|Cato Foreign Policy Briefing No. 17||January 22, 1992|
by Steve H. Hanke and Kurt Schuler
Steve H. Hanke is a professor of applied economics at the Johns Hopkins University and chief economist at Friedberg Commodity Management, Inc., in Toronto. He is special adviser on currency reform to the Deputy Prime Minister of Albania and was formerly personal economic adviser to the Deputy Prime Minister of the Socialist Federal Republic of Yugoslavia. Kurt Schuler is a Durell Fellow in Money and Banking at George Mason University.
The nations of the Commonwealth of Independent States are gathering in Washington on January 22 and 23, 1992. The U.S. Department of State has called the conference to organize aid for the new nations. Even though the State Department has indicated that the conference will be restricted to discussions about so-called humanitarian aid and self-help programs, it may be politically difficult for Secretary of State James A. Baker III to hold off the foreign aid lobby. Led by Professor Jeffrey Sachs of Harvard University, the aid lobby is in full swing. Sachs claims that the transition from socialism to capitalism in the member states of the CIS will be impossible without significant amounts of foreign aid.
In making his case to limit the scope of the conference, Baker should recall that Sachs and the aid lobby are employing smoke and mirrors, rather than economic analysis, to make their case. The most notable examples of successful transformations from socialism to capitalism are Chile and China's Guangdong province, which is located directly north of Hong Kong. In neither case was aid required. In contrast, the two recipients of the most U.S. largesse, Israel and Egypt, have been unable to transform their largely socialist economies. Foreign aid is not necessary for economic transformation, and the evidence strongly suggests that it is an impediment.
If the West is serious about helping the people of the CIS to help themselves, it should give top priority to seeing that those nations have sound, convertible currencies. As long as they continue to use the inconvertible ruble, or the inconvertible successor currencies now in the works, they will be unable to have true free-market economies. Without free-market economies, they will be unable to produce rapid economic growth.
A sound currency serves as a satisfactory store of value, a medium of exchange, and a unit of account. An unsound currency, such as the ruble, does not serve any of those functions. An unsound currency is not a reliable store of value because inflation makes its value highly unpredictable. As a result, people save by hoarding bricks, timbers, food, and other commodities, which retain value better than money and other financial assets. Although commodity hoarding is rational for people in the CIS at present, it slows economic growth. In addition to hoarding commodities, people in the CIS also use U.S. dollars and German marks as substitute stores of value because the ruble is unsound. Indeed, "dollarization" is significant and accelerating. The Federal Reserve estimates that $10 billion to $15 billion in greenbacks leaked out of the United States last year; most of that money ended up in Eastern Europe and the CIS. Large amounts of German marks have also flowed to Eastern Europe and the CIS. The use of dollar or mark currency is costly. It requires people in the CIS to give up real goods and services to obtain bits of paper that the U.S. and German governments print at almost no cost, generating a perverse form of foreign aid that flows from the CIS to the United States and Germany.
An unsound currency is not a good medium of exchange. The outside world refuses to accept it. That impedes Western investment, which could jump-start the economies of the CIS. Inconvertible currencies also impede foreign trade, which is needed to provide competition for the inefficient monopoly enterprises in the CIS. Even trade within the CIS and the Baltic states is collapsing because the ruble is such a poor medium of exchange. For example, there are reports of urban food shortages because farmers refuse to accept city dwellers' rubles. The purported food shortages do not result from lack of food supplies but from lack of a sound currency.
An unsound currency is not a good unit of account. Inflation distorts prices and makes business calculations difficult. Without a reliable unit of account, it is impossible to make meaningful accounting calculations or to write contracts. Even with a reliable unit of account, the CIS will have serious problems training people to perform elementary bookkeeping and accounting according to Western standards. (To give an idea of the magnitude of the task, in Yugoslavia there are 27 accountants trained to Western standards, whereas the economy needs about 6,000.) The additional accounting complications that inflation causes will destroy any possibility of accurately keeping the accounts required in a smooth-running market economy.
In sum, an unsound currency prevents important elements of a market economy from working. If the CIS nations cannot establish sound currencies quickly, the repercussions will be severe both at home and in Western Europe. Inconvertibility will prevent competitive markets from functioning and foreign money from being invested, which would raise living standards. Consequently, hundreds of thousands or perhaps millions of workers in the CIS will emigrate to Western Europe in search of better conditions, thereby aggravating West European unemployment and increasing support for xenophobic political parties.
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© 1992 The Cato Institute
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