For most of my professional career, I’ve watched emerging governments and central bankers repeat the same tragic mistake. They attempt to use discretionary monetary policies to fine tune the economy. The reality is that their attempts to fine tune often lead to outbreaks of inflation, banking crises, and currency crises. In short, central banks with discretionary monetary policies are engines of instability.
These tragedies are avoided by handcuffing central bankers with either a currency board arrangement or dollarization.
“If you want to stop inflation immediately, you install a currency board or ‘dollarize.’” - Steve Hanke
In emerging market countries stability can best be obtained by eliminating central banks’ discretionary monetary policies.
Why Currency Boards Work
The power of a currency board comes from its constraints. Politicians cannot print money to finance deficits. Central bankers cannot manipulate interest rates. Markets cannot be spooked by the whims of a monetary committee. That is because, in the case of currency boards, they have a fixed exchange-rate policy, but no monetary policy. As a result, they impose a hard budget constraint because they cannot extend credit to the fiscal authorities.
With the installation of currency boards (or dollarization), the results are consistent:
- A positive confidence shock ensues
- Inflation collapses, tending to approach the anchor currency’s inflation rate
- Interest rates fall, tending to approach the anchor currency’s interest rate
- Fiscal deficits are reduced
- Capital flight stops and capital inflows surge
- Deposits in the banking system surge
- Economic growth accelerates
- Stability is established
The Core Argument
Hanke's Thesis: Central banks with discretionary monetary policy are inherently prone to political capture, resulting in economic instability and inflation. A currency board (dollarization) corrects the problem by handcuffing the monetary authorities and eliminating monetary discretion. Currency boards have a fixed exchange rate policy but no monetary policy.
The argument is not merely theoretical. Every hyperinflation ever documented in the Hanke-Krus Hyperinflation Table, all 71 episodes, were caused by central banks that engaged in discretionary monetary policy, with reckless abandon. Not a single hyperinflation has occurred under a currency board (or dollarized system) in their entire 178-year history.
Hanke's Key Observation: "A central bank’s achilles heel is the fact that they can extend credit to the fiscal authority and monetize fiscal deficits. Therefore, contrary to a currency board, central banks provide no fiscal discipline."
"For developing countries, the best way to eliminate the possibility of a hyperinflation would be to mothball their central banks and put them in museums." — Steve H. Hanke
Historical Evidence: Central Bank Failures
Country | Period | Peak Daily Inflation Rate |
Hungary | 1945–1946 | 207.00% (world record) |
Zimbabwe | 2007–2008 | 98.00% (Nov 2008) |
Yugoslavia | 1992–1994 | 64.60% (Jan 1994) |
Germany (Weimar) | 1921–1923 | 20.90% |
Venezuela | 2016–2019 | 4.10%
(Exceeded 1,000,000% annual in 2018) |
Venezuela | 2020 | 3.11% |
In all cases of hyperinflation, a central bank, under political pressure, printed money. There are no exceptions in 71 documented hyperinflations contained in the Hanke-Krus World Hyperinflation Table.
Currency boards and dollarization have always proven to be effective cures for hyperinflations as well as elevated inflations. A classic case is Bulgaria. In February of 1997 hyperinflation peaked at 242% per month. The installation of a currency board in July crushed the hyperinflation immediately.
“We sometimes forget that central banking, as we know it today, is, in fact, largely an invention of the past hundred years or so, even though a few central banks can trace their ancestry back to the early nineteenth century or before. It is a sobering fact that the prominence of central banks in this century has coincided with a general tendency towards more inflation, not less. By and large, if the overriding objective is price stability, we did better with the nineteenth-century gold standard and passive central banks, with currency boards, or even with ‘free banking.’ The truly unique power of a central bank, after all, is the power to create money, and ultimately the power to create is the power to destroy.”
— Paul Volcker (Chairman, US Federal Reserve System, 1979-1987)
Related Pages
- Evidence on Currency Boards
- Home: Currency Boards — Return to the Currency Boards overview
- Indonesia — The Crisis of 1998 — What happens when political opposition blocks optimal policy
- Russia — Blueprint for Reform — The price of rejecting the currency board option
Related Topics
- Monetarism — The theoretical foundation
- Dollarization — An alternative to central banking
“Currency boards are simple, transparent, and credible — the three things central banks are not.” - Steve Hanke