Competition among currencies?

By Ross H. McLeod

MELBOURNE (JP): Debate continues as to how best to interpret the causes of the Asian financial crisis. But one point not in dispute is that the countries in question suddenly experienced rapid capital outflow driven by a widespread, and in several cases, self-fulfilling-expectation that their currencies were likely to be significantly devalued.

So, consider this: if countries did not have their own currencies, they could never be subjected to destabilizing swings in capital flows resulting from exchange rate speculation. Is it possible, then, that vulnerability to occasional, but severe, financial crises could be mitigated if countries were simply to abolish their own currencies?

This is precisely what is now being proposed in some circles. A leading proponent is Kurt Schuler, whose "Dollarising Indonesia" is to be published in the December issue of the Australian National University's Bulletin of Indonesian Economic Studies. "Dollarisation" constitutes an entirely different approach from grand proposals for changes to the "international financial architecture", which is usually code for rewarding the discredited International Monetary Fund (IMF) by turning it into an international prudential regulator and lender of last resort.

There are three main benefits for countries that adopt a strong international currency as legal tender. First, it gets rid of occasional episodes of destabilizing speculation, for the reason just mentioned. Second, it avoids squandering scarce skills on implementing monetary policy, allowing their redeployment to managing other important aspects of economic policy: there is no monetary policy when there is no national money. Third, it removes the risk of mistakes in the formulation and implementation of monetary policy in both normal and abnormal conditions. Indonesia's output is now running at roughly one third less than what might have been expected in the absence of the 1997-98 currency speculation episode and its mishandling by the government, so these potential benefits are clearly considerable.

Why do most countries have their own currency? Feelings of national pride have much to do with it, yet a number of countries already make use of other countries' currencies rather than having their own. Many of the small Pacific island states have adopted the Australian dollar or the New Zealand dollar as their currency, and a number of other small nations around the world use currencies such as the U.S. dollar and the French franc.

The major economic justification for nations having their own currencies is that the monopoly right to provide cash to the economy is valuable. Cash issued by central banks is in effect an interest free loan to them from the public, the proceeds of which can be invested in earning assets. Thus, for example, if Indonesia were to adopt U.S. dollars as legal tender, it would need to convert all of the rupiah cash in circulation (plus some other monetary liabilities) into dollars. This would involve the loss of interest earnings on these foreign assets. At about 1 percent of annual Gross Domestic Product, the cost of this foregone seigniorage would not be trivial. This and the national pride factor are the main reasons why the idea of "dollarisation" has not hitherto been taken seriously by many countries.

This may all be about to change. Legislation has been introduced to the U.S. Senate by the chairman of the Joint Economic Committee, Senator Connie Mack, that would enable the U.S. government to compensate governments that decide to adopt the U.S. dollar as legal tender for loss of seigniorage (in other words, to share some of the seigniorage that the U.S. government would gain from such a policy).

If this legislation is enacted, it may mark the beginning of a new era of competition among currencies. Although it is rarely recognized, central banks already compete with commercial banks domestically to supply the "medium of exchange" -- or, more generally, to supply payments services. They supply cash, while commercial banks supply cheque account deposit services and credit cards as substitutes for using cash for transactions. The U.S. initiative would extend such competition to the international arena, with central banks competing amongst themselves to supply cash to other countries.

Countries with long track records of sound monetary management could effectively bid for the right to provide the medium of exchange to other countries whose record is much less sound, by offering to share the seigniorage. If this became a trend, we could witness the steady disappearance of minor national currencies as other stronger ones competed to replace them.

Since the cost to central banks of supplying cash is almost negligible, such arrangements should be mutually beneficial. The currency-supplying countries would keep a small part of the seigniorage for themselves and turn the rest over to currency- adopting governments. In the current U.S. proposal this would be effected by the U.S. government simply issuing appropriate quantities of consols (government bonds with infinite maturity) free of charge to adopting governments. The flow of interest on these consols would compensate for the adopting country's loss of seigniorage.

Coincidentally with the process of considering the U.S. proposal, the soon-to-be independent nation of East Timor will be considering whether to introduce a new national currency, or to use that of some other country or region. The main candidates include the Indonesian rupiah, the euro, the Japanese yen and the U.S. dollar. But there is no reason why the Australian dollar should not also be on the list. After all, it has come through the Asian financial crisis with flying colors.

The writer is from the Indonesia Project at the Australian National University.