Twenty-five years ago, most of the world's currencies
were linked to the dollar by fixed or pegged exchange rates. (I will
explain those terms later.) The system was known as the Bretton Woods
system, named after the New Hampshire town where an international
monetary conference establishing the system had been held in 1944.
Although the dollar was far from perfect, it provided some discipline
against inflation and thereby aided economic growth, especially for
developing countries. From 1960 to 1970, average annual inflation in
developing countries was 3-4 percent, about the same as in developed
countries.1 The rather spotty statistics of economic growth for
developing countries indicate that growth per person was increasing
roughly as fast as in developed countries.
The Bretton Woods system began to unravel in 1971 and
collapsed completely by 1973. It unraveled because the U.S. government
abandoned the policy of keeping the dollar convertible into gold at
$35.00 per troy ounce. Over the years the Federal Reserve System, the
U.S. central bank, created money too fast to be compatible with the
government's stock of gold at the existing exchange rate. Foreigners
therefore converted dollars into gold at a rapid rate, which reduced the
U.S. government's stock of gold. Rather than replenish the stock of gold
by having the Federal Reserve raise interest rates, the U.S. government
decided to make the dollar a floating currency in terms of gold.
Other countries thought that they could do better by
floating their currencies also, rather than maintaining pegged exchange
rates with either the dollar or gold. At first it was mainly developed
Western countries that floated their currencies. Over time, though, more
and more developing countries also floated their currencies against the
dollar.
After the collapse of the Bretton Woods system in the
early 1970s, developing and developed countries alike experienced lower
growth and higher inflation. From 1970 to 1980, average annual inflation
was 9.1 percent in developed countries and 26.2 percent in developing
countries. But since about 1980, developed countries have reduced
inflation, while developing countries have not.
From 1980 to 1992 average inflation for developed
countries fell to 4.3 percent a year, while for developing countries it
accelerated to an astounding 75.7 percent. The result has been a
slowdown in economic growth for developing countries. From 1980 to 1992,
economic growth was 2.3 percent per person a year in developed
countries, but only 0.9 percent in developing countries. The trend has
continued since 1992. Only a few East and South Asian developing
countries grew rapidly; many other developing countries actually had
declining income per person.
Central Banks Responsible
The dramatic rise in inflation and fall in economic
growth in many developing countries since 1971 has been caused by their
central banks. Except in Latin America, few developing countries had
central banks before the 1950s. Until then most developing countries
were colonies of European countries, particularly Britain and France.
The currencies of almost all developing countries were linked in one way
or another to the dollar, pound sterling, or franc. The dollar,
sterling, and franc all experienced difficulties before 1971, but even
so they imposed a sort of quality control on the currencies of
developing countries by means of exchange-rate links.
Before developing countries established central banks
they had a variety of arrangements for maintaining exchange-rate links
with the dollar, sterling, or franc. A few countries had free banking-
competitive issue of banknotes by commercial banks although government
intervention ended that system before World War II in most places where
it had existed. Other countries, including some French and Portuguese
colonies, had monopoly issue of notes by a commercial bank that was
granted the monopoly privilege by the government. Still other countries,
mainly French colonies, had monetary institutes. A monetary institute is
a government body that issues banknotes under fairly strict rules, such
as a requirement that it have foreign reserves (bank deposits or
high-quality bonds in a foreign currency) of 50 percent or more against
its banknotes in circulation and other liabilities. Monetary institutes
in French colonies were supervised by the French government, which kept
a watchful eye on them because it did not want to pay for their
mistakes.
Still other developing countries, mainly British
colonies, had currency boards. A currency board is a monetary authority
that issues banknotes and coins (and, in some cases, deposits) backed
100 percent by assets in a foreign "anchor" currency and fully
convertible into the anchor currency at a fixed exchange rate and on
demand. As reserves, a currency board holds low-risk, interest-earning
bonds and other assets payable in the anchor currency, equal to 100
percent or slightly more of its bank notes and coins in circulation (and
deposits, if any), as set by law.,
Although there. were differences in the ways that these
monetary systems worked, they shared two important features. The first
was that all provided relatively low inflation by means of stable
exchange rates to their anchor currencies or to gold or silver. The
second feature, which was related to the first, was that all kept
government away from the monetary printing press, through private
ownership (in the case of free banking and monopoly issue of notes by a
commercial bank) or strict rules governing monetary policy (in the case
of the currency board and monetary institute systems).
The record of these pre-central banking monetary
systems was very good. Devaluations happened occasionally except in
currency board systems, but they were imposed by governments and were
not the fault of commercial banks or monetary institutes. Most of the
pre-central banking systems maintained full convertibility of their own
currencies into their anchor currencies; that is, there were no
restrictions on exchanging their currencies into the anchor currencies.
The record of central banks in developing countries was
much worse even before the 1970s. During the Bretton Woods period
(1946-1971), central banks in developing countries that had signed the
Bretton Woods agreement carried out more than 150 devaluations. All but
a few developing countries with central banks devalued against their
anchor currency-typically the dollar-at least once during the period.
And few had currencies that were fully convertible into their anchor
currency; instead, they had extensive restrictions or outright
prohibitions on exchanging their currency into any foreign currency.
Exchange-Rate Systems and Inflation
Developing countries have done much worse by having
central banks than they would have done by continuing their previous
monetary systems or by ceasing to issue their own currencies and using
the dollar, sterling, or franc instead. The reasons have to do with the
relation between exchange rate systems and inflation.
There are three types of exchange-rate systems: fixed,
pegged, and floating. In theory a developing country could have a
high-quality currency under any of these systems, but in practice a
fixed exchange rate is the only system with a consistent record of doing
the job. Free banking, monopoly issue of notes by a commercial bank, the
monetary institute system, and the currency board system were all
systems of fixed exchange rates.
People often confuse fixed and pegged exchange rates.
They are quite different, however, and have quite different effects.
Both are maintained constant in terms of an anchor currency (which can
be gold), but the similarity ends there. A pegged exchange rate is
maintained constant for the time being in terms of the anchor currency,
but carries no credible long-term guarantee of remaining at its current
rate. A fixed exchange rate is preferably established by law as
permanent, or at most is alterable only in emergencies. A
rough-and-ready classification is that a truly fixed exchange rate is
altered no more than once every thirty years. (Thirty years is the
longest period for which there are active bond and mortgage markets in
many countries.) If the exchange rate is altered more than every thirty
years it should be considered pegged.
Many people think the Bretton Woods system was one of
fixed exchange rates. It was not; rather, it was a mixture of fixed and
pegged rates. Few currencies in the Bretton Woods system floated: in
1970 the only ones were the Canadian dollar, South Korean won, and
Lebanese pound. As I mentioned, most central banks in developing
countries that had signed the Bretton Woods agreement devalued at least
once during the Bretton Woods period. The record of central banks in
developing countries was no better: most of them devalued at least twice
during the period. In contrast, few of the pre-central banking systems
(and no currency board systems) devalued during the Bretton Woods
period.
Since the Bretton Woods system ended the pattern has
continued. The collapse of the Bretton Woods system continued the
weakening of barriers to inflation that began when developing countries
established central banks. Of the more than 150 developing countries
with central banks, the currencies of all but a dozen have depreciated
against the dollar since 1970. Some of the depreciations have been huge:
a Russian ruble is today worth about 1/4,000 its 1970 value in dollars,
and the Brazilian currency, adjusted for all the zeros that have been
chopped off it over the years, is worth less than one-billionth its 1970
value.
Central banks have performed so poorly in developing
countries because pegged and floating exchange rates alike do not
furnish enough of a barrier against political pressures for inflation.
Pegged exchange rates have not worked well in developed countries or
developing countries. They invite currency speculators to profit from a
devaluation that is almost certain to occur eventually. The Bretton
Woods system collapsed because the U.S. dollar was pegged rather than
fixed to gold. The largest attempt to peg exchange rates since the
Bretton Woods system is the Exchange Rate Mechanism of the European
Monetary System, which links several West European currencies to the
German mark. It has experienced great difficulties leading to successful
speculative attacks on most of its currencies on several occasions, most
recently in 1992 and 1993. Among developing countries, the devaluations
of the CFA franc (the currency of 13 former French African colonies) and
the Mexican peso in 1994 are recent examples of the difficulty of
maintaining pegged exchange rates.
Floating exchange rates have a better record in
developed countries. After the painful inflationary experience of the
1970s, developed countries found ways to keep inflation to levels not
much higher than during the Bretton Woods period. Control of inflation
in developed countries has been erratic, but it has been superb compared
to developing countries. However, few developing countries have
succeeded for long periods in combining low inflation and floating
exchange rates. For example, the severe inflations that have occurred in
many former Communist countries since 1989 have occurred mainly in
floating exchange-rate systems.
All this experience suggests that the only way for most
developing countries to have low inflation is to forget about pegged or
floating exchange rates and to have a truly fixed exchange rate with a
relatively stable anchor currency issued by a developed country, such as
the dollar. And the only way to have a truly fixed exchange rate is to
abolish central banks in developing countries and return to one or
another of the pre-central banking systems.
The Ebb of Central Banking?
In the 1950s and 1960s a powerful combination of
misplaced nationalism and interventionist economics convinced most
developing countries that to assert their sovereignty and to fine-tune
the economy they needed to replace their monetary institutes or currency
boards with central banks. All but a handful of developing countries
established central banks.
Recently the tide has begun to turn. On the heels of an
inflation exceeding 2,000 percent a year, Argentina stabilized its
currency by means of a currency board-like system in April 1991.
Estonia, which had suffered inflation exceeding 1,000 percent a year
under the Soviet ruble, issued a new currency by means of a currency
board-like system in June 1992. And after breaking free of the Soviet
Union, experimenting with central banking, and suffering inflation
exceeding 1,000 percent a year in 1992, Lithuania established a currency
board-like system in April 1994. Argentina and Lithuania use the dollar
as their anchor currency, while Estonia uses the German mark.
Like orthodox currency board systems, the Argentine,
Estonian, and Lithuaman systems have 100 percent foreign reserves.
Unlike orthodox currency board systems, though, they have had some
restrictions on convertibility (now weak or removed) and the fixity of
the exchange rate is not entirely secure because the monetary
authorities are not well insulated from political pressure. Even so,
since establishing currency board-like systems all three have had much
lower inflation and have reversed the economic decline they were
previously suffering. Their experience contrasts with the experience of
other countries in their regions that have retained central banking.
Estonia and Lithuania are enjoying economic growth while Russia,
Ukraine, and most other former Soviet republics continue to have
economic decline and inflation of hundreds of percent a year. Argentina
has had four consecutive years of economic growth and has reduced
inflation to mid-single digits, which is highly unusual for Latin
America.
Other countries in Latin America and the former Soviet
Union are now considering establishing currency boards or currency
board-like systems. Monetary institutes are not experiencing a similar
revival because their principles are not as simple and understandable as
those of currency boards. Free banking has received attention from a
growing number of economists, but has not yet convinced a broader
political constituency. Developing countries established central banks
with high hopes that have been un-fulfilled. The best thing they can do
to reverse their poor onetary and economic performance of recent years
is to abolish their discretionary central banks and fix their currencies
to foreign currencies with relatively good records of low inflation. The
currency board system is a well understood and eminently practical way
of doing so. Other alternatives to central banking are also worth
considering. The important thing is to minimize, and preferably
eliminate, discretionary government control in mone-tary policy.
Statistics of inflation and economic growth cited in
the next few paragraphs are from World Bank, World Development Report,
1982, pp. 110-11, and 1994, pp. 162-63. Within groups, statistics are
weighted by gross national product (GNP), so countries with large GNPs
affect the group statistics more than countries with small GNPs.
At the time of the original publication, Mr. Schuler
was an economist in Arlington, Virginia.
Reprinted with permission from The
Freeman, a publication of the Foundation for Economic Education, Inc.,
April 1995, Vol. 45, No. 4.
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