20. Preventing Currency Crises: The Currency Board Versus The Currency Principle

CHAPTER 20

---

Preventing Currency Crises: The Currency Board Versus the Currency Principle

Introduction

The institution of the currency board began to gain increasing favor among mainstream economists in the mid- 1990s because of its apparent success in taming hyperinflation in Argentina, restoring orderly monetary conditions to Estonia and Lithuania, and restraining inflation in Hong Kong. Eventually, the IMF, which had bitterly opposed the implementation of currency boards in Argentina, Indonesia and the Baltic countries in the early 1990s did an abrupt about face and purportedly even mandated the establishment of a currency board in Bulgaria as a precondition of granting credit.¹

A backlash against currency boards began to build when the repercussions of the Southeast Asian currency crisis of 1997 shook the foundations of Hong Kong’s currency board and financial system later that year and then again in 1998. Argentina’s currency crisis of 2001, which resulted in the total collapse of its currency board, solidified the case against this monetary regime and stimulated a renewed faith in central banking and orthodox IMF policies for emerging market economies. Since then, criticism of so-called “hard peg” currency arrangements for developing nations has grown steadily and has recently even penetrated to the college textbook literature.²

Instead of a currency board, mainstream critics advocate that governments of emerging market economies implement conventional flexible exchange-rate regimes dominated by central banks. This type of arrangement, they claim, will forestall currency crises and provide scope for activist monetary stabilization policy. A small but vocal group of economists and international policymakers even proposes the restriction of international capital movements where emerging market economies are involved. However, these are precisely the policies that have repeatedly failed in the past, plunging developing countries into recurrent cycles of hyperinflation and recession, suppressing capital accumulation and hampering long-term progress toward material prosperity.

It is argued in this paper that the currency board does indeed suffer from an inherent flaw that renders it susceptible to currency crises, but that this defect has been incorrectly identified by mainstream critics because they have misinterpreted the nature and causes of such crises. It is also contended that a “hard-peg” arrangement based on the “currency principle” does not share the currency board’s vulnerability to recurrent crises. The “currency principle” was initially, but imperfectly, formulated in the mid-nineteenth century by the British Currency school. It had long since fallen into disrepute by the time Ludwig von Mises reformulated it in the early twentieth century. This principle served as the point of departure for the development of a comprehensive theory of currency crises by Mises and other monetary theorists in the 1930s. Mises³ also used this principle in formulating a proposal for postwar monetary reform for small countries whose currencies had been wrecked by the breakdown of the international monetary order during the 1930s.⁴

Section 2 of the paper presents what may be called the neo-Currency school theory of currency crisis, a theory that was developed as an explanation of the breakdown of the international gold standard in the interwar period. The structure and operation of the currency board system is explained in section 3 and the systemic flaw that predisposes it to currency crises is identified. In section 4, the neo-Currency school (NUS) theory of currency crises is applied to elucidate the financial perturbations that engulfed Hong Kong at the end of the l990s. Hong Kong is chosen for analysis because its currency board is generally touted as the most orthodox and successful by proponents.⁵

The Neo-Currency School Theory of Currency Crises

The NCS theory of currency crises was formulated in the 1930s to explain an unprecedented event in monetary history: the nearly contemporaneous abandonment of the gold standard during peacetime by all major industrialized nations. The NCS approach to currency crises was developed and expounded by economists whose theoretical perspective on money and finance had been shaped by Mises’s path-breaking work, The Theory of Money and Credit,⁶ which had been initially published in German in 1912. Besides Mises,⁷ other notable proponents of the NCS theory included Friedrich Hayek,⁸ Lionel Robbins,⁹ Gottfried von Haberler,¹⁰ Fritz Machlup¹¹ and Michael A. Heilperin.¹²

The Neo-Currency School that emerged in the 1930s derived from the British Currency school (BCS) of the mid-nineteenth century.¹³ The latter had recognized that Great Britain’s return to the gold standard in 1821, after a hiatus of almost a quarter of a century, had not rid the economy of recurring inflationary booms that culminated in financial crises. The BCS theorized that the financial crises and ensuing deflationary busts that had struck the British economy in 1825, 1836 and 1839 were the result of prior inflationary “overissue” of currency by the fractional-reserve banking system whose gold reserves were concentrated in the Bank of England, a privileged private bank that effectively operated as a central bank. The BCS theorists recognized that the gold standard was capable of moderating and reining in such overissue, but that it would do so only after a time lag during which regional or national prices would rise relative to world prices, causing a balance-of-payments deficit and an external drain of gold reserves. This in turn set the stage for panic among domestic bank note holders and depositors resulting in the threat of bank runs inducing the central bank to raise the discount rate and contract the supply of money and bank credit to reverse the loss of reserves. This deflationary policy resulted in financial crisis and recession.

The BCS developed its famed “currency principle” as the solution to the problem. According to this principle, variations in the quantity and value of the British “mixed” currency, defined to include gold in circulation plus bank notes, were to conform precisely to the variations that would occur if the money supply consisted exclusively of gold coin. In practice, the principle dictated that changes in the supply of bank notes be rigidly linked, pound for pound, with changes in the supply of gold, with additional bank notes issued only in exchange for deposits of gold of equal denomination. With the money supply thus varying in accordance with the state of the balance of payments, currency overissue would be totally suppressed and domestic prices would vary in lockstep with world prices.

Unfortunately, there were two fateful flaws in the BCS theory that resulted in a failure to correctly apply the currency principle on the policy level. First, the currency principle was not applied to bank deposits because the latter were not included in the BCS’s definition of the money supply. And second the BCS did not realize the implication of implementing a policy based on this principle under a monetary regime in which the gold reserves of the entire system were concentrated in the central bank. Thus the enactment of the BCS program into law as the Bank Act of 1844, also known as Peel’s Act, failed in its stated purpose of abolishing currency crises and by the late nineteenth century the BCS and its currency principle had been discredited.

In resurrecting the currency principle, Mises¹⁴ identified and corrected the most important defect in the BCS formulation of the principle by extending its coverage to bank deposits. Furthermore, all the NCS theorists more or less recognized the inconsistency between the currency principle and a system of nationally centralized reserves, a position that was stated most clearly by Hayek as we shall see in the next section. Emerging in a much different politico-economic environment, however, the NCS went far beyond the BCS in another respect. NCS theorists characterized the currency principle as more than merely a technical recipe for monetary policy. Rather, they viewed it as a method of re-integrating and anchoring the money supply process in the regime of private property rights and the rule of contract. The NCS theory thus characterized currency crises as the inevitable outcome of a series of interventions by governments aimed at circumventing or abolishing the relatively rigid limits on credit expansion imposed by the classical gold standard. In effect, the theory represented the logical extension of Menger’s theory of the origin of commodity money as a general medium of exchange to the explanation of money’s progressive transformation into a government “policy tool.” Following Menger’s historico-logical approach, the NCS theorists of the 1930s gave a rich or “thick” explanation of currency crises as the logical outcome of hampered market processes operating under specific political, ideological and institutional conditions.

A. The National Reserve System: Origin and Effects

According to the NCS theory, currency crises occur within the institutional framework of a fractional-reserve banking system in which the cash reserves of the private commercial banks have been nationalized and concentrated in the central bank. This system was generally referred to as the “one-reserve system”,¹⁵ however Hayek suggested a more descriptive name for it, “the system of national reserves.” This system was not the outcome of market forces, but rather was superimposed on the commercial banks by governments “in order to make it easier for the central banks to embark upon credit expansion.”¹⁶ The United States, for example, effectively nationalized bank reserves in 1917. The Amendment to the Federal Reserve Act of June 21, 1917 mandated that only reserve deposits held at the Federal Reserve Banks would be counted as legal reserves of member banks, resulting in a centralization of gold reserves at the Fed.¹⁷

In European countries, where central banks began to emerge as early as the late seventeenth century, the nationalization of reserves began even earlier, under the classical gold standard.¹⁸ Other countries arrived at the national reserve system by adopting the gold exchange standard after World War I in order to economize on their gold holdings which yielded no return. This attenuated version of the gold standard naturally centralized reserves in the form of interest-bearing foreign securities in the central bank and thus placed “in the hands of governments the power to manipulate their nations’ currency easily.”¹⁹ Another postwar device for “economizing gold,” the gold bullion standard, under which currencies were only convertible into large and expensive bars of gold, also served to concentrate gold reserves in the hands of the central bank and “made possible an increase in circulating media out of all proportion to the current production of gold.”²⁰

The national reserve system brought about two momentous changes in the institutional framework of financial markets. The first was a radical alteration of the way in which the commercial banks conducted business. When a central bank was granted the legal or de facto monopoly of warehousing the gold deposits of the public, its notes and deposits were no longer treated as instantaneously redeemable property titles to the actual money commodity housed within its vaults. The gold now became subsumed under the general category of central bank “assets” serving as “reserves” against its issue of instantly maturing “liabilities,” i.e., notes and deposits. These notes and deposits in time came to be generally accepted by the public as money itself rather than what they actually were: titles to money or “money certificates” that conveniently substituted in trade for the money commodity.

This development in turn led the commercial banks to hold the minimum amount of reserves—now in the form of central bank notes and deposits—necessary to meet the day-to-day net redemptions of their own instantaneous liabilities. These included not only their demand deposits but also their interest-bearing savings deposits, upon which notice of withdrawal was increasingly waived, despite the fact that the funds for both of these categories of deposits had been invested by business borrowers for shorter or longer periods in the economy’s structure of production.²¹ This mismatching of the maturity structure of the commercial banks’ assets and liabilities, which had always existed to a limited extent when fractional reserves banks were responsible for holding their own gold reserves, was thus greatly promoted by the practically unlimited access granted to banks under the national reserve system to loans from the central bank when they found themselves short of reserves.

Mises²² concisely summed up the revolution in banking practice that resulted from the national reserve system:

[The banks] no longer keep a reserve against their daily maturing liabilities. They do not consider it necessary to balance the maturity dates of their liabilities and assets in such a way as to be any day ready to comply unaided with their obligations to their creditors. They rely upon the central bank. When the creditors want to withdraw more than the ‘normal’ amount, the private banks borrow the funds needed from the central bank. A private bank considers itself liquid if it owns a sufflcient amount either of collateral against which the central bank will lend or of bills of exchange which the central bank will rediscount.

The national reserve system effected a second revolutionary alteration in the financial system of the interwar period. This was the layering of different moneys—more properly, money substitutes—of a progressively narrower range of acceptability atop one another so that the monetary structure of a nation came to resemble an inverted pyramid resting upon a narrow base of gold, the universally accepted money. As Hayek,²³ who was the first to fully elaborate the implications of this institutional structure, explained:

The ordinary individual will hold only a sort of money which can be used directly for payments of clients of the same bank; he relies upon the assumption that his bank will hold for all its clients a reserve which can be used for other payments. The commercial banks in turn will only hold reserves of such more liquid or more widely acceptable sort of money as can be used for inter-bank payments within the country. But for the holding of the reserves of the kind which can be used for payments abroad, or even those which are required if the public would want to convert a considerable part of its deposits into cash, the banks rely largely on the central bank. … It was only with the growth of centralized national banking systems that all inhabitants of a country came … to be dependent on the same amount of more liquid assets held for them collectively as a national reserve.²⁴

Hayek’s analysis of the national reserve system sheds important light on the effects of international monetary flows under alternative institutional arrangements. Within the national currency area, interlocal transfers of money, no matter how large or abrupt, put no strain on the overall financial system because they do not entail any disturbance of the gold base of the national monetary pyramid. In particular, they do not necessitate that the central bank raise its discount rate to “protect” its “gold reserves,” because the monetary transfers were accomplished wholly though changes in the assets and liabilities of banks within the same national reserve system. This is especially important because, as Hayek²⁵ pointed out, “not every movement of money … is a transfer of capital.”²⁶ That is, not every net flow of money between regions is a response to a shift of supply and demand on the investible funds market. Some movements of money result either from a temporary and reversible discrepancy between the imports and exports of a given region or from a more permanent reconfiguration of the interregional pattern of the demand for money. In both cases, therefore, no change of the discount rate or of interest rates in general is warranted, since no transfer of real capital is involved.

When we consider purely monetary transfers between two regions that are parts of different national reserve systems, matters are not much different as long as these transfers are the result of normal fluctuations in the balance of trade or occasional changes in the relative demands for money. In these cases, the accompanying movements of gold from one country to another would be relatively minor and would be rapidly ended or reversed by relative changes in the price structures of the two countries as described by the classical price-specie-flow mechanism. In order for this mechanism to function central banks need do no more than honor their contractual obligations to redeem at par and on demand the titles to gold they issued and to strictly limit the new receipts issued to the actual amount of new gold that is brought to them for storage, i.e., to operate as honest and simple bailees in warehousing the money commodity. If central banks operated in this manner, the expansion of the money supply in the surplus country and the contraction of money supply in the deficit country would be precisely equal to each other and to the net transfer of gold through the balance of payments. This outcome is precisely the same economically as it would be if the transfer of money occurred between two regions that were constituents of the same system of national reserves.

The (Mis)Behavior of the Central Bank

According to the NCS analysis, then, when central banks behaved according to the “currency principle”—ensuring that the national money supply varies on a one-to-one basis with gold flows to and from abroad—the nation’s currency was unlikely to encounter crisis conditions. Things were radically different, however, when a central bank attempted to lower domestic interest rates by unilaterally expanding bank credit. This caused the pyramided layers of money substitutes to expand relative to the national reserve of gold, resulting in a progressive rise of domestic prices. The rise in domestic prices and the decline of domestic interest rates relative to levels prevailing abroad would precipitate a deficit on both current and capital accounts.²⁷ This overall deficit in the balance of payments would persist until the cheap money policy was brought to an end. In the meantime, the deficit was financed by the steadily dwindling “gold reserves” of the expansionist central bank. This “external drain” of gold would eventually inspire a loss of confidence in the domestic currency, precipitating an “internal drain” of gold as domestic and foreign investors and the public at large rushed to convert into gold the ever-growing mass of money substitutes issued by the central bank and the commercial banks. As this crisis point approached, the central bank, if it wished to maintain the gold standard, would be compelled to sharply raise its discount rate in order to contract bank credit and replenish its depleted stock of gold.²⁸

The outflow of gold reserves and the rise of the discount rate marked the turning point in the business cycle, when it was revealed that domestic interest rates could not be permanently reduced by central bank credit expansion below their natural level as determined on international capital markets by the quantity of voluntary savings. The rise of the discount rate was therefore not an exogenous cause of the ensuing recession, but rather a necessary step in the corrective process which revealed to entrepreneurs that there were not sufficient savings and real capital goods available to sustain the investment projects they had initiated under the stimulus of cheap money.

The NCS theorists emphasized that the inapt rhetoric of war used to describe the sequence of events leading up to the loss of reserves led to serious misconceptions among economists and the public about the causal process involved as well as the role of central banks in this process. Mises²⁹ cut through this rhetoric and identified the true cause as the violation of contract:

The truth is that all that a central bank does lest its gold reserves evaporate is done for the sake of the preservation of its own solvency. It has jeopardized its financial position by embarking upon credit expansion and must now undo its previous action in order to avoid its disastrous consequences.… No “defender” is needed to “protect” a nation’s currency system.… When the Bank of England redeemed a bank note issued according to the terms of the contract … [i]t simply did what every housewife does in paying the grocer’s bill. The idea that there is some special merit in a central bank’s fulfillment of its voluntarily assumed responsibilities could originate only because again and again governments granted to these banks the privilege of denying to their clients the payments to which they had a legal title.

In particular, the central bank in the deficit (surplus) nation did not need to increase (decrease) the discount rate and bring about a contraction (expansion) of the national money supply that was a multiple of the loss (gain) of gold through the balance of payments. The raising of the discount rate by the central bank of a deficit nation thus was not one of the “the rules of the game” of the gold standard.³⁰ It was merely a byproduct of the cessation of credit expansion by a central bank that had been vainly attempting to maintain the domestic interest-rate structure below that prevailing on the global capital market. In other words, the fundamental rule of contract, not arbitrary and changeable rules of the game, dictated the central bank’s decision to preserve the redeemability of its demand liabilities at par.

Indeed, to the proponents of the NCS theory, the gold standard emerged in defiance of the arbitrary rules of the bimetallic standard adhered to by governments for centuries in a futile attempt to stabilize the exchange ratio between gold and silver.³¹ In the their view, then, the international gold standard was not a creation of policy rules but rather an organic product of the market economy, and its functioning, like that of all market institutions, was “controlled by the operation of inexorable economic law.³²

Anti-Deflation Policy and the Problem of “Hot Money”

Under the attenuated gold standard that arose in the 1920s, most central banks sought to evade the inevitable deflation of the domestic money pyramid entailed by external payments deficits. They began to treat money as a tool of policy rather than as simply the property of their depositors and note-holders who had been contractually assured complete and unimpeded disposal of their gold for domestic or foreign transactions. The NCS theorists pointed out that the efforts of central banks in the postwar period to deliberately implement antideflation policy not only conflicted with their contractual obligations but disabled the balance of payments adjustment process that had operated under the gold standard to continually adapt the spatial distribution of money to the ever changing conditions of international monetary equilibrium.

In a retrospective on his early contributions to international monetary theory, Machlup³³ emphasized that equilibrating money flows were an inherent feature of the international gold standard and that the policy of creating domestic credit to replace gold and foreign exchange reserves lost through payments deficits only recreated monetary disequilibrium and caused further outflows of gold:

Under a gold standard … any excess stock of money leads to a deficit in the balance of payments which in turn leads to an outflow of gold reserves and to a concomitant contraction of the money stock, restoring the balance … But all this presupposes that domestic credit creation does not recreate the excess money stock and rising prices.… I tried to make it clear that these policies of offsetting the contractionary effects of official sales of foreign exchange by expansions of domestic credit were sabotaging the adjustment mechanism. The automatic contraction of the money supply in the course of financing the payments deficit was the very essence of the adjustment process, and to offset this contraction was to prevent the adjustment and to make the deficit chronic.³⁴

Robbins recognized that the classical gold standard was essentially in conflict with and destined to be undermined by the political institution of central banking that had grown up concurrently with it but separately from it. Central banks had been set up specifically to make loans to governments, that is, to expand credit. They were thus deliberately designed to replace the general rule of property and contract with arbitrary policy rules. As noted above, the national reserve system was imposed by governments precisely as a method of promoting central bank expansionism by neutralizing internal drains of gold to competing domestic banks. But this system could not prevent the external drain of gold to less expansionary central banks abroad and the emergence of so-called “balance-of-payments problems.” As Robbins³⁵ stressed:

[When] governments have been inclined to use [central banks] as instruments of positive policy, they have become the most potent cause of general economic nationalism. If the government of a certain area imposes upon the banks under its jurisdiction a policy of expansion at a time when the local position offers no scope for such expansion, then … the international equilibrium is ruptured. The “problem” of maintaining international equilibrium at once arises—and with it all the policies designed to solve such a problem.

One of the manifestations of this institutional disruption of international monetary equilibrium was the sudden emergence of “hot money” in the early 1930s. NCS theorists perceived that this phenomenon was caused by the behavior of the central bank, which, when operating under the national reserve system, produced a peculiar incentive structure for commercial banks that encouraged abrupt movements of deposited funds. A country that incurred persistent deficits in its balance of payments as a consequence of a relatively inflationary monetary policy would eventually encounter growing skepticism regarding its ability to maintain the gold parity of its currency. This was because in the interwar period it eventually came to be expected that central banks would no longer impose orthodox discount rate policy, as they had before World War I, in response to the serious gold/foreign exchange outflow inevitably precipitated by their attempt to unilaterally depress domestic interest rates. Instead, it was anticipated, they would now engage in further inflationary credit expansion to prevent the necessary contraction of the domestic money stock, and this would only intensify the gold drain.³⁶

Foreign-exchange speculators and foreign investors were the first to formulate and manifest these pessimistic expectations by selling the currency short and withdrawing their short-term capital from domestic banks and sending it to safe havens abroad. These flows of hot money through the capital account would further exacerbate the overall deficit and put “pressure” on the currency’s exchange rate. If the central bank continued its policy of recreating the excess supply of money, the hot money flows would worsen and the government would soon be confronted with a full-blown currency crisis. The only way out would be either devaluing the currency, imposing foreign exchange controls, or abandoning the gold standard altogether.

One of the key insights of the NCS theory was that the phenomenon of hot money was not generated by the normal operation of the gold standard. In fact its emergence signaled the breakdown of the inflationary national reserve system that was instituted to neutralize the adjustment mechanism of the gold standard. “Capital flight,” as it was often labeled, did not embody genuine movements of capital that occur under a sound international monetary system. As Heilperin³⁷ pointed out; most international movements of short-term funds during the 1930s were “operations with cash and with demand deposits … result[ing]from purely financial transactions disconnected in their origin from any other international economic operations.” Heilperin³⁸ went on to explain, “when anticipations of the future are uncertain and when pessimism prevails home investments are deferred and cash balances increase. Funds of purchasing power wait for an appropriate moment to be invested, and as that moment gets postponed the non-invested savings (or hoards) keep accumulating. It is those funds which are easily induced into more or less panicky movements from country to country, from currency to currency.”

The root of the hot-money problem lay in the national reserve system. Under this system, the commercial banks came to treat the accumulation of speculative cash balances as genuine savings and loaned them out to domestic business, maintaining only minimal cash reserves against them. They operated in this manner because, as noted above, each individual bank regarded itself as sufficiently liquid as long as it owned securities that the central bank was normally willing to rediscount or accept as loan collateral. But the quantity of gold and foreign exchange reserves concentrated in the central bank—the ultimate cash upon which the financial system rested—was grossly insufficient to cover the sight deposits of all commercial banks, rendering the overall system at all times illiquid. Institutionally, these sight deposits took the form mainly of savings or time deposits upon which interest was paid and whose mandatory “notice of withdrawal” was progressively shortened and then effectively waived altogether as banks responded to the perverse incentives generated by the national reserve system.³⁹

Mises⁴⁰ summarized the interrelated roles of the system of national reserves, the cheap-money policy of the central bank and the conditions of moral hazard that these two institutional factors created for the commercial banks in generating currency crises. He pointed out that “short-term debt,” specifically saving deposits, had come to play a dominant role in the banking system of the 1930s. Banks of creditor countries had invested an enormous amount of funds in interest-bearing deposits in banks located in debtor countries, with the understanding that they would be able to withdraw such “saving deposits” at a moment’s notice. But it was impossible for all or most of the lending banks to retrieve their credits all at once since these funds had been, in turn, lent to businesses for capital investment in the debtor country. Thus “international credit relations were based on a fallacious assumption of liquidity” and banks in debtor countries “became exposed to the dangers of a panic.” It was not therefore the “flight of capital” proper that endangered monetary stability. Savings invested in industrial plants, corporate shares, and real estate could not literally flee to another country; in the absence of bank credit expansion, every seller of such titles to real capital assets must be replaced by a buyer, either foreign or domestic, in order for the seller to realize his proceeds and invest them abroad. The result is that the withdrawal of capital from a country “can never be a mass movement.”

For Mises, the “one apparent exception” to this rule was “the saving deposit which can be withdrawn from the bank at once or at short notice.” Even in this case, a “hot money” problem would not have ensued, had the central bank refrained from expanding credit to assist the errant banks. Without inflationary credits from the central bank, the commercial banks would have been forced to negotiate generalized “Standstill Agreements” with their domestic and foreign creditors that acknowledged the reality of the distinction between cash balances and invested savings and “adjusted payments due to payments receivable.”

Mises⁴¹ concluded:

It is obvious that not the flight of capital but the credit expansion in favor of the saving banks is the root of the evil.… The pith of the problem lies in the deposit policy. Banks which promise no more than they can fulfill without extraordinary assistance from the central bank never jeopardize the stability of the country’s currency. And even the other banks who [sic] have been imprudent enough to assume liabilities which they cannot meet are only a danger when the central bank tries to assist them. If the Central Bank were to leave them to their fate, their peculiar embarrassment would not have any effect on the foreign exchanges.⁴²

Mises⁴³ also contended that had the central banks not tacitly assumed the role of lender of last resort entailed by the national reserve system, then commercial banks would have been forced to deal prudently with the hot money influx by keeping “a reserve of gold and foreign exchange big enough to pay back the whole amount in case of a sudden withdrawal.” Of course this would have entailed their “charging their customers a fee to keep their funds safe” instead of paying interest on them.

Mises⁴⁴ applied the theory of currency crises to explaining the devaluation of the Swiss franc in 1936. In late September of that year the French franc had been devalued, causing a widespread expectation that Switzerland would follow suit and devalue the Swiss franc. During the early 1930s Swiss commercial banks had accumulated a large fund of hot money deposits which they had pledged to redeem on demand, while lending them out to business. A large part of these loans had gone to firms in foreign countries which had since implemented foreign exchange controls that effectively blocked repayment of these loans. The only recourse for the Swiss banks would have been to seek emergency loans from the Swiss National Bank in order to pay their depositors. But the depositors would have immediately demanded that the National Bank redeem the notes paid out in gold and foreign exchange in order to transfer their funds to Great Britain, the U.S. or even to France which had already devalued and so did not pose a threat of a second devaluation in the short term. The National Bank would have thus lost most of its reserves. This in turn would have generated a domestic panic and the remainder of its reserves would have drained out into the cash balances of Swiss depositors, effecting a collapse of the monetary system. However, if the National Bank had resisted the requests of the private banks for aid, then the country’s leading financial institutions would have become insolvent. So the Swiss government solved the crisis by immediately devaluing the Swiss franc by 30 percent and suspending domestic gold payments, thereby relieving the pressure on its reserves.⁴⁵

So, according to the NCS theory, a currency crisis is not a mysterious scourge that suddenly strikes from out of the blue but is the predictable pattern of events that is caused by a combination of identifiable politico-economic institutions and policies.

The Currency Board As a National Reserve System

The contemporary currency board is in effect, if not by design, a national reserve system only formally distinct from the gold exchange system of the interwar years. As pointed out by the NCS theory of currency crises, the national reserve system is a self-liquidating system. It is foredoomed by an inherent flaw to degenerate into either a system of “flexible” exchange rates or a system of rigid exchange controls.

Under the currency board system, although currency board notes and deposit liabilities themselves are backed one hundred percent (or more) by debt claims denominated in the foreign reserve currency, commercial banks are free to issue demand deposits and instantly maturing “saving” deposits that are only fractionally backed by the notes and deposits issued by the currency board. In other words, the currency board system provides for one hundred percent reserves only for the domestic monetary base, sometimes referred to as “high-powered money.”⁴⁶ Furthermore, just as under the interwar gold exchange standard, the ultimate cash reserves of the entire banking system are centralized in the hands of a government agency. In consequence, the domestic money supply under the currency board resembles Hayek’s inverted pyramid of different kinds of money substitutes of progressively narrower range of acceptability, i.e., currency board notes and commercial bank deposits, which is perched atop a slender base of the foreign currency that serves as the ultimate cash reserves of the system.

This renders the system vulnerable to financial panics, initiated by or involving “capital flight” into foreign currency. This is especially true in emerging market economies where large inflows of foreign capital can rapidly expand the domestic monetary base and money supply, thereby raising domestic prices to a level that renders the domestic currency overvalued at the prevailing exchange rate. As Hayek argued, in the absence of a relative increase in the demand for money in the receiving country, a capital inflow does not necessitate a permanent expansion of the domestic money supply. The initial inflow of money capital is merely the first step of the process by which the capital transfer is effected in real terms. Once this process has been completed, balance of payment equilibrium is re-established and the distribution of the common money between the two countries is returned to its original pattern.

The outcome is much different, however, where the expansion of the domestic money supply is a multiple of the initial capital inflow—where, in Machlup’s terms, new money is issued on the basis of “domestic credit”—which is the case under the currency board. The persistent decline in the purchasing power of money and loss of foreign exchange reserves under such circumstances stimulate a movement by foreign speculators and investors to withdraw their deposits from domestic banks and liquidate their holdings of domestic securities, converting their proceeds into the reserve currency for investment abroad. This exacerbates the loss of the reserve currency and threatens to precipitate a full-blown banking panic among domestic depositors, accompanied by an “internal” drain of foreign currency reserves. Recently, Nouriel Roubini⁴⁷ has argued in a similar vein:

The argument that currency boards cannot collapse because the monetary base is fully backed by the foreign reserves of the country is patently incorrect. If an attack on the currency occurs, domestic residents may try to get rid of domestic financial assets and buy foreign assets by running down the foreign reserves … of the central bank. The domestic financial assets that may be used to buy foreign currency are not limited to the monetary base (that is fully backed by foreign reserves in a CB [central bank] but rather the entire stock of liquid monetary assets that is usually a large multiple of the monetary base.

These events, if left unchecked, would not only exhaust foreign reserves but would break the fractional-reserve banking system. Clearly, then, at the first sign of a flight from the currency, there would be an almost irresistible pressure on the currency board to assume the central banking function of “lender of last resort” in order to avert a banking panic. The massive injection of credit and liquidity into the financial system, even if not immediately followed by a currency devaluation, transforms the currency board into a central bank and clearly undermines the credibility of its commitment to maintain a rigidly fixed exchange rate in the future.

The recent case of Hong Kong, recounted in the next section, illustrates the inherent instability of the currency board that is manifested in national currency crises and its natural tendency to devolve into a central bank during such crises.

Recent Experience With the Currency Board in Hong Kong

Hong Kong’s Currency Board System

Hong Kong’s currency board, known officially as the Linked Exchange Rate System, began operation in October 1983 and implemented a fixed exchange rate between the Hong Kong dollar and the U. S. dollar of HK$7.80 per US$1.00. Under this system, which is administered by the Hong Kong Monetary Authority (HKMA), the monetary base, including, among other items, all currency in circulation (most of which is issued by three private note-issuing banks) and commercial bank clearing accounts held with the HKMA is fully backed by foreign exchange reserves in the form of short-term debt instruments denominated in U.S. dollars.⁴⁸ Thus any change in the monetary base is fully matched by a change in the stock of foreign reserves at the prevailing exchange rate and fluctuations of the monetary base are completely and solely dependent on the net flow of dollars to and from Hong Kong. This means that the flow as well the stock of the monetary base is fully backed by dollar reserves. For example, from December 1998 to November 2005, the stock monetary base increased from HK$193,718 million to HK$276,859 million while the stock of currency board “backing assets” increased from HK$209,684 million to $HK308,989 million. The “backing ratio” of U.S. dollar reserves to the monetary base thus increased slightly from 108.24 percent to 111.61 percent. The monetary base flow of HK$83,141 million during this period was therefore more than matched by the influx of US$ backing assets equal to HK$99,305 million.⁴⁹

According to the neo-Currency theory, however, the important stock and flow ratios for analyzing currency crises relate foreign exchange reserves to a broader measure of the money supply that encompasses the total stock of the medium of exchange.⁵⁰ If we calculate the backing ratio of US$ assets to the HK$ M3 over the same period we find that this ratio stood at 11.4 percent in December 1998 when M3 was HK$1,840,824 million and rose to 13.2 percent in November 2005 when M3 totaled HK$2,331,578 million.⁵¹ Thus M3 flow was HK$490,763 million during the same period, almost five times as large as the backing asset inflow of HK$99,305 million. Since most items included in M3 are instantaneously redeemable in US$ at par, the currency board system in Hong Kong is just as vulnerable to a currency crisis as the national reserve systems of the 1930s based on the gold exchange standard. The fact that the monetary base is more than 100 percent backed by foreign exchange is completely irrelevant, since under the national reserve system the monetary base itself is generally exceeded by the total supply of monetary assets of lesser degrees of acceptability by orders of magnitude.

Now, an argument can be, and has been, made that the foreign exchange assets backing HK$ M3 is much greater than the backing assets recorded on the HKMA balance sheet. The reason is that, since the mid-1970s the Hong Kong political authority has been accumulating its fiscal reserves in foreign exchange and transferring them to the Exchange Fund, which also holds the backing assets of the HKMA.⁵² If we include these cumulative fiscal surpluses along with the backing assets held by the HKMA, the ratios of foreign currency reserves to the monetary base and to MS increase dramatically. For instance, the ratio of foreign currency reserves to the monetary base stood at 3.61 in December 1998 and 3.45 in November 2005. However for the same two months, the foreign currency reserves/M3 ratio equaled .53 and .41, respectively. Also flow M3 during this period was HK$490,763 million compared to HK$255,856 million for the flow of foreign currency reserves, or about two times as great. Thus even with this dubious broadening of the definition of “backing assets,” the stock and flow ratios of foreign currency reserves to M3, still violate the currency principle and reflect a systemic flaw in Hong Kong’s currency board system that leaves it vulnerable to currency crises.

Moreover, there are a number of reasons why this inclusion of foreign currency reserves generated by the fiscal operations of government in the backing assets of the money supply should be rejected. First, precisely because they are not the result of private commercial operations, they are not a component of the balance sheet of the HKMA and have no direct causal connection to the determination of the money supply, movements in the structure of interest rates, and fluctuations in the purchasing power of money. These exchange reserves, therefore, do not have a direct role in generating the economic conditions that lead up to currency crises. Second, as the backing assets of the HKMA near exhaustion during a currency crisis, the probability of a substantial domestic currency devaluation would increase along with a corresponding appreciation of foreign currency reserves. It is at least a matter of reasonable doubt whether the government would expend its imminently more valuable fiscal reserves in an attempt to quell a currency crisis already in progress.⁵³

The NCS theory thus implies that a monetary system structured like that of Hong Kong, especially given the great degree of “openness” of its economy, would be subject to cycles of inflation and depression, of booms and busts, brought on by flows of reserves through its balance of payments. A net inflow, for example, resulting from an external payments surplus generates both equilibrating and disequilibrating expansion in the total money stock. The part of the increase in the money stock that exactly matched the net increase of foreign exchange reserves would be necessary to increase prices to a level that would tend to bring both the purchasing power of the local currency and the domestic structure of interest rates into alignment with prices and interest rates in the reserve-currency country. The outcome would be balance-of-payments equilibrium. However, the additional enlargement of the money stock produced by the multiplication and pyramiding of domestic bank credit atop the new reserves of foreign exchange would elevate domestic prices to a level that was inconsistent with balance of payments equilibrium. The structure of domestic interest rates would also be depressed below the level compatible with the overall quantity of voluntary savings, foreign and domestic, that were available for domestic investment. As long as net foreign exchange inflows continued, as they did in Hong Kong during the 1990s up until the last quarter of 1997, the underlying disequilibrium both in the financial sector and in the real structure of production would be masked and exacerbated.

This disequilibrium is only sustainable until a headline event, typically a currency crisis in a similarly situated economy abroad, suddenly awakens investors, currency speculators, and the public at large to the fact that the domestic currency is overvalued. Then despite—or because of—the existence of the currency board system, it is recognized that the currency peg may not be sustainable and there is an imminent threat of depreciation of the domestic currency. At this point there is the characteristic “capital flight” into foreign currencies and financial assets. In accordance with the theories of the NCS, the capital flight takes the form of an outflow of hot money rather than of actual capital funds invested in the real sector of the economy. With this mass withdrawal of unbacked domestic bank deposits convertible on demand at the fixed exchange rate into foreign currency reserves, the national reserve system is thus put under pressure, interest rates skyrocket, bank credit shrinks, and the national money stock contracts rapidly. The first effect on the real sector is a precipitous drop in investment and the liquidation of malinvested capital projects undertaken on the basis of mistaken anticipations of the continuation of artificially lowered interest rates. The drop in investment results in an unexpected decline in demand for new capital goods construction and a time-consuming reallocation of labor to less capital-intensive lines of production. Thus, a fall in real GDP and rise in unemployment accompanies the decline in investment. Moreover, the revelation of capital malinvestment and collapse of capital goods’ prices brings in its wake a fall in financial asset markets on which titles to aggregates of capital goods are traded, such as stock, bond, and real estate markets.

The Hong Kong Currency Crises of 1997–1998

During the 1990s Hong Kong experienced a financial boom that was accompanied by strong if not overwhelming growth in real output.⁵⁴ From 1990 to 1996 “broad monetary growth” averaged 13.8 percent per year while the annual growth in CR1 averaged 9.1 percent.⁵⁵ During this period the annual average of stock prices on the Hang Seng Index, using 1984 as the base year, more than quadrupled from 300.18 in 1990 to 1,406.6 in 1997.⁵⁶ Even more starkly, on the first trading day of 1990 the Hang Seng Index closed at 2,838.1 and nearly sextupled to its peak at 16,673 at the market’s close on August 7, 1997. A real investment boom stimulated the bubble in financial markets, with gross fixed investment as a percent of GDP rising by over 7 percentage points from 26.4 percent in 1990 to a peak of 33.6 percent in 1997.⁵⁷

The unraveling of the Hong Kong boom and the run-up to a full blown currency crisis began in October 1997.⁵⁸ The Southeast Asian crisis had begun when the Thai baht was devalued on July 2 1997. Hong Kong was unscathed by the crisis. Then, on October 20 the Central Bank of Taiwan abruptly discontinued its program of supporting the New Taiwan dollar, which immediately depreciated by 9 percent. At the beginning of the summer, the Taiwanese central bank had accumulated a massive stock of foreign reserves that exceeded by orders of magnitude the stocks held by the Southeast Asian countries engulfed in crisis. Although there was no close connection between the Hong Kong and Taiwanese economies, the inability of the Taiwanese central bank to “defend” its currency even with its huge stock of reserves immediately raised questions about the HK$. Hong Kong was almost immediately swept up in a rapidly intensifying currency crisis of its own. In the following two days local residents as well as foreigners began panic sales of the HK$ and Hong Kong stocks. By October 23, hedgers and speculative short-sellers had driven the short-term interest rates to 280 percent and stock prices plunged by 23.3 percent, as the Hang Seng Index dropped from 13,601 on October 17 (the last trading day before the depreciation of the New Taiwanese dollar) to 10,426.3 on October 23. After partially recovering and languishing in the 11,000 range after a number of months, the stock market spiraled slowly downward with the Hang Seng Index breaking below 8,000 in late July 1998 and continuing downward.

Hong Kong survived the crisis with its currency board and currency peg intact, only to confront a more serious “attack” on its currency following on the heels of the Russian default of August 1998. Sounding like any conventional central banker trying to evade responsibility for an overvalued currency, Joseph Yam, Chief Executive of the HKMA, spoke of “a much more complicated situation, in which speculators launched coordinated and well planned attacks across our financial markets.”⁵⁹ This time the currency board system broke in the face of a second stock market collapse and the HKMA used its assets to purchase shares in the market. It is estimated that in a two week period the currency board used US$15 billion of its US$96.5 billion foreign reserve holdings (including the government fiscal surplus). While a second meltdown of the stock market was averted by these operations, the government absorbed 5 percent of the total stock market float.⁶⁰ For July 1998, the month immediately preceding the crisis, total foreign currency reserves had equaled US$96.5 billion but dwindied to a total of US$88.4 billion in September 1998.

The financial crises of 1997 and 1998 set in motion the purgative recession-adjustment process in the real sector. Investment as a percentage of GDP, which had reached a peak of 33.6 percent in 1997 plummeted to 30.2 percent in 1998 and 25.6 percent in 1999.⁶¹ This latter figure was below the investment/GDP ratio of 26.4 percent at the beginning of the inflationary boom in 1990. The liquidation of the malinvestments of the boom was also reflected in the annual growth of real GDP, which fell from 4.9 percent in 1997 to –0.5 percent and 0.3 percent in 1998 and 1999 respectively.

With its intervention to provide “liquidity” to the stock market in the 1998 crisis it appears that Hong Kong’s currency board has shown its true stripes as a conventional central bank. Several measures taken since then to re-establish and enhance its credibility as a currency board actually reveal the fatal flaw in the currency board system. For example, under the Convertibility Undertaking, the HKMA announced that it would guarantee the US$ value of clearing accounts (reserves) of the licensed banks. Basically this means that, in the event of the abandonment of the peg and depreciation of the HK$, the banks would have a legally enforceable claim on the government for losses suffered on some of their HK$-denominated assets. In 2005 a Convertibility Zone of plus or minus HK$.05 was established around the fixed peg of HK$7.80 to US$1.00, within which “the HKMA may choose to conduct open market operations consistent with Currency Board principles with the aim of promoting smooth functioning of the money and foreign exchange markets.”⁶² In addition “a cushion of liquidity” is provided by a Discount Window facility that permits banks to borrow from the HKMA via repurchase agreements using as collateral Exchange Fund bills and notes, which are claims on foreign exchange reserves held by banks as backing for currency issues. In effect, this permits a doubling of the monetary base in the case of a financial crisis.⁶³

Conclusion

After the outright collapse of the Argentine currency board system and the subtle transformation of the Hong Kong currency board, contemporary opinion remains an odd mixture of insight and confusion regarding the true nature of this peculiar monetary regime. On the one hand, some economists have identified the flaw in the system as the bank credit creation it permits without appreciating its full implications. For example DeRosa⁶⁴ has written:

[R]egardless of the size of the reserves held by the currency board, external shocks may be big enough to damage confidence in the currency board. This happened to Hong Kong in October 1997 … and again in August 1998 despite there being a massive stock of reserves.

The Achilles heel of a currency board is that the public’s perception of its permanence can vanish in a moment. If the integrity of the board or the intention of the government to maintain the board comes into doubt, then something akin to a bank panic can ensue when local citizens, foreign investors, and foreign exchange traders try to sell the local currency.

Unfortunately, DeRosa does not put his finger on the ultimate cause of the system’s vulnerability to bank panics: the fact that domestic credit creation by commercial banks produces a national reserve system.⁶⁵ Indeed some observers explicitly deny that domestic credit creation takes place under a currency board at all. Thus Guillermo Calvo⁶⁶ contends, “A common feature in recent crisis is a large expansion of domestic credit from the central bank.… Actually, as illustrated by the tequila crisis [that afflicted Mexico in 1994–1995], in most cases (Argentina and Hong Kong SAR are exceptions) the loss of international reserves is almost entirely driven by international reserves.” While Calvo’s diagnosis of modern financial crises is in accordance with the NCS theory of currency crises with respect to most traditionally pegged exchange-rate regimes, his parenthetical exception of the Argentine and Hong Kong currency boards is seen to be unjustified in light of the argument of this paper. In fact, national reserve systems absent a central bank are perfectly capable of continually expanding domestic credit and re-creating an excess supply of money. Eventually this ongoing process of bank credit expansion leads to a severely overvalued monetary unit that precipitates a bank panic and financial crisis.

Finally we might note the revealing response of two leading currency board proponents to the earlier Argentine currency crisis of 1995. Hanke and Schuler⁶⁷ initially frankly recognized that the currency board was in effect a national reserve system. They nonetheless dismissed the currency principle as a guide to sound money and argued that even inverse movements of the money supply and the balance of payments were completely consistent with stability of the currency board regime:

It is even possible for changes in the money supply under a currency board system to move opposite from balance-of-payment changes. However that is perfectly acceptable. There is no reason why the money supply in a modern fractional-reserve bank banking system should have a rigid relation with the balance of payments, if other factors simultaneously move the money supply in the other direction. Hong Kong and Singapore experienced balance-of-payments deficits for decades at a time, yet their money supplies steadily increased because they were attracting large inflows of foreign investment.

Hanke and Schuler went on to contend that “market forces of profit and loss” would determine the appropriate variations in the money supply as long as the currency board remained “entirely passive” and converted “notes and coins into and out of the reserve currency as the public and banks demand.” In this case, when the rate of return on investment (adjusted for risks and net of transactions costs) in the currency board country exceeded interest rates abroad, foreign investment would flow in increasing bank reserves and causing a multiple expansion of bank loans and the money supply. The money supply would stop expanding when further expansion of bank loans “would be less profitable than investing the funds abroad.” The money supply would thus be endogenously determined by a vaguely specified interest-rate arbitrage mechanism.

Hanke,⁶⁸ at least, seemed to abandon this argument for the stability of the money supply process under the currency board when he was forced to address the Argentine currency crisis of 1995, which was marked by domestic bank runs. Now, Hanke⁶⁹ distinguished between “a sound currency” and “a sound credit system,” and claimed that the crisis reflected on the soundness of the latter, not the former. Contradicting his earlier view of an optimal money supply determined by market forces, Hanke arbitrarily dichotomized the money supply process into the efficient provision of currency by the currency board and the unruly behavior of private bank deposits. Hanke⁷⁰ thus blamed Argentina’s plight on the fact that it lacked any of the four “classic policies” for preventing “internal drains” or domestic bank runs: deposit insurance; the existence of a lender of last resort; the ability to suspend the convertibility of bank deposits into currency; or 100 percent-reserve banking. He thus supported a proposed deposit insurance system funded by compulsory contributions from the banks themselves, with each bank’s premium based on an asset risk assessment conducted by the Argentine central bank. Perhaps perceiving the advantages of the currency principle he also recommended, “One avenue worth further exploration is 100 percent banking.” In any case, Hanke has in effect conceded the point of the NSC theory: that a pure currency board system, lacking additional restraints on commercial bank credit creation, is incapable of preventing currency crises.

The conclusions of this paper are twofold. First, the Neo-Currency School theory of currency crises developed in the 1930s sheds valuable light on the likely performance of currency boards in emerging market economies. Second, the case of Hong Kong, when interpreted in the light of this theory, reveals a vital structural flaw even in the most rigid currency board system.

Bibliography

Anderson, Benjamin M. 1979. Economics and the Public Welfare: A Financial and Economic History of the United States, 1914–1946. 2nd ed. Indianapolis, Ind.: Liberty Press.

Batemarco, Robert and Joseph T. Salerno. 1993. “SME: A New Measurement of the U.S. Money Supply.” The Mid-Atlantic Journal of Business 29 (March): pp. 109–31. Available at http://www.highbeam.com/doc/1G1-14332205.html

Cochran, John P., and Steven T. Call. 1998. “The Role of Fractional-Reserve Banking and Financial Intermediation in the Money Supply Process: Keynes and the Austrians.” The Quarterly Journal of Economics 1 (Fall): pp. 29–40.

Calvo, Guillermo A. 2005. Emerging Capital Markets in Turmoil: Bad Luck or Bad Policy? Cambridge, Mass.: The MIT Press.

Cecchetti, Stephen G. 2006. Money, Banking, and Financial Markets. New York: McGraw-Hill Irwin.

Currency Board Homepage at http://kisisel.cc.ankara.edu.tr/politics.ankara.edu.tr/kibritci/curboard. html

DeRosa, David F. 2001. In Defense of Free Capital Markets: The Case Against a New International Financial Architecture. Princeton, N.J.: Bloomberg Press.

De Soto, Jesús Huerta. 2006. Money, Credit and Economic Cycles, Melinda A. Stroup, trans. Auburn, Ala.: Ludwig von Mises Institute.

Enoch, Charles and Anne-Marie Gulde. 1997. “Making a Currency Board Operational.” Paper on Policy Analysis and Assessment of the International Monetary Fund (November).

Gertchev, Nikolay. 2002. “The Case Against Currency Boards.” The Quarterly Journal of Austrian Economics 5 (Winter): pp. 57–75.

Ghosh, Atish R., Anne-Marie Gulde, and Holger C. Wolf. (2003). Exchange Rate Regimes: Choices and Consequences. Cambridge, Mass.: The MIT Press.

Haberler, Gottfried von. [1936] 1968. Theory of International Trade. Alfred Stonier and Frederic Benham, trans. Clifton, N.J.: Augustus M. Kelley Publishers.

Hanke, Steve H. 1996. “Argentina, the ‘Germany’ of South America?” In The Contributions of Murray Rothbard to Monetary Economics, Clifford F. Thies, ed., pp. 19–30. Winchester, Va.: Durell Institute at Shenandoah University.

Hanke, Steve H., Lars Jonung, and Kurt Schuler. 1993. Russian Currency and Finance: A Currency Board Approach to Reform. New York: Routledge.

____, and Kurt Schuler. 1991. Currency Boards for Eastern Europe. The Heritage Lectures 355. Washington, D.C.: The Heritage Foundation.

____, and Kurt Schuler. 1993. “Currency Boards and Currency Convertibility.” The Cato Journal 12 (Winter): 687–705.

Harding, W.P.G. 1925. The Formative Period of the Federal System (During the World Crisis). New York: Houghton Mifflin Company.

Hayek, F.A. [1937] 1971. Monetary Nationalism and International Stability. New York: Augustus M. Kelley Publishers.

Heilperin, Michael A. 1935. “Economics of Banking Reform.” Political Science Quarterly 50 (September): pp. 359–76.

____. 1968. Aspects of the Pathology of Money: Monetary Essays from Four Decades. London: Michael Joseph Limited.

____. [1939] 1978. International Monetary Economics. Philadelphia: Porcupine Press.

Hong Kong Monetary Authority. 2002. “Definition of Money Supply.” Quarterly Bulletin (May). pp. 16–23. Available at http://www.info.gov.hk/hkma/eng/public/index. htm.

____. 2005. HKMA Background Brief No. I: Hong Kong’s Linked Exchange Rate System (November). Available at http://www.info.gov.hk/hkma/eng/public/hkmalin/index.htm.

Humpage, Owen F. and Jean M. Mclntire. 1995. “An Introduction to Currency Boards.” Federal Reserve Bank of Cleveland Economic Review 31 (Quarter 2): pp. 2–11.

Kasa, Kenneth. 1999. “Why Attack a Currency Board?” Federal Reserve Bank of San Francisco Economic Letter (November 26). Available at http://www.frbsf.org/econrsrch/wklyltr/wklyltr99/el99-36.html.

Kopcke, Richard W. 1999. “Currency Boards: Once and Future Monetary Regimes.” New England Economic Review (May/June): pp. 21–37.

Machlup, Fritz. 1964. “Foreign Debts, Reparations, and the Transfer Problem.” In International Payments, Debts, and Gold: Collected Essays by Fritz Machlup. pp. 396–416. New York: Charles Scribner’s Sons.

____. 1980. “My Early Work on International Monetary Problems.” Banca Nazionale Del Lavoro Quarterly Review 133 (June): pp. 115–46.

Mises, Ludwig von. 1981. The Theory of Money and Credit. 3rd ed. Indianapolis, Ind.: Liberty Classics.

____. 1990. “Senior’s Lectures on Monetary Problems.” In Money, Method, and the Market Process: Essays by Ludwig von Mises, Richard M. Ebeling, ed., pp. 104–09. Norwell, Mass.: Kluwer Academic Publishers.

____. [1978] 1996. “The ‘Austrian’ Theory of the Trade Cycle.” In The Austrian Theory of the Trade Cycle and Other Essays, 2nd ed. Richard M. Ebeling, ed., pp. 25–35. Auburn, Ala.: Ludwig von Mises Institute.

____. 1998. Human Action: A Treatise on Economics, Scholar’s Edition, Introduction by Jeffrey M. Herbener, Hans-Hermann Hoppe, and Joseph T. Salerno, Auburn, Ala.: Ludwig von Mises Institute.

____. 2000. “A Noninflationary Proposal for Postwar Monetary Reconstruction.” In Selected Writings of Ludwig von Mises: The Political Economy of International Reform and Reconstruction, Richard M. Ebeling, ed., pp. 71–118. Indianapolis, Ind.: Liberty Classics.

Mishkin, Frederic S. 2004. The Economics of Money, Banking, and Financial Markets, 7th ed. New York: Pearson Addison Wesley.

Palyi, Melchior. 1972. The Twilight of Gold, 1914–1936: Myths and Realities. Chicago: Henry Regnery Company.

Phillips, C.A., T.F. McManus, and R.W. Nelson. [1937] 1972. Banking and the Business Cycle: A Study of the Great Depression in the United States. New York: Arno Press & The New York Times.

Robbins, Lionel. 1937. Economic Planning and International Order. London: Macmillan.

Rothbard, Murray N. 1995. Classical Economics: An Austrian Perspective on the History of Economic Thought, vol. 2. Brookfield, Vt.: Edward Elgar Publishing Company.

Roubini, Nouriel. 1998. “The Case Against Currency Boards: Debunking 10 Myths about the Benefits of Currency Boards.” Working Paper. Stern School of Business, New York University. Available at http://www.dse.unive.it/summer-school/papers/rubini.htm.

Salerno, Joseph T. 1992. “Gold and the International Monetary System: The Contribution of Michael A. Heilperin.” In The Gold Standard: Perspectives in the Austrian School, 2nd ed., Llewellyn H. Rockwell, Jr., ed., pp. 81–111. Auburn, Ala.: Ludwig von Mises Institute.

____. 1994. “Ludwig von Mises’s Monetary Theory in Light of Modern Monetary Thought.” The Review of Austrian Economics, vol. 8, no. 1: pp. 71–115.

____. 1998. “Beyond Calculational Chaos: Sound Money and the Quest for Capitalism and Freedom in Ex-Communist Europe.” Polis: Revistã “tinke Politice,” 5, no. 1: pp. 114–33.

Schwartz, Anna J. 1992. Do Currency Boards have a Future? London: Institute of Economic Affairs.

Shu-ki, Tsang. 1998a. ‘The Hong Kong Government’s Review Report: An Interpretation and a Response” (May 4). Available at http://sktsang.computancy.com/attrachment/web985.html.

____. 1998b. “Is a Currency Board System Optimal for Hong Kong” (May 18). Available at http://sktsang.computancy.com/attrachment/web986.html.

____. 1998c. “Handling Credit Crunch under Hong Kong’s Currency Board System” (August 6). Available at http://sktsang.com/ArchiveI/web987.html.

Yeager, Leland B. 1976. International Monetary Relations: Theory, History, and Policy, 2nd ed. New York: Harper & Row Publishers.

Yu, George. 1998. “Is Hong Kong Ready to Delink the Currency?” Reprinted from HKCER Letters (March). Available at http://www.hku.hk/hkcer/articles/v49/george.htm.

Zarazaga, Carlos E. 1995. “Can Currency Boards Prevent Devaluations and Financial Meltdowns?” Federal Reserve Bank of Dallas Southwest Economy (July/August): pp. 2–9. Available at www.dallasfed.org/research/swe/1995/swe9504. pdf.

---

From: “Preventing Currency Crises: The Currency Board Versus the Currency Principle” Indian Journal of Economics and Business 6, no. 1 (2007): pp. 161–83.

¹ Nikolay Gertchev, “The Case Against Currency Boards,” The Quarterly Journal of Austrian Economics 5 (Winter 2002): p. 66.

² Stephen G. Cecchetti, Money, Banking, and Financial Markets (New York: McGraw-Hill Irwin, 2006).

³ Ludwig von Mises, The Theory of Money and Credit, 3rd ed. (Indianapolis, Ind.: Liberty Classics, 1981), pp. 485–90.

⁴ For a modern application of Mises’s proposal to Eastern European transition economies see Joseph T. Salerno, “Beyond Calculational Chaos: Sound Money and the Quest for Capitalism and Freedom in Ex-Communist Europe,” Polis: Revistã de “tinke Politice,” 5, no. 1: pp. 114–33 [reprinted here as Chapter 19].

⁵ Steve H. Hanke, Lars Jonung and Kurt Schuler, Russian Currency and Finance: A Currency Board Approach to Reform (New York: Routledge, 1993), p. 82.

⁶ Mises, Theory of Money and Credit.

⁷ Ludwig von Mises, “Senior’s Lectures on Monetary Problems,” in Money, Method, and the Market Process: Essays by Ludwig von Mises, ed. Richard M. Ebeling, pp. 104–09 (Norwell, Mass.: Kluwer Academic Publishers, 1990); idem, Human Action: A Treatise on Economics, Scholar’s Edition, Introduction by Jeffrey M. Herbener, Hans-Hermann Hoppe, and Joseph T. Salerno (Auburn, Ala.: Ludwig von Mises Institute, 1998); idem, “A Noninflationary Proposal for Postwar Monetary Reconstruction,” in Selected Writings of Ludwig von Mises: The Political Economy of International Reform and Reconstruction, ed. Richard M. Ebeling (Indianapolis, Ind.: Liberty Classics, 2000), pp. 71–118.

⁸ Friedrich Hayek, Monetary Nationalism and International Stability (New York: Augustus M. Kelley, [1937] 1971).

⁹ Lionel Robbins, Economic Planning and International Order (London: Macmillan, 1937).

¹⁰ Gottfried von Haberler, Theory of International Trade, trans. Alfred Stonier and Frederic Benham (Clifton, N.J.: Augustus M. Kelley, [1936] 1968).

¹¹ Fritz Machlup, “Foreign Debts, Reparations, and the Transfer Problem,” in International Payments, Debts, and Gold: Collected Essays by Fritz Machlup (New York: Charles Scribner’s Sons, 1964), pp. 396–416; idem, “My Early Work on International Monetary Problems,” Banca Nazionale Del Lavoro Quarterly Review 133 (June 1980): pp. 115–46.

¹² Michael A. Heilperin, “Economics of Banking Reform,” Political Science Quarterly 50 (September 1935): pp. 359–76; idem, Aspects of the Pathology of Money: Monetary Essays from Four Decades (London: Michael Joseph Limited, 1968); idem, International Monetary Economics (Philadelphia: Porcupine Press, [1939] 1978). Heilperin is nearly forgotten today, but he was a prolific writer and an important thinker on international monetary economics whose career extended from the early 1930s to the early 1960s. He published books and articles in three languages, his native Polish, French, and English and was a colleague of Mises’s at the Graduate Institute of International Studies in Geneva. For an overview and evaluation of his work, see Joseph T. Salerno, “Gold and the International Monetary System: The Contribution of Michael A. Heilperin,” in The Gold Standard: Perspectives in the Austrian School, 2nd ed., ed. Llewellyn H. Rockwell, Jr. (Auburn, Ala.: Ludwig von Mises Institute, 1992), pp. 81–111.

¹³ Murray N. Rothbard, Classical Economics: An Austrian Perspective on the History of Economic Thought, vol. 2 (Brookfield, Vt.: Edward Elgar Publishing Company, 1995), pp. 225–74 provides a comprehensive discussion of the British Currency School and its origins, doctrines, and opponents.

¹⁴ Ludwig von Mises, “The ‘Austrian’ Theory of the Trade Cycle,” in Richard M. Ebeling, The Austrian Theory of the Trade Cycle and Other Essays, 2nd ed. (Auburn, Ala.: Ludwig von Mises Institute, [1978] 1996), pp. 25–27.

¹⁵ Mises, Human Action, p. 462; Hayek, Monetary Nationalism, p. 12.

¹⁶ Mises, Human Action, p. 262.

¹⁷ C.A. Phillips, T.F. McManus, and R.W. Nelson, Banking and the Business Cycle: A Study of the Great Depression in the United States (New York: Arno Press & The New York Times, [1937] 1972), pp. 24–25; W.P.G. Harding, The Formative Period of the Federal System (During the World Crisis) (New York: Houghton Mifflin Company, 1925), pp. 72–74. As Benjamin Anderson (Economics and the Public Welfare: A Financial and Economic History of the United States, 1914–1946, 2nd ed. [Indianapolis, Ind.: Liberty Press, 1979], p. 56) pointed out, the theory underlying this Amendment was “not very clear” but “in 1916 and in early 1917 there was a very definite practical consideration that we might be involved in war, and that it was important that the gold of the country be concentrated in a central reservoir as a basis for war finance.” So the centralization of gold reserves in the Fed was undertaken with the definite intention of facilitating an inflationary monetary policy.

¹⁸ According to Mises, “In order to make it easier for the central banks to embark upon credit expansion, the European governments aimed long ago at a concentration of their countries’ gold reserves with the central banks (Mises, Human Action, p. 462).

¹⁹ Ibid., p. 780.

²⁰ Phillips et al., Banking and the Business Cycle, p. 49.

²¹ For discussion of the changes in the legal and institutional conditions that led to the transformation of time deposits into instantaneous liabilities and their role in generating bank credit inflation and financial instability in the 1920s and 1930s, see Heilperin, Aspects of the Pathology of Money, pp. 267–68 and idem, International Monetary Economics, pp. 92–93; Mises, “Senior’s Lectures on Monetary Problems,” pp. 107–08; Phillips et al., Banking and the Business Cycle, pp. 29, 95–101.

²² Mises, Human Action, p. 462.

²³ Hayek, Monetary Nationalism, pp. 10, 12.

²⁴ Two minor mistakes marred Hayek’s analysis. It ignored Mises’s crucial distinction between “money” and “money substitutes” and it confounded the Mengerian concept of “acceptability” or “marketability” and the Keynesian notion of “liquidity.” Different kinds of money substitutes can be more or less widely acceptable, but as soon as any kind comes to be considered as less than perfectly “liquid,” it will be deprived of its monetary function. For an enlightening discussion of the difference between the two concepts from a slightly different perspective, see Heilperin, International Monetary Economics, pp. 93–94. For an explanation of Mises’s taxonomy of money and a defense of his distinction between money and money substitutes, see Joseph T. Salerno, “Ludwig von Mises’s Monetary Theory in Light of Modern Monetary Thought,” The Review of Austrian Economics 8, no. 1: pp. 75–77 [reprinted here as Chapter 2].

²⁵ Hayek, Monetary Nationalism, p. 31.

²⁶ Heilperin (International Monetary Economics, pp. 92–93) made a similar distinction: “ ‘[C]apital’ is the fund of purchasing power made available for investment. It is to be distinguished from monetary funds whose destination has not yet been decided upon by the owners. One has to note that the organization of credit does not make possible a sharp distinction between the two types of funds—which is one of the great factors in economic instability.”

²⁷ Of course, if the country in question is experiencing relatively rapid growth in real output, the credit expansion may not manifest itself in rising prices of consumer goods, but solely in declining interest rates and swelling bubbles in financial and real estate markets. This occurred in the U.S. in the 1920s and 1990s.

²⁸ After the discovery of open market operations in the 1920s, the central bank could also initiate monetary contraction and avoid a currency crisis by selling securities to the commercial banks and the public.

²⁹ Mises, Human Action, pp. 456–57.

³⁰ As Mises (Human Action, p. 459) explained: “it has been asserted that the ‘orthodox’ methods of fighting an external drain by raising the rate of discount no longer work because nations are no longer prepared to comply with ‘the rules of the game.’ Now the gold standard is not a game, but a social institution. Its working does not depend on the preparedness of any people to observe some arbitrary rules.”

³¹ Mises, Human Action, pp. 468–70.

³² Ibid., p. 459.

³³ Machlup, “My Early work on International Money Problems,” pp. 118–19.

³⁴ In this passage Machlup combines passages from his 1923 text with his commentary on this text in 1980. 1 have suppressed the brackets that he inserted.

³⁵ Robbins, Economic Planning, p. 302.

³⁶ For an insightful discussion of the historical, political, intellectual, and ideological factors responsible for this radical transformation of central banks’ view of the role they played in the operation of the gold standard after 1914, see Melchior Palyi, The Twilight of Gold, 1914–1936: Myths and Realities (Chicago: Henry Regnery Company, 1972), pp. 45–60, 101–06. Also see Anderson, Economics and the Public Welfare, pp. 182–89.

³⁷ Heilperin, International Monetary Economics, pp. 97–98.

³⁸ Ibid., p. 100.

³⁹ For a recent analysis of the general effects of the mishandling of speculative cash balances as genuine savings by the banking system see John P. Cochran and Steven T. Call, “The role of Fractional-Reserve Banking and Financial Intermediation in the Money Supply Process: Keynes and the Austrians,” The Quarterly Journal of Economics 1 (Fall 1998): pp. 29–40; also see Jesús Huerta De Soto, Money, Credit and Economic cycles, trans. Melinda A. Stroup (Auburn, Ala.: Ludwig von Mises Institute, 2006), pp. 167–295.

⁴⁰ Mises, “Senior’s Lectures on Monetary Problems,” pp. 107–09.

⁴¹ Ibid., p. 109.

⁴² Reporting on his own research on capital flight in the 1930s, Machlup (“My Early Work on International Monetary Problems,” p. 133) appears to have reached a similar conclusion regarding its nature and necessary precondition: “I found that there were ‘natural’ limits to the possible flight of capital—except if the central bank permits an expansion of domestic credit and thereby finances the capital exports. In this case the central bank provides or replenishes the domestic funds that seek conversion into foreign currencies, with the result that no capital export takes place (since the loss of monetary reserves constitutes an official capital import) and, of course, no transfer of real resources takes place.” Interestingly, Machlup (ibid.) confided that he resisted including his article on capital flight in the English-language collection of his essays “chiefly because of its implied policy recommendation for central banks never to come to the aid of commercial banks confronted with sudden withdrawals of foreign loans.” While he conceded that such “a tough position” may have been “justified” in the case in question, “as a general principle,” he feared his “1932 position appears unduly dogmatic and insensitive.”

⁴³ Mises, Human Action, p. 462.

⁴⁴ Ibid., pp. 462–63.

⁴⁵ On the Swiss devaluation, see Palyi, The Twilight of Gold, pp. 290–91 and Leland B. Yeager, International Monetary Relations: Theory, History, and Policy, 2nd ed. (New York: Harper & Row Publishers, 1976), pp. 258–63.

⁴⁶ On the design and operation of currency boards: see Steve H. Hanke and Kurt Schuler, Currency Boards for Eastern Europe. The Heritage Lectures 355 (Washington, D.C.: The Heritage Foundation, 1991); idem, “Currency Boards and Currency Convertibility,” The Cato Journal 12 (Winter): pp. 687–705; Hanke et al., Russian Currency and Finance; Anna J. Schwartz, Do Currency Boards Have a Future? (London: Institute of Economic Affairs, 1992); Owen F. Humpage and Jean M. McIntire, “An Introduction to Currency Boards,” Federal Reserve Bank of Cleveland Economic Review 31 (Quarter 2): pp. 2–11; Charles Enoch and Anne-Marie Guide, “Making a Currency Board Operational,” Paper on Policy Analysis and Assessment of the International Monetary Fund (November 1997); Richard W. Kopcke, “Currency Boards: Once and Future Monetary Regimes,” New England Economic Review (May/June 1999): pp. 21–37, and the literature cited therein. For the most thorough critical analysis of the currency board from the perspective of the NCS, see Gertchev, “The Case Against Currency Boards.” Some of the above as well as additional articles discussing various aspects of the currency board can be found on the “Currency Board” Homepage at http://politics.ankara.edu.tr/~kibritci/cur-board.html.

⁴⁷ Nouriel Roubini, “The Case Against Currency Boards: Debunking 10 Myths about the Benefits of Currency Boards,” Working Paper. Stern School of Business, New York University. Available at http://www.geocities.com/Eureka/Con-course/8751/jurus/vs-cbs.htm.

⁴⁸ For details of the history and operation of the Hong Kong currency board, see Hong Kong Monetary Authority, HKMA Background Brief No. 1: Hong Kong’s Linked Exchange Rate System (November). Available at http://www.info.gov.hk/hkma/eng/public/hkmalin/index.htm. It should be noted that there is no deposit reserve requirement in Hong Kong and that banks need only maintain a clearing balance with the HKMA sufficient to cover their interbank settlements (Tsang Shuki, “Is a Currency Board System Optimal for Hong Kong,” [May 18, 1998]. Available at http://www.hkbu.edu.hi/~econ/web986.html).

⁴⁹ Unless otherwise noted, all statistics relating to the Hong Kong currency board system are available on the HKMA website at http://www.info.gov.hk/hkma/index.htm.

⁵⁰ Some contemporary critics of currency boards also suggest that it is the ratio of a broad measure of the money supply to foreign reserves that is appropriate in gauging the adequacy of reserves in the face of a currency crisis. See Roubini, “The Case Against Currency Boards,” for references.

⁵¹ M3 is a particularly appropriate measure of the money supply in Hong Kong, because, in contrast to the M3 aggregate calculated for most other developed countries, Hong Kong M3 excludes repos and money market mutual funds which are not general media of exchange on a par with currency and bank deposits. Furthermore, unlike U.S. monetary statistics, for example, which exclude bank deposits held by foreign official institutions, monetary aggregates in Hong Kong properly do not differentiate between deposits held by resident and non-resident entities (Hong Kong Monetary Authority, “Definition of Money Supply,” Quarterly Bulletin [May 2002]: pp. 16–23. Available at http://www.info.gov.hk/hkma/eng/public/index.htm, p. 16). For a critique of U.S. monetary aggregates including M3, see Robert Batemarco and Joseph T. Salerno, “SME: A new Measurement of the U.S. Money Supply,” The Mid Atlantic Journal of Business 29 (March 1993): pp. 109–31. Available at http://www.highbeam.com/librarydocFree.asp?drjcid=1G1:14332205&key=0C177A56741C146 0120D001A026A06087D07740B74ZR7aUG72on.

⁵² Shu-ki, “Is a Currency Board System Optimal for Hong Kong.”

⁵³ David F. DeRosa (In Defense of Free Capital Markets: The Case Against a New International Financial Architecture (Princeton, N.J.: Bloomberg Press, 2001), p. 120) makes a similar point in his discussion of Hong Kong’s currency crisis of 1997:

[T]he continued operation of the [currency] board under conditions of duress is a function of the country’s willingness to sacrifice hard currency reserves. At some time or other, the country might decide that enough is enough and that keeping its foreign reserves is more important than maintaining its currency peg.

⁵⁴ Real GDP growth per year averaged 5.0 percent in 1990–1997 versus 6.8, 8.9, and 7.9 percent in the 1980s, 1970s and 1960s respectively. This has led Shu-ki (“Is a Currency Board System Optimal for Hong Kong”) to comment, “The fall in the real growth rate of per capita GDP has been particularly disappointing, as Hong Kong should not have ‘matured’ so quickly.”

⁵⁵ These statistics were computed from the electronic databases accompanying Atish R. Ghosh, Anne-Marie Gulde, and Holger C. Wolf, Exchange Rate Regimes: Choices and Consequences (Cambridge, Mass.: The MIT Press, 2003). Data on monetary aggregates are not published by the HKJVIA for the years before 1997. Thus it is difficult to gauge the degree to which the operation of the Hong Kong currency board violated the currency principle in the years leading up to the currency crises of 1997 and 1998.

⁵⁶ Shu-ki, “Is a Currency Board System Optimal for Hong Kong.”

⁵⁷ Ghosh et al., Exchange Rate Regimes.

⁵⁸ The following account is drawn from DeRosa, In Defense of Free Capital Markets.

⁵⁹ Quoted in DeRosa, In Defense of Free Capital Markets.

⁶⁰ Ibid., p. 144.

⁶¹ Ghosh et al., Exchange Rate Regimes.

⁶² Hong Kong Monetary Authority, HKMA Background Brief, p. 38.

⁶³ Ibid., p. 39; Kenneth Kasa, “Why Attack a Currency Board?” Federal Reserve Bank of San Francisco Economic Letter (November 26, 1999), p. 4. Available at http://www.frbsf.org/econrsrch/wklyltr/wklyltr99/el99-36.html.

⁶⁴ DeRosa, In Defense of Free Capital Markets, pp. 162, 163–64.

⁶⁵ See Carlos E. Zarazaga, “Can Currency Boards Prevent Devaluations and Financial Meltdowns?” Federal Reserve Bank of Dallas Southwest Economy (July/August 1995): p. 9 for an earlier and clearer statement of the problem.

⁶⁶ Guillermo A. Calvo, Emerging Capital Markets in Turmoil: Bad Luck or Bad Policy? (Cambridge, Mass.: The MIT Press, 2005), p. 341.

⁶⁷ Hanke and Schuler, Currency Boards for Eastern Europe, p. 15.

⁶⁸ Steve H. Hanke, “Argentina, the ‘Germany’ of South America?” in The Contributions of Murray Rothbard to Monetary Economics, ed. Clifford F. Thies (Winchester, Va.: Durell Institute at Shenandoah University, 1996), pp. 19–30.

⁶⁹ Ibid., p. 28.

⁷⁰ Ibid., p. 29.