Money: Clearing the Ruble

About the only thing the Soviets ever learned to produce was the ruble. Indeed, the printing presses at the Gosbank have been working at full capacity, churning out rubles around the clock. The only thing that might jeopardize the chance to set a world record for inflation is a paper shortage.

If the Commonwealth of Independent States hopes to ever introduce markets, it must replace the ruble with a convertible, stable currency. A sound currency serves as a satisfactory store of value, medium of exchange, and unit of account. An unsound currency such as the ruble does none of these things.

An unsound currency inhibits a nation's ability to liberalize its economy. For example, inflation causes people to "save" by hoarding commodities, rather than by holding money or other financial assets. That Russian or Ukrainian farmers refuse to sell their produce for rubles should not surprise us.

The outside world will not accept inconvertible currencies as a medium of exchange. This impedes foreign investment and trade, which promote economic growth. Exports from the former USSR to the outside world are at pathetic levels, ranging from 1.2 percent of net material product in Kirghizia to 8.6 percent in Russia.

Nor is an unstable currency a good unit of account. Inflation distorts prices and makes business calculations more difficult. Hence it becomes harder to establish and enforce such essential elements of a market economy as contracts and accounts.

Unfortunately, CIS leaders believe a central bank is the way to make the ruble convertible. Guided by experts from the International Monetary Fund, World Bank, and Harvard University, they are busy learning how to run central banks. That central banking fetish could prove to be disastrous.

Central banks in developing countries have very poor records. The World Bank classifies 99 countries—mostly developing nations—as low- and middle-income, and their average annual inflation rate was 16.7 percent from 1965 to 1980 and 53.7 percent from 1980 to 1989. The political pressures for inflation are ferocious in these countries, and the central banks there lack the independence to counteract those pressures.

Even Paul Volcker, former chairman of the Federal Reserve Board, questions the value of central banks for developing nations. Addressing a group of central bankers in Jackson Hole, Wyoming, in 1990, Volcker noted that markets developed long before central banks and that the reliance on central banks in former communist nations might actually retard their transition to markets.

There is a better way: a currency board instead of a central bank. A currency board issues notes and coins convertible into a foreign reserve currency at a fixed rate on demand. As reserves, the board holds high-quality, interest-bearing securities denominated in a reserve currency. (If local officials don't want to rely on fiat currencies, the board may also denominate its reserves in gold or other commodities.) A board's reserves are equal to 100 percent of its notes and coins in circulation.

A currency board does not accept deposits, and it generates income from the difference between the interest earned on the securities it holds and the expense of circulating its notes and coins. Unlike a central bank, a currency board has no discretionary monetary policy. Instead, market forces alone determine the domestic money supply.

More than 60 countries (mainly former British colonies) have had currency boards. All successfully maintained convertibility at a fixed exchange rate. Each nation enjoyed these benefits: the same low inflation rates as the metropolitan centers (such as London) they were linked to by reserve currencies; branch banks from those metropolitan centers; access to capital at competitive rates; indigenous firms, often with corresponding arrangements in the metropolitan centers, to mediate between local savers and investors; and prices roughly in line with those in the international sphere.

When the colonies gained independence, misplaced nationalism motivated many of the newly independent countries to replace currency boards with central banks. The former colonies mistakenly thought, as the former Soviet republics now do, that the only way they could have their own currencies was to have their own central banks.

The new central banks adopted discretionary monetary policies, which caused the new currencies to deteriorate sharply, making most inconvertible. The central bank-issued currencies became sources of national embarrassment rather than national pride.

Currency boards still exist, however, in Hong Kong, in Brunei, and (in a modified form) in Singapore, where they continue to operate with great success. The Hong Kong currency board was established in 1935, linking the Hong Kong dollar to the pound sterling. More recently, the U.S. dollar has served as the Hong Kong dollar's reserve currency. Real per-capita income in Hong Kong has grown annually by 6.3 percent from 1965 to 1989—the fourth highest growth rate among the 124 countries the World Bank tracks. And Hong Kong has attracted foreign investment, enabling it to grow despite the merchandise trade deficits it has experienced in most years since 1935.

Hong Kong actually abandoned its currency board in 1974; until 1983, the Hong Kong dollar was a floating currency. Exchange rates, the money supply, and inflation became far more volatile in that period than they had been before. In 1983, when it appeared that China might seize the colony, the value of the currency plummeted. To save the Hong Kong dollar, the currency board returned. Since then, even with uncertainty about Hong Kong's future after integration with China in 1997, the Hong Kong dollar has remained at a fixed rate of HK$7.80 per U.S. dollar.

Russia briefly had its own currency board. When troops from Britain and other Allied nations invaded northern Russia at the close of World War I, they found monetary chaos. The Russian civil war had begun, and every party to the conflict had issued its own near-worthless currency; there were more than 2,000 separate issuers of fiat rubles.

To facilitate trade with northern Russia, the British established a currency board there in 1918. The National Emission Caisse issued "British ruble" notes, backed by British pounds sterling and convertible into pounds at a fixed rate. British Foreign Office archives reveal that the father of the British ruble was none other than John Maynard Keynes, who was a British treasury official at the time.

Despite a raging civil war, the British ruble was a great success. The currency never deviated from its fixed exchange rate with the British pound. The British ruble was a reliable store of value, medium of exchange, and unit of account. In consequence, it drove other rubles out of circulation in northern Russia. With British rubles, the Allied army was able to buy and sell goods almost as easily as if it were home on maneuvers. Unfortunately, the British ruble didn't last long: The National Emission Caisse ceased operations in 1920, after Allied troops withdrew from Russia.

To avoid economic disaster, the CIS should borrow a page from John Maynard Keynes. Keynes's script requires the establishment of a currency board, which would issue a new local currency. The currency would be fully backed by a reserve currency and convertible into that currency at a fixed rate. That rate would be set so as to render exports competitive.

The CIS would not need huge reserves to establish a currency board because the real value of the ruble supply is only about $5 billion. To obtain reserves, the republics could liquidate the vast assets of the outlawed Communist Party and convert the proceeds into a reserve currency.

To make the currency board credible and to ensure the safety of its assets, it should incorporate and be based in a safe haven such as Switzerland. And to insulate the board from government manipulation, the majority of its directors should be foreign nationals, designated by private institutions, such as leading commercial banks, in their home countries.

A currency reform along the lines we suggest would provide a convertible currency within weeks. Following World War I, even with the delays from printing British rubles in London and shipping them to Russia, the British ruble was introduced just 11 weeks after Keynes proposed it. That's a pretty quick turnaround, even compared to the pace of change in what was, until recently, the Soviet Union.

Steve H. Hanke, professor of applied economics at the Johns Hopkins University, advises Albania, Bulgaria, and Ukraine on currency reform. Kurt Schuler is a graduate student in economics at George Mason University.