The specie flow mechanism for adjustment of payments that David Hume described as early as 1752 operated for many countries before World War I and is still relevant for a few countries and situations.1 It has the advantage of being automatic, that is, of not depending on fallible central bankers or politicians for prudent decisions, but it leaves a country with very little ability to manage its own monetary affairs. Although they were not followed precisely,2 the formal system is based on two rules:
1 National currencies are to be backed rigidly by gold; that is, the stock of base money is determined solely by the stock of gold held by the government or the central bank. The central bank therefore has no monetary policy discretion; it must create a money supply that is based on its holdings of gold.
2 Gold is to be the only foreign exchange reserve asset; that is, payments deficits cause a parallel loss of gold, and vice versa.
These two rules mean that the domestic money supply is determined by the balance of payments (and by the gold-mining industry). A payments surplus causes an inflow of gold and a parallel increase in the stock of base money. A deficit causes gold to flow out, and the money supply must fall proportionally. This is analogous to the monetarist world described in the previous chapter, except that sterilization cannot occur. The money supply must be allowed to fall when a country has a payments deficit and to rise in the case of a surplus.
These changes in the money supply produce payments adjustment through three linkages. In the case of a payments deficit, the resulting decline in the money supply:
1 raises domestic interest rates, which attracts capital inflows, thereby improving the capital account of the balance of payments;
2 puts downward pressure on the price level, thereby improving price competitiveness. Exports should rise and imports fall, improving the current account;
3 puts downward pressure on economic activity and on real incomes. Imports should fall by the marginal propensity to import times the decline in domestic incomes. A reduction in the money supply is recessionary and discourages imports, thereby improving the current account.
The first two of these linkages are not particularly difficult or painful; the third, however, is unpleasant or worse for deficit countries. To the extent that wages and prices are downward rigid or sticky in the short run, which appears to be the case in modern industrialized economies, the second linkage becomes largely inoperative, necessitating greater reliance on the third. This payments adjustment mechanism means that countries with payments deficits are likely to be forced into recessions and then be unable to use an expansionary monetary policy to escape such downturns.
For surplus countries, the same three linkages operate in the opposite direction. Interest rates fall, worsening the capital account, and prices rise, a condition that hurts the trade account. Output and incomes rise, thereby increasing imports. If the economy is fully employed, however, output and real incomes cannot rise. Thus inflation can become serious as the money supply rises without the central bank being able to control it.
This system means that the central bank has no policy discretion in the management of the money supply. The recessionary implications for deficit countries, and the prospects for inflation in the case of a surplus, suggest why this system was abandoned. In the late 1970s and early 1980s a few "gold bugs" argued for a return to this approach, but this discussion has now largely ended.
The pre-1914 gold standard has the additional disadvantage of being subject to shocks from the gold-mining industry. When major ore discoveries are made, the government or central bank is required to purchase gold and issue new money, resulting in inflation. Spain experienced disastrous inflation in the sixteenth century when its conquest of Latin America produced huge inflows of gold.
The specie flow mechanism may seem to be an historic relic, but is remains quite relevant today, and may become more so in the near future. A number of small countries have always lacked their own currencies and have instead used the currency of another country, and there is a modest trend toward more countries adopting this approach. Panama and Liberia have always used the US dollar, and a number of small island countries in the South Pacific use Australian or New Zealand money. Kosovo and Montenegro are now largely or entirely "euroized," in that almost all circulating currency is euros, and most bank accounts, loans, and other transactions are denominated in euros. Ecuador recently abandoned its national currency and is now dollarized, and El Salvador is in transition to that circumstance.
A balance of payments deficit in such a country means that there is more money flowing out of the country than is flowing in, and there is no central bank to sterilize the outflows and restore the previous money supply level. A payments deficit reduces the money supply in the amount of the deficit, producing the specie flow adjustment process with the same three linkages discussed earlier. A payments deficit increases the money supply by the amount of the surplus, producing the same adjustment process in the opposite direction.3
Dollarization or euroization requires that the country start out with sufficient foreign exchange reserves to buy back from the public all outstanding base money. Foreign exchange reserves are turned into cash which is transported (with considerable security efforts) into the country and the local currency is simply bought back from the populace. Banks accounts and loans are denominated in dollars or euros, with reserves against deposits also being held in dollars. In adopting this approach, the country gives up the profit or seignoriage that comes from running a central bank and must live with the monetary policy adopted by the country whose currency it uses. Monetary policy in Kosovo is determined by the Governing Council of the European Central bank, and the policy prevailing in Ecuador is settled by the Federal Open Market Committee of the Federal Reserve System. Seignoriage for the two countries goes to the ECB and the Federal Reserve System.
One major disadvantage in the use of a foreign money, or with the operation of a currency board which is discussed below, is the lack of an apparent lender of last resort for commercial banks. One of the original and important functions of a central bank is to provide prompt loans to solvent commercial banks that are experiencing liquidity problems. The San Francisco Federal Reserve Bank cannot be expected to lend to banks in Quito, and banks in Kosovo are unlikely to find an accommodating loan officer at the European Central Bank in Frankfurt. Countries that dollarize or euroize must set up separate financial institutions to make such loans, and arranging adequate funding for such entities may be difficult.
One might wonder why a country would even consider giving up its own currency for the dollar or the euro. Often countries that do so have had a very poor history of economic and monetary policy management, and adopting a foreign money is a means of gaining credibility. Ecuador is a prime example of this circumstance; before it dollarized, its currency was held in very low regard by its citizens, and its economy was in crisis. Dollarization, although painful, calmed the economy and allowed a recovery to begin. When a country has a long and firmly established history of mismanaging monetary policy, maybe it should give up the effort and let someone else provide a policy for it. Argentina would then appear to be an obvious candidate for dollarization, but its recent debt crisis drained its foreign exchange reserves so thoroughly that it may lack sufficient dollars to undertake the effort.
Currency boards, which have recently drawn increased attention among policy makers and economists, create another situation in which balance-of-payments adjustment occurs through the specie flow mechanism. A currency board resembles a central bank with one very large difference: it is forbidden from purchasing assets other than foreign exchange reserves. It is prohibited by law from lending to the government or purchasing other domestic assets. This means that changes in foreign exchange reserves cannot be sterilized through purchases or sales of government debt. A loss of foreign exchange reserves, resulting from a balance-of-payments deficit, must create a parallel reduction in the stock of base money. If the reserve ratio is unchanged, which is supposed to be the case, a proportionate reduction in the money supply must occur. The money supply is regulated by changes in foreign exchange reserves that result from payments imbalances, and adjustment occurs through the specie flow mechanism.
In the past currency boards were maintained primarily by small countries with historic ties to the United Kingdom, such as the members of the United Arab Emirates, or by British dependencies. During the 1990s currency boards have been adopted in some high-inflation developing countries, such as Argentina, and in transition economies, such as Estonia and Bulgaria. In the latter two cases, such arrangements were very successful in bringing down what had been high rates of inflation.
Although a currency board would appear primarily to be a restraint on monetary policy, in practice it represents a more severe constraint on fiscal policy, because such a replacement for a central bank makes it impossible for the government to force the central bank to monetize its budget deficits. As was noted in the previous chapter, central banks in many developing and transition economies have little or no policy independence, but instead must create money to finance government deficits. In some underdeveloped countries, as was also noted earlier, the government actually orders the central bank to print paper money in the amount of its projected budget shortfall, which has typically meant large increases in the money supply and rapid inflation. A currency board is intended to absolutely end such behavior.
A currency board is a means of gaining credibility for a central bank and a currency which have had little in the past, because of high inflation driven by the monetization of government budget deficits. If the public understands that domestic money is backed by foreign exchange reserves rather than by domestic government debt, people will become willing to use and hold the local currency, reversing the common use of dollars or euros as a local currency.
Currency boards work best in small open economies where modest changes in the money supply will produce relatively prompt payments adjustment and where the foreign exchange requirements for financing such an enterprise are not prohibitive. In the case of Bulgaria, for example, the IMF strongly encouraged the creation of such a board and lent the foreign exchange which allowed it to begin operations. When such an arrangement was suggested for Indonesia, however, the IMF opposed such a decision because massive amounts of foreign exchange would have been required to finance its operations, and because the Indonesian economy is large and not very open, meaning that the specie flow mechanism would have been particularly painful. Suggestions that a currency board be adopted in Russia are likely to fail for the same reasons: the economy is too large and insufficiently open, and the financial requirements of such a board would be excessive. Currency boards may be set up, however, in more of the small countries which emerged from the USSR if it becomes clear that fiscal and monetary discipline cannot be realized through any other means.
The Estonian and Bulgarian currency boards have reportedly operated thus far in a traditional manner with fixed commercial bank reserve ratios, which result in domestic money supplies which rise and fall proportionately with changes in foreign exchange reserves, thereby producing the classic specie flow adjustment process. Perhaps because they followed the rules closely, these currency boards have been successful. Argentina's, however, collapsed in early 2002. The Argentinian board was reportedly somewhat more "creative" in finding ways to escape the intended constraints of the specie flow mechanism. Changes in reserve ratios for domestic commercial banks were sometimes used to offset changes in foreign exchange reserves, thereby allowing the money supply to remain unchanged despite balance of payments deficits or surpluses. As this and other means of evading the rules came to be understood by investors, confidence in Argentina's currency board deteriorated. More importantly, the expected constraints on government budget deficits never materialized, and various levels of government (particularly the provinces) borrowed enormous amounts of money, with many of the loans denominated in dollars.
As it became apparent that these loans could not be repaid, and that both fiscal and monetary policy were unsound, confidence collapsed and massive capital outflows quickly drained foreign exchange reserves. The fixed parity of the peso to the dollar had to be abandoned for a float which produced a massive depreciation. This created a broader financial and political crisis, which remains unresolved at the time of this writing. If a currency board is to be successful, its rules must be followed fully, and it must produce constraints on fiscal deficits as well as on money supply expansion. Neither occurred in Argentina.4
This same specie flow mechanism forces the balance of payments of a state or region within a country toward adjustment. We usually do not think of the balance of payments of Massachusetts, but there is one, and it must be adjusted when it is out of equilibrium. A deficit in the Massachusetts balance of payments means that residents of the state are making more payments to nonresidents than they are receiving from them. The stock of dollars held by Massachusetts residents must fall by the amount of that deficit. As checks are cleared against Massachusetts banks and in favor of out-of-state banks, the stock of member bank reserves in the local banking system declines, requiring a reduction of lending activity. A payments deficit reduces the money supply of a state, and imposes the same adjustment process as was described above for a country on the gold standard.
The implications of this mechanism are often quite severe. When a state or region suffers a major export loss, the resulting declines in output and incomes are not limited to the export industry. The resulting payments deficit drains money out of the local economy and banking system, deepening the resulting economic downturn. Eventually, local wages and other costs of doing business decline sufficiently to attract new businesses, and a recovery begins. The migration of unemployed people out of the state reduces both purchases of imports and the demand for local housing, which lowers real estate prices, making the state more attractive for incoming businesses. A sharp decline in the textile and shoe industries in Massachusetts during the 1950s caused such an adjustment process, and the state economy did not fully recover for many years. Declining expenditures on national defense and weak markets for the state's computer industry produced a similar process in Massachusetts during the early 1990s. The recent collapse of the dot com sector of the US economy means that the San Francisco area is now in the same unpleasant situation.
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