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Wall St. and Business Wednesdays: Steve Hanke On Monetary Policy In Iraq

The Euro Could Help Iraq's Economic Recovery

by Steve Hanke

For all the speed of the military campaign against it, Iraq has sustained heavy damage: numerous civilian and military casualties; a battered physical infrastructure; disrupted trade; drastic political, administrative and social dislocation; and the psychological difficulties and resentments of a vanquished people adjusting to the peculiarities of life under alien rule. These grim realities promise no end of problems for postwar Iraq.

The victors - whether viewed as liberators or conquerors - have grand ideas about remaking the Iraqi economy and society within a year of the war's end. One of the items on the Bush administration's agenda is the establishment of a stable currency. Exactly what the cognoscenti plan to do with the currency remains a mystery, however.

To be successful, a currency reform plan must be informed by Iraq's history, well crafted and available fast. Speedy implementation is of the essence because victors often find that good will on the part of the vanquished is apt to be short-lived.

Iraq established a central bank in 1947. Like central banks in most developing countries, the Central Bank of Iraq's history has been replete with mismanagement, coercive stop-gap measures and, yes, the production of an unstable, unreliable currency. The Iraqi dinar has not been tradable on international markets for years. Consequently, international transactions have been possible only with foreign currencies. But access has been controlled by the Central Bank of Iraq's advisory committee on foreign exchange. Attempts to compete with Saddam Hussein's foreign exchange trading monopoly have been, to put it mildly, credibly deterred.

Since 1979, when Mr Hussein came to power, the Iraqi dinar has collapsed. In 1979, 1 dinar was equal to $3.39. More recently, the official rate - unchanged since 1982 and available only to Mr Hussein and his cronies - has been 1 dinar to $3.22. For Iraqis outside Mr Hussein's inner circle, the only way to obtain foreign currency has been through the black market. But the black market rate is now reported to be about 3,000 dinars to the dollar.

Central banking and unstable money were not always the norm in Iraq. A century ago, what is now Iraq was part of the Ottoman empire. The official currency of the empire was the Ottoman pound but the most widely used currency in Iraq was the Indian rupee, which was linked to the pound sterling. After the territory was captured by British forces in 1916, and removed from the Ottoman empire, the British made the Indian rupee the official currency and retired the Ottoman pound. Iraq was thus officially "rupee-ised".

After prolonged agitation by Iraqis, Britain granted the country independence in October 1932. As part of the preparations for independence, the Iraqi currency board opened in April 1932. It issued the Iraqi dinar at par with the British pound. The board fully backed the dinar with British pound reserves and maintained its fixed exchange rate to the pound. Until it was replaced with a central bank in 1947, the currency board operated without problems.

A currency reform for Iraq must not include a central bank. Iraq's history suggests two superior alternatives. The first option would require a return to an orthodox currency board. Designing such a system for Iraq would require discarding the model used by the Inter- national Monetary Fund in Argentina, Estonia, Lithuania and Bulgaria. All of these systems graft central banking features on to the orthodox currency board model, and, as Argentina demonstrated, the mix can be explosive.

Ideally, legislation for an Iraqi currency board would follow the classic British model. Bosnia and Herzegovina's currency board, mandated by the Dayton/Paris treaty of 1995, is a close approximation.

The other possibility would be to "euro-ise" Iraq. Postwar Iraq could use the euro just as it once used the Indian rupee. The euro has international acceptance and neither the US nor Britain uses it, which may be something of a political advantage. Several other countries have replaced their local currency with a foreign currency in the past few years, including Ecuador, El Salvador and East Timor (which use the dollar) and Montenegro and Kosovo (which use the euro). Even for countries in difficult economic circumstances, no significant technical obstacles stand in the way of abandoning a domestic currency and replacing it with a foreign one.

To give the Iraqis some measure of confidence in their prospects, a reliable, internationally convertible currency must be a priority.

Steve Hanke is a professor of applied economics at Johns Hopkins. This article originally appeared in The Financial Times on April 16, 2003.


Dinar Plans

by Steve H.Hanke

Millions of fresh dinars, graced with the visage of Saddam Hussein, recently began rolling off Iraq's printing presses at the behest of the Coalition Provisional Authority. This inspired about as much confidence and unity as the Allies would have garnered with the introduction of Mussolini lire and Hitler marks after World War II.

To belatedly correct this maladroit decision, L. Paul Bremer, head of the provisional authority, announced on July 7 that new Iraqi dinars will be introduced over a three-month period starting in October. These will replace both the Saddam dinars and the "Swiss" dinars that circulate in Iraq's Kurdish areas. And to reinforce its adeptness, the provisional authority has handed the banknote-printing contract (awarded without competitive bid, as it were) to a company with a subsidiary that, on July 9, became the subject of a price-fixing investigation by the Justice Department.

Mr. Bremer has now declared that an independent central bank will govern the emission of new dinars. This seems like an unattainable objective. We should not hold our collective breath anticipating a Bundesbank clone to be plopped down in Baghdad.

What are the chances that an "independent" Iraqi central bank will be able to restore confidence and pursue the sole objective of price stability without government interference? Simply put, no central bank can be independent without a strong dose of fiscal control. After all, any budget deficit that cannot be financed in domestic or foreign debt markets will have to be financed by money creation. This is the inflation tax at work. If Iraq is going to resist the inflation tax (which is, incidentally, the easiest tax to collect when the legal and fiscal infrastructure is nonexistent or flimsy), the transitional administration needs to produce an iron-clad budget.

The prospects for such a budget are dim, however. On the revenue side, the administration plans to rely on oil revenues. Never mind the investments and repairs needed to activate the oil fields fully, as well as theft, smuggling and sabotage. Opportunities for spreading the tax base are few, as little productive activity survives, and resources are not in place to administer income or excise taxes. And there are so far no privatizations in the works.

On the expenditure side, the administration will need to confront a number of demons. Besides paying for reconstruction -- no easy task -- the transitional administration will have to unwind the institutions of a command economy. It will inherit bankrupt state-owned enterprises. The banking sector will have to be recapitalized and revamped to operate in a market economy. A decision must be made on whether outstanding debt from the Hussein regime will be serviced. And all of this is not to mention the growing wish list cobbled together by Washington, including massive health-care spending, investment in educational facilities, and the construction of that great open-ended contingency and hallmark of Western welfare states, the "social safety net." The gap between potential revenues and planned expenditures will be large. The relatively large primary deficit in the interim budget is already scheduled to be financed by printing money.

Even if the fiscal management in Iraq is exemplary, the idea of an independent, Bundesbank-style Iraqi central bank is nearly laughable. Indeed, the language being used to describe the future operations of the central bank gives a false air of sophistication to what will be a primitive affair. Interventions in the foreign-exchange market will not take place at a Reuters terminal, but in the open outcry of the bazaar, where traders will have to be coerced in some way to buy and sell at the desired exchange rate. The interbank market -- an indispensable institution for directing the course of interest rates and the availability of liquidity -- will probably consist of several trucks plodding through the desert laden with banknotes and paperwork. Money markets -- in which short-term paper is traded, and where central banks buy and sell bonds when conducting open market operations -- will again be more like the bazaar than Lombard Street, if they exist at all. The Iraqi central bank can also forget about such modern conveniences as real-time gross settlement, indirect instruments of monetary policy, and any close supervision of the banking system.

In short, the transitional administration wants to erect some huge central-banking edifice, but no scaffolding is to be found. The British were at least competent enough to point out the legal and economic prerequisites of central banking when that idea first came to the region. Then, as now, those prerequisites are absent in Iraq. But the coalition authority hasn't the slightest appreciation of the technical issues it's blundered into.

A successful currency-reform plan must be well-crafted and informed by Iraq's history. In the past, Iraq has had success with "dollarization" and a currency board. From 1916 to 1932, Iraq used the Indian rupee, which was linked to sterling, as its official currency. When Iraq became independent in 1932, the Iraq Currency Board was opened. It issued a convertible Iraqi dinar at par with the British pound, backing the dinar fully with pound reserves. Until the central bank commenced operations in 1949, the currency board operated without problems.

A currency reform for Iraq must not include a central bank, even one that is nominally independent. Iraq's history suggests two alternatives would be superior to a central bank. It could return to a currency-board system governed by a foreign national. Ideally, legislation for an Iraqi currency board would follow the model of the classic British currency boards. Bosnia and Herzegovina's currency board, which was mandated by the Dayton/Paris Treaty of 1995, is a close approximation of such an orthodox system. Indeed, the quick execution of the legislation for Bosnia's currency board is a testament to the technical expertise of the Treasury under Robert Rubin and Lawrence Summers. The system inspired confidence, was a cohesive force in unifying a country ravaged by civil war and has produced sound money.

It could also "dollarize" by replacing the dinar with the euro (or the greenback). The euro has international acceptance, and neither the U.S. nor Britain uses it, which may be something of a political advantage in the current context. Several other countries have replaced their local currency with a foreign currency in the last few years, including Ecuador, El Salvador, and East Timor (which use the dollar), and Montenegro and Kosovo (which use the euro). No significant technical obstacles stand in the way of making the euro Iraq's official currency. If the transitional administration is going to switch currencies, why not upgrade to one that's worth using?

Mr. Hanke, a professor of Applied Economics at Johns Hopkins, is a senior fellow at the Cato Institute.

This article ran in the July 21, 2003 edition of The Wall Street Journal

Copyright 2003 Dow Jones & Company, Inc. All Rights Reserved

(1) Here is a response to the July 21 Wall Street Journal editorial-page commentary, "Dinar Plans", by Steve Hanke, from the Coalition Provisional Authority in Baghdad, published in the Wall St. Journal:

Most surprising to me was Mr. Hanke's statement that the Coalition Provisional Authority in Iraq is financing deficits by printing money. He is dead wrong. For complicated market reasons, we are printing a small amount of one denomination of the currency to swap for another, and then not spending what is received. The country has great needs, but we are spending the money we have.

It was an important step for the economy when CPA Administrator Bremer recently announced a new Iraqi currency, printed largely in the pattern of a former national currency. Iraq lacks what we take for granted in the U.S. -- namely a single usable currency in which we have confidence. At present Iraq has two currencies: one in the north that is old and physically falling apart. The other is for the rest of the country and, for practical reasons beyond this article, does not work in ordinary commerce. Iraq's new currency, to be introduced Oct. 15, will create a unifying currency for all of the country. It is a step toward stable money. Iraqis with whom I speak overwhelmingly support this decision.

Administrator Bremer also has established the independence of the central bank. But Mr. Hanke criticized the existence of the central bank and felt the decision of independence was irrelevant. I disagree. Independence is another important step to obtain a sound currency, which, after all, is a foundation for economic growth. In the past, Iraq's central bank served as an appendage of the finance ministry and, even more, to political officials, who directed at will the printing of money to cover deficits.

We also are reopening Iraq's closed banks. In fact, this week certain branches of banks in Baghdad will start cashing checks drawn on depositors' accounts. This may not seem big in the U.S. However, imagine life if everything had to be done with cash, as is now the case in Iraq. Also, we have opened Iraq to free trade, cut back on subsidies to state-owned companies and have freed up many price controls. In short, we are working to build a market economy under difficult conditions.

Peter McPherson
Director, Economic Development
Coalition Provisional Authority Baghdad

Wednesday, August 27, 2003

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