine and newspaper in the world, and it continues to reverberate to this day, even in so-called scholarly books and journals. For example, in his 2000 memoir, From Third World to First, The Singapore Story: 1965-2000, Lee Kuan Yew asserted that “in early February 1998, Bambang, the president’s son, brought Steve Hanke, an American economics professor from The Johns Hopkins University, to meet Suharto to advise him that the simple answer to the low exchange value of the rupiah was to install a currency board.” (Lee 2000: 280). Among other things, this bit of misinformation was a surprise, since I have never had any contact with Bambang Suharto. But, it is not just politicians who fail to “fact check” their assertions. Theodore Friend’s 2003 tome, Indonesian Destinies, misspells my name and then proceeds to say that I “counseled the [Suharto] family to peg the exchange rate at 5000” (Friend 2003: 314).



Setting the record straight was also complicated by the official spinners at the IMF. Indeed, they were busy as little bees rewriting monetary history to cover up the IMF’s mistakes, and Indonesia represents one of its biggest blunders. To this end, the IMF issued a 139-page working paper “Indonesia: Anatomy of a Banking Crisis: Two Years of Living Dangerously 1997–99” in 2001 (Enoch et al. 2001). The authors include a “politically correct” version of the currency board episode in which they assert, among other things, that I counseled President Suharto to set the rupiah-dollar exchange rate at 5000. This pseudo-scholarly account, which includes 115 footnotes, fails to document that assertion. That’s because it simply cannot be done. That official IMF version of events also noticeably avoids referencing any of my many published works or interviews based on my Indonesian experience. Nor does it refer to an exclusive interview that I had with Stephens Broening of the International Herald Tribune (Broening 1998). That


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interview should have been of particular interest to the IMF “scholars” since I addressed my preferred procedure for setting an exchange rate for a currency board. That procedure is the one I had employed in Bulgaria, In that interview, I also indicated that no exchange rate had been set for the proposed Indonesian currency board.



As if the Indonesian controversy was not bad enough, the currency board idea became engulfed in even more controversy in Argentina. During the 1989-91 period, at the suggestion of President Carlos Menem, I worked closely with Congressman José María Ibarbia and his colleagues (the so-called Alsogaray faction) in the Argentine Congress to develop a blueprint for a currency board. This blueprint, Banco Central o Caja de Conversion?, was published in Buenos Aires, debated in the Argentine Congress, and presented to President Carlos Menem (Hanke and Schuler 1991a).



To stop a triple digit inflation, Argentina eventually introduced a Convertibility system in April 1991. Convertibility stopped inflation in its tracks and laid the foundation for an economic boom. Convertibility had certain features of a currency board: (a) a fixed exchange rate, (b) full convertibility, and (c) a minimum reserve cover for the peso of 100% of its anchor currency, the U.S. dollar. However, it had two major features that disqualified it from being an orthodox currency board and rendered Convertibility a pegged exchange-rate arrangement. It had no ceiling on the amount of foreign assets held at the central bank relative to the central bank’s monetary liabilities. So, the central bank could engage in sterilization and neutralization activities, which it did. In addition, it could hold and alter the level of domestic assets on its


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balance sheet. So, Argentina’s monetary authority could engage in discretionary monetary policy, and it did so aggressively.



In late 1991, I expressed my concerns about the flaws in the Convertibility system and predicted that the system would eventually encounter problems (Hanke 1991). As time passed, my critiques became more pointed (Hanke 2008). But, my critiques were to no avail. In December 2001, Argentina suspended its debt payments and trading of the peso, and, on January 6, 2002, Argentina abandoned the Convertibility system, and the Argentine peso was devalued.



But, that wasn’t the only damage associated with the demise of the Convertibility system. Even though Convertibility was not a currency board, most economists failed to recognize this fact. Indeed, a scholarly survey of 100 leading economists who commented on the Convertibility system found that almost 97% incorrectly identified it as a currency board system (Schuler 2005). By mischaracterizing the Convertibility system as a currency board, economists and commentators of all types have been able to spin a false narrative about the so-called failure of Argentina’s currency board. The confusion in policy-making circles spawned by this false narrative has been and remains significant.




A close cousin of the currency board is dollarization. Indeed, both are fixed exchange-rate regimes. Dollarization occurs when residents of a country use a foreign currency instead of the country’s domestic currency. The term dollarization is used generically and covers all cases in which a foreign currency is used by local residents. Even though other foreign currencies, such


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as the euro, are sometimes used instead of local currencies, it is the U.S. dollar that dominates; hence, the use of the term dollarization.



There are different varieties of dollarization. Unofficial dollarization occurs when a country issues domestic currency, but foreign currencies, or assets denominated in foreign currencies, are also used as a means of payment and/or a store of value. Data on the magnitude of total unofficial dollarization are unavailable. However, estimates of U.S. dollar notes held abroad provide a sense of the magnitude. The U.S. Federal Reserve estimates that as much as 72% of all dollar notes are held abroad (Judson 2017). Today, the stock of dollar notes outstanding is $1.99 trillion. So, as much as $1.43 trillion worth of dollar notes are held overseas. And, this is just the tip of the iceberg. Indeed, that number only includes U.S. dollar notes held overseas. It does not include foreign dollar currency bank deposits and foreign holdings of dollar-denominated bonds, nor does it include other dollar-denominated monetary assets. If we add in all the uses of the U.S. dollar as a unit of account and vehicle currency for the execution of foreign trade and capital transactions, a simple fact emerges: the world is unofficially highly dollarized.



Another type of dollarization is semiofficial dollarization. In this case, a country’s monetary system is officially multimonetary. Both domestic and foreign currencies are legal tender. Peru is an example. With semiofficial dollarization, foreign currency bank deposits are often dominant, but a domestic currency is still widely used for transactional purposes and mandated for the payment of taxes. Semiofficial systems force local central banks to compete with foreign challengers. Consequently, a domestic central bank in such a system should, in principle, be more disciplined than would otherwise be the case.


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Official dollarization occurs when a country does not issue a domestic currency but instead adopts a foreign currency. With official dollarization, a foreign currency has legal tender status. It is used not only for contracts between private parties but also for government accounts and the payment of taxes. Today, the following 37 countries and territories have dollarized systems: American Samoa, Andorra, Bonaire, the British Virgin Islands, the Cocos (Keeling) Islands, the Cook Islands, Northern Cyprus, East Timor, Ecuador, El Salvador, Gaza, Greenland, Guam, Kiribati, Kosovo, Liechtenstein, the Marshall Islands, Micronesia, Montenegro, Monaco, Nauru, Niue, Norfolk Island, the Northern Mariana Islands, Palau, Panama, Pitcairn Island, Puerto Rico, San Marino, Tokelau, the Turks and Caicos Islands, Saba, Sint Eustatius, Tuvalu, the U.S. Virgin Islands, Vatican City, and the West Bank. This list does not include monetary unions, like the European Monetary Union, in which member countries all use a “foreign” currency, namely the euro.




Panama, which was dollarized in 1903, illustrates the important features of a dollarized economy. Panama is part of the dollar bloc. Consequently, exchange rate risks and the possibility of a currency crisis vis-à-vis the U.S. dollar are eliminated. In addition, the possibility of banking crises is largely mitigated because Panama’s banking system is integrated into the international financial system. The nature of Panamanian banks that hold general licenses provides the key to understanding how the system as a whole functions smoothly. When these banks’ portfolios are in equilibrium, they are indifferent at the margin between deploying their liquidity (creating or withdrawing credit) in the domestic market or internationally. As the liquidity (credit-creating potential) in these banks changes, they evaluate risk-adjusted rates of return in the domestic and


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international markets and adjust their portfolios accordingly. Excess liquidity is deployed domestically if domestic risk-adjusted returns exceed those in the international market and internationally if the international risk-adjusted returns exceed those in the domestic market. This process is thrown into the reverse when liquidity deficits arise.



The adjustment of banks’ portfolios is the mechanism that allows for a smooth flow of liquidity (and credit) into and out of the banking system (and the economy). In short, excesses or deficits of liquidity in the system are rapidly eliminated because banks are indifferent as to whether they deploy liquidity in the domestic or international markets. Panama can be seen as a small pond connected by its banking system to a huge international ocean of liquidity. Among other things, this renders unnecessary the traditional lender-of-last-resort function performed by central banks. When risk-adjusted rates of return in Panama exceed those overseas, Panama draws from the international ocean of liquidity, and when the returns overseas exceed those in Panama, Panama adds liquidity (credit) to the ocean abroad.



To continue the analogy, Panama’s banking system acts like the Panama Canal to keep the water levels in two bodies of water in equilibrium. Not surprisingly, with this high degree of financial integration, there is virtually no correlation between the level of credit extended to Panamanians and the deposits in Panama. The results of Panama’s dollarized money system and internationally integrated banking system have been excellent when compared with other emerging market countries (Hanke 2002b).


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Since Panama is part of a unified currency area, its inflation rate mirrors, broadly speaking, the rate of inflation in the United States. For example, over the past 16 years, inflation in Panama has averaged 2.8% per year; whereas, the U.S. inflation rate has averaged 2.1% per year. Moreover, Panama’s real growth rate in U.S. dollar terms has steadily risen since 2000, increasing much more rapidly than any other country in Latin America in that period.



Whereas Panama has been dollarized for over a century, several countries have dollarized only recently. One is Montenegro. While still part of the rump Yugoslavia, Montenegro, in 1999, dumped the hapless dinar and replaced it with the mighty German mark. President Milo Djukanovic engineered this dramatic, daring, and dangerous move. It will go down as one of the 20th century’s most significant currency reforms, setting Montenegro on a path towards independence, membership of the North Atlantic Treaty Organization, and what might one day be entry into the European Union.



In Montenegro, I served as state counselor, a position that carried cabinet rank, and as adviser to Djukanovic. In that capacity, I determined that the replacement of the Yugoslav dinar with the German mark was both feasible and desirable (Bogetic and Hanke 1999).



In 1999, Montenegro was still, along with Serbia, part of the Federal Republic of Yugoslavia. Strongman Slobodan Milošević was the president of Yugoslavia and had control of the army. On November 2, 1999, Djukanovic made a decisive move that would set Montenegro on a course towards independence: he granted the mark legal tender status. This all but eliminated the dinar from circulation in Montenegro. It also infuriated Milošević. Although he refrained from


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unleashing the Yugoslav army on Montenegro, he was reported to have given serious consideration to that idea.



Milošević’s operatives did, however, engage in a great deal of mischief. For one thing, I became a marked man. Goran Matic, the Yugoslav information minister, produced a steady stream of bizarre stories. These were disseminated through Tanjug, the Yugoslav state news agency. Among other charges, I was accused of being the leader of a smuggling ring that was destabilizing the Serbian economy by flooding it with counterfeit dinars. The most spectacular allegation, however, was that I was a French secret agent who controlled a hit-team code-named ‘Pauk’ (‘Spider’), and that this five-man team’s mission was to assassinate Milošević.



In addition to this comedy of the absurd, there was a serious side. I knew this was the case because, although Mrs. Hanke and I were kept in the dark about the specific nature of the threats, Djukanovic’s office always assigned us with heavy security when we traveled to Montenegro’s capital of Podgorica – a difficult destination that required a flight from Zagreb to Dubrovnik, Croatia and then a long trip through the mountains to Podgorica.



A recent case of dollarization occurred in Zimbabwe. In 2008, Zimbabwe realized the second-highest hyperinflation in world history. The monthly inflation rate in November 2008 was 79,600,000,000% (Hanke and Kwok 2009). Faced with that inflation rate, Zimbabweans simply refused to use Zimbabwe dollar notes. Consequently, Zimbabwe unofficially and spontaneously dollarized. In April 2009, the government was forced to officially dollarize. With that, the


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“printing presses” were shut down, the government accounts became denominated in U.S.


dollars, a new national unity government was installed, and the economy boomed.





That rebound persisted during the term of the national unity government, which lasted until July 2013. During this period, real G.D.P. per capita surged at an average annual rate of 11.2 percent. And, with the imposition of a hard budget constraint, Zimbabwe’s budget deficits were almost eliminated.



Zimbabwe’s period of stability was short lived, however. With the collapse of the unity government and the return of President Robert Mugabe’s Zimbabwe African National Union – Patriotic Front party in 2013, government spending and public debt surged, resulting in economic instability. To finance its deficits, the government created a “New Zim dollar,” and Zimbabwe de-dollarized (Hanke 2017b). The New Zim dollar was issued at par to the U.S. dollar but traded at a significant discount to the U.S. dollar. The money supply exploded in Zimbabwe and so did the inflation rate. On September 14, 2017, Zimbabwe entered its second bout of hyperinflation in less than ten years (Hanke and Bostrom 2017).



Another recent example of dollarization is Ecuador, where I operated as an adviser to the minister of economy and finance. During 1999, the value of Ecuador’s currency, the sucre, plummeted, losing 75 percent of its value against the U.S. dollar. As a result, President Jamil Mahuad announced on January 9, 2000 that Ecuador would abandon the sucre and officially adopt the U.S. dollar. With that announcement, inflation plunged, and Ecuador’s economy stabilized.


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Ecuador’s dollarization is an outstanding example of “The 95% Rule” in action. At least 95% of what was written about the feasibility and prospects for currency boards or dollarization is either wrong or irrelevant. The IMF, the Banco Central del Ecuador, leading investment banks, and economic commentators—including Nobelist Paul Krugman—all warned that Ecuador’s dollarization would be a disaster. How wrong they were (Hanke 2003).



Ecuador’s dollarization also illustrates the importance of public opinion and public support. Even though many prominent politicians—including Ecuador’s former President Rafael Correa—have found the monetary straitjacket imposed by dollarization to be most uncomfortable, they have not dared to replace it, because the public strongly supports dollarization (Santos 2015). Consequently, dollarization is the longest-lived exchange-rate arrangement that has endured in Ecuador since its independence in 1822.




So, for this money doctor, the prescription that, in principle, should work and the one that has worked to introduce hard budget constraints and establish stability has been fixed exchange-rate regimes—either currency boards or dollarized systems. While attending to patients, I have made many observations and learned many lessons. Some are narrow and somewhat personal, but important. Others are more general.



Let’s begin with nine somewhat narrow principles and rules.


  1. The 95% Rule – My work as a money doctor confirms an assertion I first heard the late Armen Alchian make during a lecture at the University of Virginia in the summer of


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1967: 95% of the material in economics journals and financial press is either wrong or irrelevant. Accordingly, to be right and relevant, you have to think most things through by yourself.



  1. The Plumbing Principle – To develop effective reforms, the late Lord Peter Bauer was fond of counseling me to avoid a curse that afflicts most economists: to float above the detail. I have taken his advice to heart. Consequently, my reform blueprints always contained the details and institutional plumbing required to establish and operate new monetary regimes. They were based on a careful examination of primary documents and data.



  1. The Market Experience Principle – Related to the plumbing principle is the market experience principle. I have had over 65 good years of experience trading currencies and commodities. And, some of those years were notable. For example, in 1995, when I was president of Toronto Trust Argentina (TTA) in Buenos Aires, TTA was the world’s best performing emerging market mutual fund (Hanke 2019). There is nothing quite like market experience to assist a money doctor.



  1. The Repetition Rule – At the 1997 Forbes CEO Forum in Los Angeles, the late Prof. Peter Drucker reminded me that the hallmark of great salesmanship is repetition enhanced by incremental product improvement. I have attempted to follow his wise counsel. Indeed, a recent bibliography on currency boards contains 394 entries under my name (Strezewski 2020).


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  1. The Patience Principle – Over many enjoyable summer holidays at Palazzo Mundell in Tuscany, I learned an important principle from Nobelist Robert Mundell: the patience principle. Simply stated, a money doctor must develop and circulate his ideas but have the patience to refrain from striking until the iron is hot, namely in times of crisis and stress.



  1. The Strike While the Iron is Hot Rule – When the iron is hot, a money doctor must move. One example will illustrate this rule. Prime Minister Adolfas Šleževičius had visited


Estonia in 1993, was impressed by Estonia’s currency board, and inquired as to who was the currency board’s architect. Upon learning that I had designed Estonia’s system, he contacted me in Paris and invited Mrs. Hanke and me for a private lunch in Vilnius. Mrs. Hanke and I caught the next flight from Paris to Vilnius and lunched with Šleževičius on


January 26, 1994. Before the dessert was served, Šleževičius had decided that Lithuania would install a currency board and that I would serve as state counselor.





  1. The Pay Your Own Way Rule – To retain one’s independence and ensure one’s speed and freedom of movement, my principle adviser, namely Mrs. Hanke, advised me to conduct all of my affairs as a money doctor on a pro bono basis, not as a paid consultant. I have strictly followed this rule, and it has paid handsome dividends.



  1. The Be Prepared to Live Dangerously Rule – As Machiavelli repeatedly stressed, nothing great could ever be achieved without danger (Machiavelli 1979). How right he was.


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Some currency reforms of the type proposed by this money doctor have threatened to upset apple carts. That threat has put me in the cross hairs of state-sponsored assassins on three occasions. Fortunately, the attempts failed to hit their intended target.



The first two attempts were in Indonesia. During one of our nightly meetings in his little den at his private residence, President Suharto surprised me by stating that he had good intelligence that I was a marked man. He informed me that two foreign services wanted me out of the picture. As a result, Suharto assigned part of his personal security detail to look after Mrs. Hanke and me on a 24/7 basis. Two ladies were assigned to Mrs. Hanke and usually three or four young men watched after me. The next time we received this “marked man” treatment was in Montenegro in 1999. As I have recounted earlier in this chapter, that episode was very public.



  1. The Numero Uno Rule – If possible, listen carefully to counsel from a trusted advisor who is cultured and wise to the ways and art of statecraft. For me, following this rule has been both possible and pleasurable. I have relentlessly relied on sage counsel from Mrs. Hanke, a Parisian and, as Americans would say: my wife, Liliane.




Beyond the narrow and somewhat personal lessons that I have learned while practicing as a money doctor, there have been many broader lessons. The broader ones relate to economists. Economists are surprisingly unaware of economic history and the economics literature. They rarely read primary documents and study primary data. They display a tendency towards


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intellectual laziness. Consequently, they have a great propensity to repeat and echo whatever is in “the wind.”



Given the excellent performance of currency boards, one would have thought that economists would have asked the obvious question: What led to the demise of currency boards and their replacement by central banks after World War II? Well, I have found that few have ever bothered to ask the question. Never mind. I posed the question to myself and have concluded that the demise of currency boards resulted from a confluence of three factors. A choir of influential economists was singing the praises of central banking’s flexibility and finetuning capacities. In addition to changing intellectual fashions, newly independent states were trying to shake off their ties with former imperial powers, including currency boards. And, the IMF and World Bank, anxious to obtain new clients and “jobs for the boys,” lent their weight and money to the establishment of new central banks. In the end, the Bank of England provided the only institutional voice that favored currency boards. That was obviously not enough (Tignor 1998).



So, central banking swept currency boards away in most of the newly independent states. How did that monetary revolution work out? Well, few economists have bothered to ask that question, and fewer have bothered to produce studies that address it. Perhaps that is because the few studies that have been conducted paint a grim picture of central banking. Indeed, the claims made by the economists who were singing the glories of central banking are refuted (Schuler 1996; Hanke 2002a). With the replacement of currency boards by central banks, fiscal deficits ballooned, debt levels surged, inflation accelerated, economic growth slowed and became more volatile, banking crises became more frequent, and the domestic and international purchasing


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power of newly issued domestic currencies evaporated. Not a pretty picture, and not a picture on display in standard economics textbooks.



Beyond the failure to ask and answer these basic questions, economists have failed to understand Milton Friedman’s works and positions on exchange-rate regimes. This is important and has resulted in mountains of misinformation which have generated confusion in policy-making circles (Schleifer 2005: 84-93).



Friedman’s first and most famous foray into the exchange rate debate was as much an attack on exchange controls and a case for free trade as anything else. He originally wrote “The Case for Flexible Exchange Rates” (1953) as a memorandum in 1950, when he served as a consultant to the U.S. agency administering the Marshall Plan. At the time, European countries were imposing a plethora of controls on cross-border flows of trade and capital. Friedman opposed these restrictions. He concluded that adopting floating exchange rates across Europe would remove the need for exchange controls and other distortionary policies that impeded economic freedom.



It is important to stress that economic freedom was also a primary motivator for Friedman’s advocacy of unified currency regimes for developing countries. Friedman (1973: 47) concluded:



“While the use of a unified currency is today out of fashion, it has many advantages for development, as its successful use in the past, and even at present, indicates. Indeed, I suspect that the great bulk, although not all, of the success stories of development have occurred with such a monetary policy, or rather an absence of monetary policy. Perhaps the greatest advantage


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of a unified currency is that it is the most effective way to maximize the freedom of individuals to engage in whatever transactions they wish.”



Even though the title of Friedman’s renowned 1953 article has contributed to the misperception that he was a dogmatic proponent of floating rates, a close reading makes it clear that he was not arguing so much in favor of floating exchange rates as in favor of full convertibility. He simply saw floating exchange rates as the best way to achieve full convertibility quickly in Western Europe. The overriding “free-trade” motivation is made clear when Friedman discusses the sterling area: “In principle there is no objection to a mixed system of fixed exchange rates within the sterling area and freely flexible rates between sterling and other countries, provided that the fixed rates within the sterling area can be maintained without trade restrictions” (Friedman 1953: 193).



Another factor that led people to pigeonhole Friedman as a dogmatic advocate of floating rates was the fact that Harry Johnson and other economists associated with the University of Chicago were strong, and according to most observers, one-sided in their advocacy of floating rates. Many incorrectly concluded that Friedman espoused the same views as some of his colleagues. Johnson’s tendentious views on exchange rates are diagnosed by Richard Cooper. In commenting on a review article by Johnson titled “The Case for Flexible Exchange Rates, 1969” (Johnson 1969), Cooper (1999: 8–9) wrote:



“The essay is well-balanced in its overall structure: he states the case for fixed rates; the case for flexible rates; and the case against flexible rates. But only one paragraph is devoted to stating the


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case for fixed rates, the remainder of the section to why it is “seriously deficient.” And the section on the case against flexible rates is basically devoted to knocking it down, consisting as it does in Johnson’s view “of a series of unfounded assertions and allegations.” It is not a balanced account; Johnson had made up his mind and hoped to impose his conclusions on others by a devastating critique of the (unnamed) opposition.



Johnson’s affirmative analysis is itself based on a series of unfounded assertions and allegations, an idealization of the world of financial markets without serious reference to their actual behavior.”



In the 1960s, Friedman turned his attention toward monetary problems in developing countries, where inflation and exchange controls were pervasive. For many of these countries, Friedman was skeptical about floating exchange rates because he mistrusted their central banks and doubted their ability to adopt a rule-based internal anchor (such as a money-supply growth rule). To rid developing countries of exchange controls, his free-market elixir was the fixed exchange rate (an external anchor). As Friedman put it:



“The surest way to avoid using inflation as a deliberate method of taxation is to unify the country’s currency [via a fixed exchange rate] with the currency of some other country or countries. In this case, the country would not have any monetary policy of its own. It would, as it were, tie its monetary policy to the kite of the monetary policy of another country—preferably a more developed, larger, and relatively stable country” (Friedman 1974: 270).


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In many cases, he advocated fixed exchange rates rather than floating. For example, in response to a question during his Horowitz lecture of 1972 in Israel, Friedman (1973: 64) concluded: “The great advantage of a unified currency [fixed exchange rate] is that it limits the possibility of governmental intervention. The reason why I regard a floating rate as second best for such a country is because it leaves a much larger scope for governmental intervention.… I would say


you should have a unified currency as the best solution, with a floating rate as a second-best solution and a pegged rate as very much worse than either.”



It is not surprising that Friedman was clear and unwavering in his prescription for developing countries: “For most such countries, I believe the best policy would be to eschew the revenue from money creation, to unify its currency with the currency of a large, relatively stable developed country with which it has close economic relations, and to impose no barriers to the movement of money or prices, wages, or interest rates. Such a policy requires not having a central bank” (Friedman 1973: 59).



In 1992, I co-authored a book, Monetary Reform for a Free Estonia, which carries the following dust jacket endorsement by Friedman: “A currency board such as that proposed by Hanke, Jonung, and Schuler is an excellent system for a country in Estonia’s position” (Hanke, Jonung, and Schuler 1992). On May 5, 1992, I presented our proposal to the Estonian parliament, and, on June 24, the Russian ruble was replaced by the kroon, which traded at a fixed rate of 8 per German mark (subsequently 15.65 per euro).


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During the Asian financial crisis of 1997–98, Friedman again entered the fray when he lent his support to my proposed currency board for Indonesia. Shortly after Suharto accepted my proposal, the Far Eastern Economic Review (March 26, 1998) published “The Sayings of Chairman Milton.” His thoughts on a currency board for Indonesia were: “If the Indonesians would live by the discipline, it could be a good thing. What else can they do?”



Where did Friedman stand with regard to one of the world’s showcase free-market economies? He favored Hong Kong’s fixed exchange rate. As Friedman wrote in 1994, “The experience of Hong Kong clearly indicates that a particular country like Hong Kong does not need a central bank. Indeed it has been very fortunate that it has not had one. The currency board system that was introduced in 1983 has worked very well for HK and I believe it is desirable that it be continued” (Friedman 1994: 55). And, I would add, that Hong Kong’s currency board system performed very well during the Asian financial crisis and, most recently, during the troubles and political turmoil that have afflicted Hong Kong over the past year (Greenwood and Hanke 2019a; Greenwood and Hanke 2019b).



These examples should put to rest the widespread notion that Friedman exclusively favored floating exchange rates. But, unfortunately, it is clear that most economists have either not read, misunderstood, or chosen to ignore Friedman’s works on the subject. Their propagation of misinformation has greatly complicated this money doctor’s espousal of hard budget constraints imposed by fixed exchange-rate regimes for emerging market countries.




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With the collapse of the Soviet Union and its satellites, a newfound interest in currency boards and, more broadly, fixed exchange-rate regimes rose like a Phoenix. It arose because of a desire to install a monetary regime to which the fiscal regime would be subordinated. By putting the monetary authorities in a straitjacket, currency boards were viewed as a means to impose hard budget constraints and fiscal discipline.



This newfound embrace of fixed exchange rates did not go unchallenged. Indeed, cottage industry housing passionate opponents of currency boards and fixed exchange rates developed. The works they produced, much like those in development economics, have displayed a “disregard for contrary opinions” (Bauer 1976: 231). Or, as Michael Polanyi phrased it: “the normal practice of scientists to ignore evidence which appears incompatible with the accepted system of scientific knowledge” (Polanyi 1958: 138). The opponents of fixed exchange-rate regimes suffer from parasitic citation loops in which like-minded works are often exclusively cited. As for the empirical evidence, it is swept away like flies. The opponents also typically employ “nirvana economics” in which the ideal of central banking is compared to the actual operation of currency boards and dollarized systems. What ended up as a campaign against fixed exchange rates produced a long list of arguments and what are often nothing more than clichés.



The most common cliché that has been propagated by the opponents of currency boards is the notion that certain preconditions must be satisfied before currency boards can be adopted. It was even repeated by the Council of Economic Advisers (CEA): “A currency board is unlikely to be successful without the solid fundamentals of adequate reserves, fiscal discipline and a strong and well-managed financial system, in addition to the rule of law” (CEA 1999: 289).


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This statement is literally fantastic and demonstrates how far off base professional economists can get when they fail to carefully study the history, workings, and results of alternative real-world institutions. After all, none of the successful currency boards of the 1990s was installed in a country that came close to satisfying even one of the alleged preconditions. Interestingly, currency boards (and dollarization) are attractive regimes to employ when the preconditions stated by the CEA are not met. How the CEA, which is armed with an army of fact checkers, could make such an error is remarkable.



The second oft-cited criticism of currency boards is that they are rule bound and rigid. Consequently, it is asserted that countries that employ them are more subject to internal and external shocks than are countries with central banks. If this were true, the variability of growth measured by the standard deviations in growth rates in currency board countries would be larger than in central banking countries. The facts do not support this thesis (Hanke 1999). Like many things economists assert, the “shock argument” is not based on an examination of primary data. It is little more than an unverified conjecture—a straw man. In reality, the flexibility and discretionary powers enjoyed by central banks in emerging market countries allows them to create and stir troubled waters because they often engage in pro-cyclical, destabilizing policies (Schuler 1996).



The inability of a currency board to extend credit to the banking system constitutes a third criticism. As the United Nations Conference on Trade and Development put it, “a currency board regime makes payments crises less likely only by making bank crises more likely” (United


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Nations 2001: 117). This is yet another straw man. The major banking crises in the world have all occurred in central banking countries in which the lender of last resort function was practiced with reckless abandon (Frydl 1999). In contrast, currency board countries have not only avoided major banking crises, but their banking systems—knowing they would not be bailed out by a lender of last resort—have tended to strengthen over time.



Bulgaria is but one example. The 1999 Organization for Economic Cooperation and Development (OECD) Economic Survey of Bulgaria stated, “By mid-1996, the Bulgarian banking system was devastated, with highly negative net worth and extremely low liquidity, and the government no longer had any resources to keep it afloat” (OECD 1999: 60). However, the OECD also observed, “By the beginning of 1998, [six months after the installation of its currency board], the situation in the commercial banking sector had essentially stabilized, with operating banks, on aggregate, appearing solvent and well-capitalized” (OECD 1999: 59).



It is worth noting that, in 2014, there was a banking scandal in Bulgaria. The Corporate Commercial Bank (KTB) was declared insolvent and shuttered (Hanke and Sekerke 2014). An astounding 76% of its commercial loan portfolio had simply vanished. The KTB apparently never operated as a commercial bank. Unfortunately, the regulators at the Bulgarian National Bank failed to detect this. But, fortunately, the Issue Department (the currency board) at the Bulgarian National Bank could not engage in lender of last resort activities because credits to the KTB would have vanished without a trace. Thanks to Bulgaria’s currency board, the country’s banking system remained unscathed and stable after the collapse of the KTB.


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A fourth cliché states that competitiveness cannot be maintained after the adoption of a currency board. Hong Kong contradicts this conventional wisdom. Since its currency board was installed in 1983, it has retained its rank as one of the most competitive economies in the world (Schwab 2019). Furthermore, countries that adopted currency boards in the 1990s have maintained their competitiveness measured by exports as a percent of GDP.



A fifth assertion made by opponents of currency boards is that currency boards are desirable only in small, if not tiny, economies. It is true that most currency boards today are in relatively small economies. However, Hong Kong is not small. Indeed, Hong Kong ranks as the 35th largest economy in the world (World Bank 2020).



A sixth concern expressed by economists is that currency boards are not suitable for most countries because most prospective currency board countries are not in an optimum currency area with an anchor currency country. Therefore, currency boards would be inappropriate. Well, an optimum currency area is an artificial construct within which exchange rates should be fixed and between which exchange rates should be flexible. The problem is that the facts on the ground contradict the economists’ notion of an optimal currency area. For example, citizens of many countries voluntarily choose to hold bank deposits and make loans in U.S. dollars, and the value of dollar notes (paper money) exceeds the value of the local domestic money issued in those countries. So, citizens have themselves determined that the dollar is the best currency, regardless of what the optimal currency area theorists have concluded.


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A seventh argument, the issue of sovereignty, is intended to stir populist ire. It is argued that monetary sovereignty is lost by the adoption of a currency board because an independent monetary policy is given up. True. After all, a currency board has no monetary policy. However, national sovereignty over a country’s monetary regime is retained. Indeed, history has shown that many countries that once had currency boards have unilaterally exited from those rulebound systems, albeit to their peril.



In closing, one final comment merits attention because it reveals just how confusing the debate about the desirability of currency boards has been. Has the IMF been for or against currency boards? Well, it depends on when you ask. Ex ante, the IMF has often been opposed and has employed many of the clichés mentioned above. But, ex post, the IMF has had nothing but praise for the four currency boards installed in the 1990s, as well as Hong Kong’s (IMF 2001a, 2001b, 2001c, 2001d, and 2001e). According to the IMF, these currency boards have strengthened fiscal discipline and the banking systems, have motivated reforms, and have been the linchpins for growth.



So, the cacophony about the efficacy of various types of exchange-rate regimes coming from economists, as well as established institutions, is deafening. As a result, confusion reigns in the political arena when decisions are made (Schleifer 2005: 84-93). This makes a money doctor’s job difficult, to say the least.




There is little doubt that fixed-exchange rate regimes, either currency boards or dollarization, impose hard budget constraints. These rein in fiscal authorities, even in countries with weak


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institutions. Bulgaria, which has had a currency board since 1997, illustrates this point. Table 2 contains data before and after the installation of the currency board in July 1997. All economic indicators improved rapidly and dramatically after the currency board’s hard budget constraint was imposed. And, stability has been maintained by various types of governments for over 20 years. Indeed, if we focus only on the fiscal balance, we observe a great deal of fiscal discipline and relatively small deficits. As a result, Bulgaria has the second lowest debt-to-GDP ratio in the European Union: 18.6%. Estonia is the only EU country with a lower debt-to-GDP ratio: 8.4%.


DRAFT Table 2 Hanke – 40
Bulgaria: Before and After the Installation of Its Currency Board (July 1, 1997)
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Annual Inflation (%) 32.9 310.8 549.2 1.6 7.0 11.3 4.8 3.8 5.6 4.0 7.4 6.1 11.6
Change in Real GDP (%) -1.6 -8.0 -14.2 4.3 -8.3 4.8 3.8 6.0 5.2 6.4 7.2 6.8 6.6
Interest Rates
(Money market rate, % per 52.10 117.66 65.20 2.43 2.87 2.96 3.67 2.42 1.92 1.91 2.02 2.79 4.03
Fiscal Balance (% of GDP) -5.5 -8.1 0.8 1.1 0.1 -0.5 1.0 -1.2 -0.4 1.8 1.0 1.8 2.0
General Government Gross N/A N/A N/A 67.3 78.7 73.3 67.1 53.4 45.4 37.8 28.5 22.6 17.6
Debt (% of GDP)
Foreign Reserves 1,635 864 2,485 3,056 3,264 3,507 3,646 4,846 6,825 9,337 8,697 11,756 17,544
(Millions of U.S. dollars)
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Annual Inflation  (%) 7.2 1.6 4.4 2.0 2.8 -0.9 -2.0 -0.9 -0.5 1.8 2.3 3.1
Change in Real GDP (%) 6.1 -3.4 0.6 2.4 0.4 0.3 1.9 4.0 3.8 3.5 3.1 3.4
Interest Rates
(Money market rate, % per 5.16 2.01 0.18 0.20 0.10 0.02 0.03 0.01 -0.16 -0.20 -0.50 -0.48
Fiscal Balance (% of GDP) 1.6 -4.0 -3.1 -2.0 -0.3 -0.4 -5.4 -1.7 0.1 1.1 2.0 2.1
General Government Gross 14.7 14.5 14.2 14.4 16.6 17.2 26.4 25.4 27.1 23.0 20.1 18.6
Debt (% of GDP)
Foreign Reserves 17,930 18,522 17,223 17,215 20,507 19,883 20,129 22,153 25,176 28,375 28,711 27,900
(Millions of U.S. dollars)


Sources: International Monetary Fund, European Central Bank, World Bank


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But, the hard budget constraints imposed by exchange rate regimes aren’t always guarantors of fiscal probity. For example, Montenegro was dollarized in 1999, and its debt-to-GDP ratio is “high:” 79.3%. And Ecuador, which dollarized in 2001, became so buried in debt that it defaulted in April 2020 (Rapoza 2020).



These two outliers suggest that for greater assurance that hard budget constraints are “hard,” fiscal rules should accompany fixed exchange rate regimes. To do this, supermajority voting should be established for fiscal decisions. Many countries require supermajority voting for important decisions. Such a voting rule protects the minority from the potential tyranny of a simple majority. A supermajority voting rule is particularly important for the protection of minorities in countries where the democratic process is not circumscribed by a firm rule of law.



The arithmetic of the budget shows us that two new fiscal rules would be sufficient to control the scope and scale of the government and protect minority interests. Total outlays minus total receipts equals the deficit, which in turn equals the increase in the total outstanding debt. Rules that limit any two of these variables would limit the remaining variable. Which two variables should be limited?



The easiest way to answer the question about which two variables should be limited by supermajority voting rules is to sketch the outlines of a constitutional amendment (a fiscal rule):



Section 1 – The total national debt may increase only by the approval of two-thirds of the members of the Congress (National Assembly, Parliament, etc).


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Section 2 – Any bill to levy a new tax or increase the rate or base of an existing tax shall become law only by approval of two-thirds of the members of the Congress.



Section 3 – The above two sections of this amendment shall be suspended in any fiscal year during which a declaration of war is in effect.




With that, I conclude my stroll down memory lane. For this money doctor, fixed exchange-rate regimes—whether they be currency boards or dollarized systems—have always proven to be the proper prescription for countries experiencing economic crises. They have imposed hard budget constraints and stabilized the crisis torn patients. And, while stability might not be everything, everything is nothing without stability.


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Currency Reforms and Hard Budget Constraints

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