Memo to Gorbachev: 6 Months to Sound Money

STEVE H. HANKE and KIRT SCHULER

June 05, 1991|By STEVE H. HANKE and KURT SCHULER

Paul Volcker, former chairman of the Federal Reserve, recently shocked a meeting of central bankers when he noted that central banks are ''not the cutting edge of a market economy.'' Mr. Volcker stressed the fact that markets developed long before central banks appeared. He concluded by suggesting that central banks were one Western institution that might actually retard the transition to markets in the Soviet Union and Eastern Europe.

Mr. Volcker's message should be transmitted to Mr. Gorbachev, who is scrambling to rescue the near-worthless ruble through back-up credits and other props.

To prevent hyperinflation and to keep the economy from collapsing, the Soviet Union needs a stable currency. Such a currency would be limited in supply. In consequence, it would force workers to stop demanding wage increases unless their pro- ductivity increases. Moreover, a sound currency would force government to plug its ''soft budget constraint.''

The only proven way to provide a sound currency in a chaotic environment is to adopt a currency-board system. Indeed, the Soviet Union had a currency board during the turbulent civil war years, 1918-1920, and it worked well.

Under a currency-board system, there is no central bank. Instead, a currency board issues note and coins convertible into a foreign currency at a fixed rate and on demand. As reserves, a board holds high-quality, interest-bearing securities denominated in the foreign currency. It reserves are equal to 100 percent or slightly more of its notes and coins in circulation, as set by law. A currency board does not accept deposits. It generates income from the difference between the interest paid on the securities it holds and the expense of maintaining notes and coin circulation. A board has no discretionary monetary powers. Instead, market forces alone determine the money supply.

Over 60 countries (mainly former British colonies) have had currency boards. All were successful and maintained convertibility at a fixed exchange rate. Moreover, in countries that used boards, capital- and current-account transactions were little impeded. In consequence, those countries enjoyed the same relatively low interest and inflation rates as the metropolitan centers they were linked to by reserve currencies.

With independence and as an expression of nationalism, most currency boards were replaced by central banks. In consequence, the quality of their domestic currencies deteriorated sharply. Currency boards still exist in Hong Kong, Singapore and Brunei, where they continue to operate with great success.

Russia briefly had its own currency board. When troops from Britain and other allied nations invaded north Russia in the waning days of World War I, they found a chaotic local currency environment. The Russian civil war had begun, and every party to the conflict was issuing its own near-worthless local currency. There were over 2,000 separate issuers of fiat rubles. Trade was difficult because few people would accept fiat rubles in exchange for goods and services.

To facilitate trade with the local population in north Russia, the British established a National Emission Caisse for the area in 1918. The Caisse issued ''British ruble'' notes, backed by British pounds sterling and convertible into pounds at a fixed rate. British Foreign Office archives reveal that the father of the British ruble was none other than John Maynard Keynes, who was a British Treasury official at the time.

Despite a raging civil war, the British ruble was a great success. The currency never deviated from its fixed exchange rate with the British pound. In contrast to other Russian rubles, the British ruble was a reliable store of value, so it drove other rubles out of circulation in north Russia. With British rubles, the allied army was able to buy and sell goods almost as easily as it had been at home on maneuvers. Unfortunately, the British ruble's life was brief. The National Emission Caisse ceased operations in 1920, after allied troops withdrew from Russia.

To establish a convertible ruble, the Soviet Union should follow Keynes' proven example. It should abolish the Gosbank and replace it with a currency board. The best way to introduce the board would be to fix the ruble exchange rate with a foreign reserve currency, so that Soviet exports are competitive. The board would then pledge to exchange the new ruble for the reserve currency at that rate.

The most logical reserve currency for the new board would be the U.S. dollar because the dollar is the most preferred currency in the Soviet Union. To obtain the dollar reserves necessary for the currency board, the Soviet government could begin by converting its official stock of gold and foreign currency reserves into dollars. That would generate about $20 billion. It could raise at least another $20 billion through stand-by facilities with Western governments and other multinational lending institutions.

A currency reform along the lines we suggest would provide the Soviet Union with a convertible currency within months. The British introduced a convertible ruble just 11 weeks after Keynes proposed it. Such a sound currency would give Moscow some credibility and act to arrest the economic chaos that threatens the Soviet Union.

Steven H. Hanke teaches economics at The Johns Hopkins University and is adviser to the deputy prime minister of Yugoslavia. Kurt Schuler teaches at George Mason University in Fairfax, Virginia.

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