“In the beginning God created sterling and the franc. On the second day He created the currency board and, Lo, money was well managed. “ - Peter B. Kenen
Since the dawn of Keynesian economies, government in emerging markets have insisted on their competence and ability to control their monetary policy. However, time and time again they have shown themselves incapable of controlling their spending. My approach to this conundrum is based on one simple principle - a rules based monetary system. Thus, I have dedicated much of my life work to promoting and advising administrations on currency boards.
What is a currency board?
Currency boards are monetary authorities obligated to hold domestic currency at a fixed exchange rate with a foreign currency. I often liken them to a “monetary straitjacket,”, and prevent the central bank from financing government debt and therefore increasing the broad money supply. The fixed exchange rate mechanism helps to anchor expectations and reduce the risk of speculative attacks on the currency.
The earliest currency boards were established in the mid-nineteenth century in British colonies to provide monetary stability and facilitate trade. These boards backed their currencies almost entirely with gold or silver coins. The Mauritius Currency Board, created in 1848, was the first. It issued local notes that were fully convertible into sterling, with reserves held in precious metals.
An orthodox currency board MUST have these characteristics:
- Fixed exchange rate: The domestic currency has a fixed rate with a foreign currency.
- Full convertibility: The currency board guarantees that the domestic currency can be exchanged for the anchor currency at any time.
- Foreign reserves: The currency board holds sufficient foreign reserves to cover the entire monetary base (all domestic currency in circulation and bank reserves) (Bennett, 1994).
Currency Boards versus Central Banks: A Review
Attribute | Typical Currency Board | Typical Central Bank |
Monetary Instruments | Supplies notes and coins only | Supplies notes, coins, and deposits |
Exchange Rate Regime | Fixed exchange rate with reserve currency | Pegged or floating exchange rate |
Foreign Reserves | 100% foreign reserves | Variable foreign reserves |
Convertibility | Full convertibility | Limited convertibility |
Monetary Policy | Rule-bound | Discretionary |
Lender of Last Resort | Not a lender of last resort | Lender of last resort |
Bank Regulation | Does not regulate commercial banks | Often regulates commercial banks |
Transparency | Transparent | Opaque |
Political Influence | Protected from political pressure | Politicized |
Credibility | High credibility | Low credibility |
Seigniorage | Earns seigniorage only from interest | Earns seigniorage from interest and inflation |
Inflation Creation | Cannot create inflation | Can create inflation |
Government Financing | Cannot finance domestic government spending | Can finance domestic government spending |
Monetary Reform Preconditions | Requires no preconditions | Requires preconditions |
Speed of Reform | Rapid | Slow |
Staff Size | Small staff | Large staff |
Steve Hanke: The Money Doctor
I am widely known for my work diagnosing and resolving currency collapses across emerging and crisis-stricken economies. Throughout my career I’ve advised governments in Argentina, Bulgaria, Ecuador, Estonia, Lithuania, and more. My approach often centers on creating currency boards or stabilizing monetary institutions to restore credibility, halt inflation, and eliminate distortions that push people into unofficial markets.
Read up on my currency board work in 🇧🇬 Bulgaria, 🇪🇪 Estonia, and 🇱🇹 Lithuania, three countries where currency boards turned chaos into stability.