Milton Friedman’s view on currency boards explained by Hanke amid collapse of soft peg in Sri Lanka

ECONOMYNEXT – Milton Friedman, widely known for his work on taming floating exchange rates, was also a proponent of currency boards or hard pegs, which are also a consistent free market mechanism, said Steve Hanke, a leading American economist in an interview in Sri Lanka.

Sri Lanka is currently in the throes of a currency meltdown after its soft peg collapsed from 200 to 360 against the US dollar following two years of money printing and a failed call float attempt (forced sales of dollars to the central bank by commercial banks), which pushed the peg down.

Rates have since been raised to crush private credit and economic activity and reduce capital outflows in a bid to resuscitate the soft peg.

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

Hanke, a professor at Johns Hopkins University in Baltimore, Maryland, 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 in favor of free market mechanisms to adjust the balance of payments, and there are two ways to do this.

“Either you have a floating exchange rate or you have a fixed exchange rate with a currency board.”

Sri Lankan interventionists had the ability to suppress rates with cash injections, create currency shortages in 1950 and pressure peg, although the original monetary law did not easily allow the rupee indexed at 1.99 grain on gold be broken without the approval of Parliament.

However, after the inflationary-devaluationist orthodoxy of the 1980s peddled to the Third World (basketball, band, crawl or BBC politics) by some mercantilists based in countries with sound currencies, 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 a foreign exchange policy) with floating interest rates and no open market operations (no monetary policy) to create currency shortages.

Most East Asian countries that became export powerhouses in the 1970s and 1980s had genuine currency boards or strong pegs that closely mimicked currency boards.

Friedman supported the early 1980s Hong Kong currency board proposed by John Greenwood as well as Eastern European currency boards in which Hanke himself was involved, he said.

“In Estonia, Lars Jonung, Kurt Schuler and I wrote a book called Currency Reform for a Free Estonia: A Currency Advice Solution,” Hanke said.

“It was published in Estonian and English. Who approved this book on its dust jacket? Milton Friedman. Thus, Friedman was always for currency boards in developing countries and countries with weak institutions and unstable governments.

“He knows the hard budget constraint is put in the system and the straightjacket is put on politicians, forcing them to more or less balance the budget if you have a currency board system.

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

“The floating exchange rate has a monetary policy but no exchange rate policy. The fixed rate issued through a currency board has an exchange rate policy but no monetary policy.

A currency board allows free trade and the free flow of capital, as does a floating rate, allowing a high degree of economic freedom.

The former Soviet states of Estonia, Latvia and Lithuania, which were once closed economies under the unstable ruble where smuggling and shortages were commonplace, later rose to the top of the lists of the most economically free countries in the world under currency boards.

Sri Lanka enacted increasingly draconian exchange controls after the loose peg was created in 1950, an Import Control Act was enacted in 1969, and the economy was completely shut down in the 1970s when the Bretton Woods’ soft parities collapsed amid Arthur Burns’ raise.

Although the economy was reopened in the 1980s, monetary instability persisted amid the depreciation, allowing proponents of the closed economy to discredit the economic freedoms granted to people.

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

The currency was also depreciated in RRSPs targeting a version of BBC politics.

Money printing grew in 2020 and even tougher import controls were imposed starving tax revenue in addition to a stimulus tax cut, and the country is now in a currency meltdown with inflation at 60% and a soft peg at 360 US Dollar down from 4.70 during the currency board. (Colombo/August 04, 2022)

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