Money, Stability, and Free Societies.

• Author: Hanke, Steve H.

Monetary instability poses a threat to free societies. Indeed, currency instability, banking crises, soaring inflation, sovereign debt defaults, and economic booms and busts all have a common source: monetary instability. Furthermore, all these ills induced by monetary instability bring with them calls for policy changes, many of which threaten free societies. One who understood this simple fact was Karl Schiller, who was the German Finance Minister from 1966 until 1972. Schiller's mantra was clear and uncompromising: "Stability is not everything, but without stability, everything is nothing" (Marsh 1992: 30). Well, Schiller's mantra is my mantra.

I offer three regime changes that would enhance the stability in what Jacques de Larosiere (2014) has asserted is an international monetary "anti-system." First, the U.S. dollar and the euro should be formally, loosely linked together. Second, most central banks in developing countries should be mothballed and replaced by currency boards. Third, private currency boards should be permitted to enter the international monetary sphere.

On the Dollar-Euro Linkage

In 1944, the Bretton Woods agreement established a new global monetary system. Its hallmark was exchange rate stability. That stability was accompanied by a general acceleration of growth in the postwar golden age. By 1973, the system had been swept into the dustbin by the broom of President Richard Nixon. With that, the world entered an era of flexible, unstable exchange rates, de Larosiere's anti-system.

This exchange rate instability creates problems--big problems. Just look back to the onset of the Great Recession in 2008. As it turns out, one of the few who had a laser focus on what he deems the most important price in the world, the dollar-euro exchange rate, was Robert Mundell. A founding father of supply-side economics, Mundell is always focused on prices. That certainly separates Mundell from Ben Bernanke, who was chairman of the Federal Reserve back in September 2008. Bernanke saw fit to ignore fluctuations in the value of the dollar. Indeed, changes in the dollar's exchange-rate value did not appear as one of the six metrics on "Bernanke's Dashboard"--the one the chairman used to gauge the appropriateness of monetary policy (Wessel 2009).

Just what did Mundell take stock of in the months surrounding the collapse of Lehman Brothers, Inc. (Mundell 2009)? He observed a wild swing in the dollar-euro exchange rate (see Table 1). In the July-November 2008 period, the greenback appreciated almost 24 percent against the euro. Accompanying that swing was an even sharper one in the price of oil. It plunged by 57 percent. Gold, too, had a sharp fall of almost 22 percent. And, consistent with Mundell's supply-side theories, changes in exchange rates transmit inflation (or deflation) into economies, and they can do so rapidly. Not surprisingly, then, the annual rate of inflation in the United States moved from an alarming rate of 5.6 percent in July 2008 to an outright deflation of 2.1 percent a year later. This 7.7 percentage-point swing is truly stunning.

So, in terms of monetary policy, Mundell saw the obvious: the Fed was too tight--massively too tight. The dollar was soaring and commodity prices were collapsing. Fed Chairman Bernanke saw none of this because exchange rates weren't even on his dashboard. Alas, the Fed's massive monetary squeeze and resulting unstable dollar plunged the United States into what would become known as the Great Recession. The instability also generated an avalanche of legal and regulatory changes, such as the Dodd-Frank legislation. These changes restricted economic freedom.

So, in the interest of stability and economic freedom, it is time to jettison the international monetary anti-system. Just what has to be stabilized? The world's two most important currencies--the dollar and the euro--should, via formal agreement, trade in a zone of stability ($1.20-$1.40 per euro, for example). Under such an agreement, the European Central Bank (ECB) would be obliged to maintain this zone of stability by defending a weak dollar via dollar purchases. Likewise, the U.S. Treasury (UST) would be obliged to defend a weak euro by purchasing euros. Just what would have happened under such a system (counterfactually) since the introduction of the euro in 1999 is depicted in Figure 1. When the euro-dollar exchange rate was less than $1.20 per euro and the euro was weak, the UST would have been purchasing euros (in the 1999-2003 and the 2014-2019 periods). When the euro-dollar exchange rate was above $1.40 per euro and the dollar was weak, the ECB would have been purchasing dollars (in some of the 2007-2011 period).

On Currency Boards for Developing Countries

Although widespread today, central banks are relatively new institutional arrangements. In 1900, there were only 18 central banks in the world. By 1940, 40 countries had them. Today, there are nearly 200 central banks. Most issue currency and have wide discretion over monetary policies. There are a few countries that are "dollarized." Their central banks do not issue currencies and do not conduct monetary policies. In addition, there are also a few countries in which central banks issue their own currencies but are bound by currency board rules. In those rule-bound systems, central banks do not have the ability to conduct monetary policies.

Central banks that operate in developing countries have poor records. They are frequently the source of "high" inflations (Schuler 1996; Hanke and Boger 2018) or hyperinflations (Hanke and Krus 2013). Currency and banking...