Why should a developing country surrender its power to create money by adopting an international currency as its own? This comprehensive book explores the currency problems that developing countries face and offers sound, practical advice for policy makers on how to deal with them. Manuel Hinds, who has extensive experience in real-world economic policy making, challenges the myths that surround domestic currencies and shows the clear rationality for dollarization or the use of a standard international currency.
The book opens with an entertaining story of the Devil, who, through a series of common macroeconomic maneuvers, coaches the president of a mythical country into financial ruin. This ruler’s path is not unlike that taken in several real developing countries, to their detriment. Hinds goes on to introduce new ways of thinking about financial systems and monetary behavior in Third World countries.
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About the Author
Manuel Hinds is a consultant to international institutions and governments on issues related to the financial system. He was chief adviser to the president of El Salvador on the dollarization of the country in 2000-2001.
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Playing Monopoly with the DevilDollarization and Domestic Currencies in Developing Countries
By Manuel Hinds
Yale University PressCopyright © 2006 Yale University
All right reserved.
Chapter OneThe Standard of Value and the Reversed Liquidity Trap
Money started its long career in history as a means of exchange: the currency that everyone accepts in payment. With time, however, it evolved into something much broader than this in three steps, each larger than the precedent. First, it led to the creation of the banking system, which multiplied the money actually printed by the sovereign so that in addition to the currency bills, people could use checks and other drawing instruments against their deposits in the banks. In modern times, money exercises its payment function in many other ways, including credit and debit cards, as well as the electronic impulses needed to effect payments on the Internet. Second, people started to use money not just as a means of exchange but also as an asset with a rental price. This rental price is the net result of the interest rate and the rate of inflation, the latter being measured in terms of the change in the price at which people can exchange monetary assets for other things-which produce either capital gains or capital losses, depending on whether the prices of the other things aregoing down or up, respectively. People choose to keep money as currency bills, checking accounts, and interest-bearing accounts in the banking system or to spend it depending on the interest rate, the capital gains or losses afforded by money, and the cost of converting one of these forms into the other. Third, money became the standard of value for the population and, through this, the abstract indicator giving meaning to the economic obligations established in the main mechanism that society has to control economic activity: contracts. When developing this dimension of its functions, money became the main economic instrument linking the past, the present, and the future.
Money multiplied its impact on the economy in each of these steps. With the development of new payment mechanisms, it reduced transaction costs. When it became an asset, it propelled the development of financial intermediation, leading to the creation of credit and, through this, to the separation of the identity of the saver from that of the investor. This multiplied exponentially the possibilities of funding investment. Because of the existence of credit, an investor with an idea did not need to have money to turn it into reality.
While crucial for the functioning of the economy, money is linked inextricably to the financial system in the first two functions. By becoming the standard of value, however, it became central to the operation of all economic activity, independently of whether the financial system is involved or not. Of course, this dimension of money is also essential for the functioning of the financial sector, which is a system of contracts. Yet, its impact on the economy overspills the realm of financial operations and far exceeds what we can measure through the monetary and financial statistics, which focus on the size of the contracts held by the financial system. The future performance of the economy does not depend solely on these financial contracts. They are, in fact, subsidiary to other, more important contracts that establish what people will do with the money intermediated by the financial system, regulating the flow of real goods and services across the economy. All of them are denominated in monetary units. When money becomes the standard of value, it gets ingrained in the brains of people, providing them with the main source of market information and the means to plan for the future. Playing this role, money floats in the environment without having been created. It is an abstract measure of value, but it exists with full reality in people's minds, in the contracts they engage in, and in the daily calculations they make about the size and composition of their consumption and saving. In spite of its abstractness, people trust in it to denominate their pensions, to transfer legacies to their children, to plan their future. It is the blood of the economy.
Thus, for people, money is not just a currency but also a yardstick that they use to measure value, carry out transactions, keep their accounts, and provide the denomination of all their contracts, including those related to their savings and investments. To play those roles, money should keep its value through time.
The fact that money is so central to the operation of the entire economy makes it possible for the issuer of the means of payment to manipulate practically all aspects of economic behavior by changing the rate at which it creates money. If, for example, the central bank creates more money than the public demands, the people spend it, and this increases demand for goods and services. The increased demand can have two different effects on the economy, depending on the ability of the economy to react to it. If it cannot augment its production, the expanding demand leaks into the balance of payments with other countries, increasing imports and reducing exports (as enterprises sell in the domestic market goods that otherwise they would have exported). If the economy doesn't have enough foreign exchange to pay for the trade deficit, the value of the currency falls relative to other currencies and the excessive demand is turned into inflation through devaluation. None of this, however, would happen if the capacity utilization in the economy were lower than 100 percent. That is, if enterprises are not using their machinery to the full, there is unemployment, and if this is not the result of a shift in the composition of demand, additional demand spurs more production without creating much inflation or balance of payments problems. I have emphasized the condition in italics. It simply means that if the low capacity utilization were due to a shift in the composition of demand, higher monetary creation would also lead to inflation and balance of payments problems. Think, for example, of a country producing horse carriages in the 1910s. Its capacity utilization would have fallen to almost zero with the popularization of the automobile, and no monetary policy would have been able to increase it.
John Maynard Keynes, one of the greatest and most conservative monetary economists in modern history, was the first to expound on the possibility of expanding production by creating money. He noted that in some circumstances, which he defined very specifically, the activity of the economy could be constrained by the lack of money. That is, when money itself is scarce, its value keeps increasing relative to that of all other goods in the economy. In such circumstances, people prefer to hold on to money rather than spend it. On the other side of the financial system, potential borrowers cannot find investments that would be more attractive than holding money. This, in turn, leads to low investment in real assets, high unemployment, and depression. The solution to this problem was to create additional money, thus lowering its relative value and enticing people to spend it. Inflation, the normal effect of rapid monetary creation, would not take place because capacity utilization would be low. Thus, the greater demand for goods and services would not increase prices but would stimulate production.
This insight created macroeconomics, the art of manipulating real variables through a nominal instrument, monetary policy. For the macroeconomist, money is a policy variable that governments can use to affect the level of production, prices, and the aggregate relationships with other economies. To do this, governments should be able to change the value of money, relative to the goods and services traded within and without the economy.
Thus, conducting monetary policies requires a balance between two contradictory objectives, so that its macroeconomic manipulation, aimed at changing the value of money, does not destroy the essential role of money, which is keeping its value through time. If money loses this essential property, it also loses its ability to affect economic behavior in the ways intended by the central banks. Instead, people react in ways that introduce serious instability in the economy and constrain its ability to function normally and grow.
This contradiction is at the core of the problems of developing countries. Through excessive manipulation, their currencies have lost the ability to provide a standard of value to their populations with grave consequences that I explore in this part of the book.
Keynes was quite conscious of the need to keep the value of money through time, and he made this clear in his writings. Even if this is not widely recognized, Keynes's recommendations to overcome the Great Depression were rooted on the idea that money should keep a constant value. He based his advice to create money on the fact that during the Depression money was becoming dearer. He developed his main arguments in two great books, A Treatise on Money and The General Theory of Employment, Interest and Money. In the second book, he claimed that the root of the Great Depression was that the value of money relative to produced goods and investment was increasing. For this reason, people preferred to keep their wealth in monetary assets rather than invest it in increasing production. In an ideal world, this problem would be resolved by decreasing interest rates. In reality, however, there is a floor to the interest rates, which cannot be lower than the cost of financial intermediation. In the 1930s, he argued, the rate of interest that would attract investment in capital goods was below the cost of intermediation. That is, money had become too expensive for the good of society as the world was in a liquidity trap-people preferred liquidity to investment. He advised monetary creation through the financing of fiscal deficits to cheapen money to a reasonable level.
Keynes's two books dealt with closed economies; that is, economies that had no contact with the rest of the world. He was consistent with the same advice when addressing open economies. In a popular tract, The Economic Consequences of Mr. Churchill, he advised the devaluation of the pound sterling, which Winston Churchill had grossly and arbitrarily revalued against other currencies at the end of the 1920s. In this and in many of his other actions, he kept in mind the damage that devaluing or appreciating money could cause to the economy. That is, he appreciated monetary stability and showed this in his writings and in the creation he coauthored, the Bretton Woods system, which regulated the international monetary relations from the end of World War II to the late 1960s.
This system linked currencies through fixed exchange rates, which countries could change only through certain procedures managed by the International Monetary Fund (IMF). The emphasis, however, was not on the possibility of change, but on the desirability of keeping the value of the different currencies internationally. This would give predictability to international trade, investment, and their associated capital flows. To work, this system demanded consistency between the rate of domestic money creation and the exchange rate. This meant that the rate of monetary creation had to be the same around the world, corrected by some domestic factors, prominent among them the rate of growth of production of each of the economies. This correction was needed because an economy demands more money the more it grows, and having the same growth rate for all of them would result in imbalances in the exchange rates, as the currency of the fastest growing countries would become domestically dearer and could generate depressing pressures in the domestic markets. Thus, to make sure that exchange rate stability existed, the system focused on regulating the rate of domestic money creation so that it would be consistent with keeping a fixed exchange rate, even if such rates could diverge across countries. The United Nations created the IMF to make sure that this happened. To emphasize further that money should keep its role as a standard of value, the United Nations established that the worst offense a country can commit against the rules of the IMF is having multiple exchange rates for its currency.
The system allowed changes in the exchange rate as exceptional events. Successful exporters experienced an increasing demand for their own currency in terms of the international currencies, creating a wedge between the official exchange rate and the one prevailing in the private markets. This demanded an official revaluation of the currency, which countries carried out under the oversight of the IMF. The same happened when the price of the currency in the private markets was lower than the official one. In both cases, the country had to unify the exchange rate by appreciating or devaluing it, according to the case.
Thus, in Keynes's view, there should be only one international standard of value. Domestic standards would be linked to it by fixed, predictable exchange rates. At the time, gold was the standard of value across the world. Central banks kept gold as well as the two international currencies-the U.S. dollar and the pound sterling-as international reserves to carry out transactions across borders and protect the value of their currencies. With time, the dollar became the only international currency. It based its international role on the credibility of the United States' promise to deliver gold at a given price if other countries presented dollars for collection.
Events superseded Keynes in two main ways. First, during their recovery from the devastation of World War II, Europe and Japan experienced high rates of export growth and accumulated dollar reserves much in excess of what the United States could back with its gold reserves. One country, France, began to demand its gold in exchange for the dollars it kept in its central bank. The U.S. government decided to demonetize the gold-that is, to sever the link between its gold reserves and the value of the dollar. From that moment on, a dollar was no longer a claim on a certain amount of gold, but just a dollar. As the common saying states, a dollar is a dollar is a dollar. That effectively floated the dollar against the gold. The other countries floated against the dollar, and the international system that prevails today came into being.
Flotation came none too soon because a second factor had come into play that rendered impractical the general system of fixed exchange rates. Before the late 1960s, inconsistencies between the domestic rates of monetary creation and the exchange rates were common, creating opportunities for monetary arbitrage. For example, people could deposit money in countries with higher inflation and interest rates to enjoy the latter and then convert their funds to the international currency at the fixed exchange rate, which ensured that the gains obtained by the higher interest rates in the domestic currency would become gains in the international currency. The magnitude of these inconsistencies, however, was not enough to endanger the exchange rates across countries because the costs of transaction of international capital movements were too high. In fact, most countries imposed controls on the international flows of money. Then, in the 1960s, the development of communications allowed for the transfer of money through countries at very high speeds and with low transaction costs. At the same time, the Eurodollar market, a market for international dollar financing, was created in London with part of the excess dollars that floated around the world, providing resources for capital flows that were not under the control of any government. With costs of transaction amounting to practically nothing and with plenty of dollars to move across borders, the margin of inconsistency that would be admissible by the system of fixed exchange rates collapsed too. Capital flowed between countries at lightning speed, arbitrating interest rates, and eventually speculating against the ability of countries to keep their exchange rates fixed. Governments recognized that they could not win the war against technology and gradually dismantled their controls on capital movements across countries.
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Table of Contents
Prologue: Playing Monopoly with the Devil....................xiii
Part One. The Unfulfilled Promises of Local Currencies 1 The Standard of Value and the Reversed Liquidity Trap....................3
2 The Unfulfilled Promises in the Financial System....................16
3 The Unfulfilled Promises in Trade and Growth....................53
4 The Costs of Stability....................82
5 Missing Financial Globalization....................107
Part Two. The Reversed Liquidity Trap and Financial Crises 6 The Financial Risks of Monetary Regimes....................121
7 The Currency Origins of Financial Crises....................136
8 The Myth of the Lender of Last Resort....................167
9 The Solution of Crises and the Aftermath....................179
10 The Counterfactuals....................189
Part Three. The Optimal Currency Area and the Choice of Currency 11 The Conventional Optimal Currency Area Theory....................197
12 Toward a Redefinition of an Optimal Currency Area....................220
Epilogue: Werner von Bankrupt on the Art of Buying Countries with a Buck-Fifty....................235