Central Europe Digest sits down with CEPA Advisory Council Member Steve Hanke, Co-Director of Johns Hopkins University’s Institute for Applied Economics and the Study of Business Enterprise and father of Bulgaria’s modern currency board, to discuss the prospects for early Euro adoption in Central Europe and the lessons learned from major currency crises in the past. “Whatever their monetary policies are,” Hanke argues, “all the countries of the region that wanted to join the European Central Bank immediately would benefit if they could do so.”
CED: Recently, the World Bank revealed that Bulgaria and Latvia held insufficient international reserves to cover their short-term debt payments for 2009. Did the currency board arrangements used by these countries make them particularly vulnerable to failure to service future debt obligations?
Hanke: Latvia’s central bank has at times behaved as a currency board, but the country has never officially adopted a currency board system. In consequence, its currency has been more vulnerable to attack than the currencies of its neighbors Estonia and Lithuania; both of them employ currency board-like systems.
A currency board is an institution for assuring the stability of the exchange rate and the convertibility of the currency (specifically, the monetary base). It is not part of the job of a currency board to accumulate foreign reserves against short-term debt. The public and private debtors themselves are responsible for accumulating foreign assets, or domestic assets, that they can exchange for foreign currency.
CED: How have fixed exchange rate regimes in Latvia and Lithuania contributed to a lack of fiscal discipline?
Hanke: The government debt of the Baltic countries was low by world standards before the crisis and remains so today. And only Latvia has borrowed from the IMF thus far. It should be stressed that currency boards (and other fixed exchange-rate regimes) provide hard budget constraints that tend to contain fiscal deficits and the level of public debt.
The growth of indebtedness in the Baltic States was mainly a private-sector phenomenon, based on optimism about the Baltics’ ability to converge to Western European standards of productivity. The crisis revealed that the rise in investment had jumped too far ahead of the prospective increases in productivity, and that real estate prices, in particular, were too “high.”
CED: If Latvia, Bulgaria or Hungary were allowed immediate euro entry, would it help or hinder recovery efforts in Central Europe and the Eurozone?
Hanke: Bulgaria, Estonia, and Lithuania are in a different position from other Central and Eastern European countries because they have currency board-like systems that maintain rigid exchange rates with the euro and sufficient reserves to immediately convert the entire monetary base into euros. I have already mentioned that Latvia has a central bank that has sometimes behaved like a currency board but has never officially been one. Other Central and Eastern European countries have central banks with monetary policies more typical of central banks.
Whatever their monetary policies are, all the countries of the region that wanted to join the European Central Bank immediately would benefit if they could do so. The main benefit would be lower real interest rates resulting from eliminating fear of devaluation. There would be no effect on the ECB’s ability to run a low-inflation monetary policy.
CED: Does Montenegro’s successful “euro-ization” suggest a need for revision of the EU’s convergence criteria, particularly the need for Exchange Rate Mechanism (ERM II)?
Hanke: Definitely. For countries that already have fixed exchange rates with the euro, it is illogical to impose an additional inflation criterion, because under a fixed exchange rate, the rate of inflation is the result of the market decisions of individuals rather than a target that monetary policy can control.
CED: How has EU membership safeguarded Europe’s transition economies against additional economic volatility? What are some best and worst practices that the region can learn from other major currency crises?
Hanke: I do not think EU membership has made much difference, given the slow response of the Western EU members and their insistence on slowing Eastern Europe’s admission to the EMU and the ECB. The wisest course of action for each country is to unilaterally do what is in its best interest. In this sphere, the most courageous and wise decision was taken [by Montenegro] in late 1999 by former President and current Prime Minister Milo Djukanovic (whom I was advising at the time) when he dumped the Yugoslav dinar and replaced it with the German mark. The mark morphed into the euro, and now Montenegrins use the euro. Indeed, this currency shift was a linchpin in Montenegro’s drive for independence in June 2006, an event followed in April of this year by the approval of Montenegro’s candidacy for EU membership. It’s a lesson for other countries wanting to euroize. The key is to limit the role of domestic currencies while facilitating euro use.
Panama has successfully followed this strategy for a century. Most people doing business and banking in Panama think the U.S. dollar is Panama’s national currency. But it’s not. Panama’s currency is the balboa. One balboa is equal to one dollar. And while Panama issues balboa-denominated coins, it does not issue paper money. Thus Panamanians break out balboas only for small transactions requiring coins. The greenback is used for everything else.