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Wednesday October 5th, 2022

Milton Friedman’s views on currency boards explained by Hanke amid Sri Lanka soft-peg crisis

ECONOMYNEXT – Milton Friedman, widely known for his work on taming floating exchange rates was also a supporter of currency boards or hard pegs which is also a consistent free market mechanism, Steve Hanke, a top US economist has said in a Sri Lanka interview.

Sri Lanka is now in a monetary meltdown after its soft-peg collapsed from 200 to 360 to the US dollar in the wake of two years of money printing and a failed float attempted with a surrender requirement (forced sales of dollars to the central bank by commercial banks), which pushed the peg down.

Rates have since been hiked to smash private credit and economic activity and reduce outflows in a bid to resurrect the soft-peg.

Economists including Steve Hanke have called for a currency board to bring back sound money to Sri Lanka and allow the country to grow and prosper without economic crises.

Hanke, a Professor at Johns Hopkins University in Baltimore, Maryland has called Milton Friedman one of his mentors. Friedman is known almost exclusively for his work on floating rates.

“That’s what most people think,” Hanke said in an interview with Sri Lanka’s Echelon Magazine.

“Friedman was for free market mechanisms to adjust the balance of payments, and there are two ways to do that.

“You either have a floating exchange rate, or you have a fixed exchange rate with a currency board.”

Sri Lanka’s interventionists got the ability to suppress rates with liquidity injections, create forex shortages and pressure the peg in 1950, though the original monetary law did not easily allow the rupee pegged at 1.99 grains to gold to be broken without parliamentary approval.

However after the 1980s inflationist-devaluations orthodoxy peddled to the third world (basket, band, crawl or BBC policy) by some Mercantilists based in countries with sound money, Sri Lanka experienced accelerated depreciation and social unrest.

Sri Lanka had a currency board from 1885 to 1950, initially pegged to the Silver Indian rupee. A currency board is a fixed exchange (has an exchange policy) with floating interest rates and no open market operations (no monetary policy) to create forex shortages.

Most East Asian nations that became export powerhouses in the 1970s and 1980s had true currency boards or strong pegs that mimic currency boards closely.

Friedman backed the currency board of Hong Kong in the early 1980s proposed by John Greenwood and also Eastern European currency boards in which Hanke himself was involved, he said.

“In Hong Kong in 1983, when they put the currency board back in, John Greenwood was the architect of that, and Milton Friedman was 100 percent behind it. He endorsed the thing,” Hanke said.

“In Estonia, Lars Jonung, Kurt Schuler and I wrote a book titled Monetary Reform for A Free Estonia: A Currency Board Solution.”

“It was published in Estonian and English. Who endorsed that book on its dust jacket? Milton Friedman. So, Friedman has always been for currency boards in developing countries and countries with weak institutions and unstable governments.”

“He knows that the hard budget constraint gets put into the system and the straitjacket gets put on the politicians, forcing them to more or less balance the budget if you have a currency board system.

“So that’s where Professor Friedman was on that. It looks like a contradiction, but it’s perfectly consistent. Pure floating exchange rates and a fixed exchange rate with a currency board are identical in the sense that they are free-market mechanisms for adjustments in the balance of payments.

“The floating exchange rate has a monetary policy but no exchange rate policy. The fixed rate delivered via a currency board has an exchange rate policy but no monetary policy.”

Related: Why the Sri Lanka rupee is depreciating creating currency crises: Bellwether

A currency board allows free trade and free capital movements, just like a floating rate, allowing a high degree of economic freedom.

Ex-Soviet States of Estonia, Latvia and Lithuania which were formerly closed economies under the unstable Ruble where smuggling and shortages were commonplace, later rocketed to the top of the list of countries with the most economic freedom in the world under currency boards.

Sri Lanka enacted increasingly draconian exchange controls after the creation of the soft peg in 1950, an import control law was enacted in 1969 and the economy was completely closed in the 1970s as the Bretton Woods soft pegs collapsed amid Arthur Burns stimulus.

Though the economy was re-opened in the 1980s monetary instability persisted amid depreciation, allowing closed economy advocates to discredit economic freedoms given to people.

New trade controls were also imposed after 2015 including on vehicles and gold as flexible inflation targeting with output gap targeting (stimulus) created forex shortages while borrowing heavily abroad to make outward payments.

The rupee was also depreciated in REER targeting, a version of BBC policy.

Money printing expanded in 2020 and even more severe import controls were imposed, depriving tax revenues on top of a tax cut for stimulus, and the country is now in a monetary meltdown with inflation at 60 percent, and the soft peg at 360 to the US dollar down from 4.70 during the currency board. (Colombo/Aug04/2022)

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