An Epitaph To The Currency Board

The Dilemma of Freedom and Government: the Case of Money
Ever since LFMI started to promote the idea of a currency board, we have been frequently asked why those advocating free market principles are against a free exchange rate. To begin with, we have never viewed a fixed exchange rate as an end in itself. The raison d’etre of a currency board is a hundred percent backing of national money with foreign currency and gold reserves. A fixed exchange rate is only a means to set this arrangement in motion and is entirely meaningless and worthless without it.
Second, free market principles imply freedom of action for all private agents without exception. With regard to government, they imply curbing its functions and embedding them within a strict framework of rules. The currency board principles serve to achieve this in a most reliable and comprehensible way.
It seems improbable today that the minting of coins and the issue of paper money was a private business once, just like myriad other businesses. Over time, however, governments began to encroach on money and eventually appropriated a monopoly power to print it. Gold backing was diminished steadily until the world went off the gold standard in 1971. The state became the sole issuer and guardian of fiat money.
This governmental power poses a particular threat to society, for it infringes upon people’s freedom, pockets, and peace. In such a system a floating exchange rate is no indicator of freedom. It is but evidence of activist monetary authorities. For an exchange rate to reflect only the verdict of the market, the central bank should remain neutral to the utmost. It is the only condition under which free marketeers recognize exchange rates as market rates.
However, central banks are not established to embody neutrality. At the outset of this century central banks in many industrial countries sought to extend credits (via an increase in the money supply) to almost anyone. Afterwards, active policies had to be devised to restrict the money supply-to fight the consequences of depression. Still later, intense international rivalries on exchange markets gave way to the realisation of social goals through monetary policy. All of these programmes had one thing in common-they all were launched to eradicate the effects of their precursors. Subsequently, many more schemes followed until a fully-fledged revolution of thought dispelled a blind faith in the virtues of monetary policies, leading to much more disciplined central banks and more neutral policies. By way of illustration, the US Federal Reserve, which used to directly intervene in the exchange market almost every day, now intervenes once in a few years.
Let’s Call a Spade a Spade
It is understandable that in order to survive any government seeks to take a firm grip on its realm. A central bank is also a kind of government. A Ministry of Money, so to speak. Not surprisingly, the authorities outside and within the Bank of Lithuania are trying real hard to shake off the “yoke” of the currency board, proposing in exchange vague principles of monetary policy. It is handy to hide under the cloak of independence-as central bankers put it publicly, “when there is only the Seimas and the heavens above the Bank of Lithuania”. Obviously, the central bank’s authority would then be unlimited and uncontrolled. A blue sky above the Bank of Lithuania would mean a cloudy one above the people of Lithuania.
The programme of “scrapping the currency board” drawn by the Bank of Lithuania may inspire confidence only in those who have not read it. The programme provides for the repeal of a hundred percent reserve backing and gives the central bank the right to pursue activist monetary policies. A fixed exchange rate is implicitly promised to be preserved. But then it will not be a consolation. It will be a forerunner of danger. The programme reads, “In the beginning, wiht the help of mass media, it is necessary to explain to the public and foreign investors that the currency board and fixed rate of the Litas against the US dollar are two different things […]” Quite so. Without full backing, a fixed exchange rate is maintained temporarily and artificially, a costly and failure-prone practice. The crises that befell Mexico and other countries in the past few years occurred in similar circumstances.
“A broader treatment of the assets of the Bank of Lithuania, eligible for backing the money supply, may may be understood by the public as an attempt to “blend” the existing backing of reserve money with gold and convertible foreign currency with other assets and to pursue inflationary monetary policy,” the programme forestalls public opinion. Thus, we need to find out what will happen with the reserves, which upon the revision of the Litas Credibility Law will become “surplus”. According to the letter of the programme, the reserves will not be used to shore up the economy and will remain unimpaired. On the other hand, the supply of litas will be strictly limited and its stability safeguarded. If all of these promises are to be kept, why provide by law for the dilution of reserves? The answer to this puzzle lies most probably in that the authorities will either put the reserves to “good” use or inflate the money.
The programme is chock-full of ambiguities and contradictions. Its executives will enjoy wide-ranging rights of decision making. Stick to “a rigidly fixed exchange rate” and choose a basket of the dollar and euro as an anchor- and you will be consistent with the programme’s provisions. Opt for the euro- and you will be equally safe. Want to “make a slight correction to the exchange rate in one or another direction?” Go ahead. The programme will give you absolution. Further, the plan leaves ample room for discretionary decisions about the strategy and the use of monetary instruments, which seem to be an end in themselves. In short, the programme is tailored so as to release the monetary authorities from the fetters of binding rules.
Aware of the fact that they are losing people’s confidence, the framers of the programme expand on the most likely course of events-an increase in demand for currency. But the measures they propose ruin the confidence not only in money but also banks. The plan specifies the point at which special measures will be taken to ward off “speculative attacks.” By doing this, those at the helm of the Bank of Lithuania provide an open invitation to merciless and pragmatic market speculations. The ensuing events are easy to predict. The market always, be it sooner or later, beats central banks, for its resources are vaster and motivations stronger. And another detail. The market never fails to mete out retribution for its disruption.
Do politics-proof rules run their course?
Many say that a currency board is good only for developing countries. Yet, the number of those delighted at the prospect of its abolition in Lithuania is shrinking. Contrary to vehement persuasions, a currency board does not run its course. In Lithuania it has demonstrated a flawless performance for close to four years. Even its ideological opponents acknowledge that the arrangement curbed inflation, secured full convertibility (Hungary is still trying to achieve it), and lowered interest rates. With a currency board in effect, a foreign trade deficit poses no threat and the society is shielded from paying the horrendous price of printing money to buttress troubled banks or other interest groups. No ministry can boast of automatic safeguards and achievements similar to those which the currency board bestowed on the Bank of Lithuania.
If the selected anchor currency is considered to be a nuisance, it can be replaced. But it is too lame an excuse for rejecting currency board principles. The change of the anchor will not solve the problems of international trade anyway, for their roots are not in Lithuania. Different markets will retain different moneys and the problem of fluctuations in exchange rates for that matter. Even the “liberated” Bank of Lithuania will not be in a position to respond to interdependent fluctuations in exchange rates the world over. Nor will it be able to provide a “most favoured” exchange rate for each producer. The effects of varying exchange rates may be softened within the private realm, that is, in the “future” currency market, whose products-forwards and others- allow people to take precautions against unexpected losses due to fluctuations in exchange rates.
Recalling the unyielding trumpeting about the merits of independent monetary policy, people may ask whether it is worth replacing the “yoke” of the US dollar with that of Bundesbank or the central bank of Europe? The Lithuanian government seems to have answered this question by putting membership in the EU on top of the policy agenda. Yet, the implications are explicit-Lithuania has no prospects of “independent” monetary policy whatsoever. We will have a better or worse euro, whose lot will be determined, not by Vilnius, but by a supranational European power. Why, then, tamper with the sound monetary regime when the desired (inevitable?) accession is so close by? The wish may be obvious to psychologists but not to common-sense-led economists and politicians.
Dismantling-just like installing-a currency board requires political will. Its phasing out in Lithuania started earlier this year when the Bank of Lithuania assumed some of its classical functions: extending credits to commercial banks and holding repo and deposit auctions. This practice became the strictest judge of the interventionist central bank. It took two scandalous credits extended to the sinking Tauras bank to inexorably discredit central bank crediting powers. However, many still find sophisticated repo and deposit auctions attractive, therefore let me expose them to a closer analysis.
A Foreign Body: Rejection Versus Acceptance
Prior to the introduction of repo, a host of complaints had been voiced that Lithuanian commercial banks were having a difficult time without the Bank of Lithuania’s services. But it took only a few auctions to evidence that commercial banks were not interested in them at all. Market forces happened to render “classical” functions and proved to be remarkably effective in neutralising the “foreign body” of centralized economy.
Many will argue that it will take some time before the mechanism starts going full speed; that it is too early to jump to conclusions. Of course, this may happen and most probably will, but at the cost of market destruction. The “mechanism” will be fuelled artificially by the activist central bank that will keep offering services under increasingly favourable conditions-until demand for them is created. Having sensed the futility of repo transactions, the Bank of Lithuania extended a reverse service of holding commercial banks’ deposits. For those familiar with the essence of banking the absurdity of collecting monies from enterprises and people for the purpose of depositing them reliably in the central bank is obvious. Behind the attractiveness of this operation lie wide-ranging operational restrictions that make banks “interested” in holding assets in the Bank of Lithuania. “Surplus” liquidity-which the central bank is fighting-is but a consequence of the bank’s incursions.
However absurd the nature of the aforesaid services, the results will show very soon. Banks will grow used to favourable terms extended by the central bank, thus creating demand for state credits and repo transactions. Central bank interventions in the market will force its agents off the rails, disturbing the self-regulating mechanism. Central bank services will become a regrettable necessity. The process will turn full circle.
People will loose “their” money
Ordinary Lithuanians have an array of concerns over their money. Recalling the 1993 turmoil when the litas exchange rate kept rising and falling wildly, entrepreneurs tremble for each contract signed, investment made or credit taken. Most people realise that the only ray of hope is access to the Bank of Lithuania’s internal information. They know that things will not be the way they used to be. Now everything will depend on those in power. People should realise that and choose whether to trust them or not.
It is more than symbolic that, seeking to protect themselves against the exchange rate risk, commercial banks urged the Bank of Lithuania to legalise loans in foreign currency. The central bank argued that in this case the risk would fall heaviest on loan takers. The Bank of Lithuania was right, though inexplicit. On the one hand, the risk is assumed by banks and their depositors. On the other hand, the risk is assumed by loan takers. In most cases these are enterprises with their employees and shareholders. Both cases are dangerous, for people are on both sides of banks’ balance sheets. The dilution of money and exchange risks, which scare people stiff, are not a natural calamity. Their roots are in that same Bank of Lithuania.
A simple, trustworthy and comprehensible currency board does not exist any longer. Instead of letting this irreproachable mechanism operate by itself and reforming other areas, we are once again forced down to the level of currency “stabilization.” Instead of replacing discretionary government with rule-bound decision making, we are forgoing established and effective rules of the monetary regime.
If the Bank of Lithuania’s officials-God help them-succeed in ensuring the stability of money, people will extol their merits and wisdom. If they fail, the public outcry will be tremendous and the central bankers will be reshuffled for goodness knows which time-a dismal tradition in Lithuania. Yet, anxiety over money will persist. People will scrutinise the psychology of the officialdom. They will keep an eye out for the slightest commotion at the Bank of Lithuania. Men will replace rules. People will have what to beware of.