FROM THE OFFICE OF PUBLIC AFFAIRS
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September 6, 2004
JS-1893
Unusual Episodes in Monetary Policy Making
John B. Taylor
Under Secretary of the U.S. Treasury for International Affairs
Remarks at the Banco Central de Reserva del Peru
Lima, Peru
September 6, 2004
It is a pleasure to be here in
In my own theoretical and statistical work in monetary economics, I have always been motivated by practical policy applications. My work on how market participants learn about changes in monetary policy--published nearly thirty years ago--was motivated by finding a way to relax the rational expectations assumption for practical applications. My work on staggered wage and price setting was aimed at incorporating the actual behavior of workers and firms in practical models of monetary policy. My large-scale econometric model of the international economy brought essential exchange rate issues into monetary policy evaluation. Even the frequently cited "
Since I joined the U.S. Treasury at the start of the Bush Administration, my work on monetary policy has been more on the practical side. Because my responsibilities are in the international area, the monetary policy work relates to other countries or to international monetary issues, rather than to
Many of the monetary policy issues that I have had to deal with have been readily handled by the ideas and techniques of monetary policy analysis that have emerged from research and experience in recent years. At the U.S. Treasury, we emphasize, for example, that good monetary policy should be based on a price stability goal, a transparent process for setting the instrument of policy, and a flexible exchange rate. For small open economies, locking the exchange rate to a country with a good monetary policy is a workable alternative. These recommendations follow directly from modern monetary policy research.
But, of the policy issues we have faced, there have been a good number that have been quite unusual, requiring more "out of the box" thinking. Many of these have been unexpected: Before I came into government no one could have predicted that I would work on them. I have found that they raise deep issues of monetary economics. I want to focus my remarks today on this other type of policy issue. My plan is to work through a brief history of several of the more unusual monetary policy problems that we faced at the U.S. Treasury in the last few years. The episodes are, in chronological order: (1) the rise and fall of multiple currencies in
The Rise and Fall of Multiple Currencies in
This problem arose in mid-2001, when
The result was an extraordinary fragmentation of
The quasi-currencies clearly challenged the fundamental role that money plays in the economy, greatly complicating the advances in monetary theory that have helped improve the conduct of monetary policies.
First, quasi-currencies undermined the central bank's ability to set monetary targets, control the money supply, and ultimately to maintain price stability. Without this control over the money supply, the monetary authorities could not exercise their most critical function.
Second, the use of quasi-currencies created instability and uncertainty as to money demand, further complicating the central bank's ability to manage monetary policy and in turn leading to increased volatility in other key variables, such as interest rates and the exchange rate. This volatility hurt activity in the real sector of Argentina's economy and contributed to the severity of the economic downturn in 2002.
Third, the quasi-currencies could not perform the full range of functions money performs. Given their ad hoc nature, they were not usable as a reliable store of value. They were only partially usable as a medium of exchange--and given the wide range at which they were valued, they created tremendous uncertainty and increased transaction costs for internal trade within Argentina. Each of the quasi-currencies traded at a different exchange rate to the peso, and these rates fluctuated, sometimes quite considerably, over time. The fracturing of Argentina's monetary system thus fractured the real market for goods and services and had an effect similar to raising trade barriers.
During my discussions with Argentine officials, my colleagues and I at the U.S. Treasury emphasized these problems with the unusual multiple currency situation. Eventually it became clear to all that the problem had to be dealt with. A transitional IMF program that began in 2003 was designed to focus on the basic growth of the monetary aggregates and the provincial deficits, and this gave Argentina a framework both to anchor monetary policy and deal with the multiple currencies. I remember one of the most challenging elements of the launch of the transitional IMF program was the design of the monetary targets, about which I spoke with the central bank governor numerous times. Setting these targets was complicated by widely differing estimates of money demand and, consequently, widely differing approaches to money supply growth.
In any case, the Argentine government and central bank were then able to launch a program to buy back the quasi-currencies. By the end of 2003, virtually all of the quasi-currencies were withdrawn from circulation. Since then, monetary policy in Argentina has been able to focus again on developing a price stability strategy with far less uncertainty. And they have been successful as inflation has dropped from about 40 percent to 4 percent.
The Ending the Run on Dollar Deposits in Uruguay in August 2002
In the spring and summer of 2002, Uruguay faced a run on its banking system. Although Uruguay did not have a multiple domestic currency problem in the sense of Argentina, it had nearly 90 percent of its deposits denominated in dollars.
With such a large fraction of deposits in dollars, the central bank had difficulty performing its traditional lender of last resort function without a large amount of dollar reserves. Unfortunately, there was an over-reliance on Uruguay's investment grade rating in order to tap capital markets should a crisis emerge. Although Uruguay's financial system had substantial dollar assets to match its dollar liabilities, there was a large currency mismatch on corporate and household balance sheets, with incomes denominated in local currency. This left the banking system highly vulnerable in the event of a sharp currency depreciation, since many loans would become non-performing.
These problems came to a head when the problems in Argentina intensified and the Argentine government imposed a freeze on bank deposits at the end of 2001. At that time Argentines started to draw down their accounts in Uruguay, both to get liquidity and to defend against a potential freeze in Uruguay. This deposit flight caused institutions with concentrations of Argentine depositors to come under pressure. The pressure on the financial system caused foreign reserves to fall and public concern grew that the government could not honor its guarantee of bank deposits.
During the spring and summer of 2002, I kept in close contact with Uruguayan government and IMF officials as they reported the decline in deposits and endeavored to deal with it. At first Uruguay simply drew on its existing IMF program; then a new program was launched in March, and it was augmented in June. The aim was to help build reserves in the financial system and bolster public confidence that the government's fiscal affairs were being put on sound footing.
However, it became apparent in the early summer that these measures were not enough to stop the run, and at the end of July we began a series of intensive meetings with Uruguayan and IMF officials to develop a strategy for dealing with the problem once and for all. In general, our policy is to help countries hit by events in a neighboring country if they are following good economic policies overall. Uruguay certainly met the criteria of that policy.
These discussions culminated in agreement on a package that mobilized additional funds from the IMF, World Bank, and Inter-American Development Bank to back several categories of deposits in the system, while suspending the operations of four private domestic banks and reprogramming dollar time deposits. To bridge to the disbursement of funds from the international financial institutions, the U.S. Treasury provided a short-term, $1.5 billion bridge loan to the government of Uruguay, which bolstered confidence and enabled Uruguay to reopen the banks without a resumption of the bank run.
The package was a success. It ended the bank run and prevented a collapse of the payment system in Uruguay. Uruguay's economy stabilized and within a year was growing at annualized rates in excess of 10 percent. The bridge loan from the U.S. Treasury was repaid in just four days. Uruguay has just declined to draw on its latest disbursement from the IMF under the program, which was launched at that time.
The Uruguayan example shows the kind of special policies that need to be in place when a country's central bank does not have full lender of last resort capabilities. A central bank must ensure that adequate supplies of foreign currency are available and that there is appropriate regulatory and prudential oversight. The Uruguayan case also highlights the need for policymakers to deepen their understanding of how currency and duration mismatches in both the financial and non-financial sector can interact, so that the right policies can be put into place in the first place.
Phasing Out Multiple Currencies in Post-Taliban Afghanistan in 2002
The U.S. Treasury has been significantly involved in economic reconstruction in Afghanistan, including developing an early needs assessment to guide fundraising, encouraging private sector development, providing assistance to the finance ministry in creating the first post-Taliban budget, and establishing measurable results systems for assistance. Here I will focus on monetary policy.
In Afghanistan, like Argentina, we were faced with a multiple domestic currency problem, in some respects, even more daunting than in Argentina. Three versions of the national currency were circulating in the country during the days of the Taliban. There was the official Afghani, which had been issued prior to the Taliban rule and which the Taliban and the government in exile had continued to issue. And there were the currencies of two warlords who had issued their own versions of the official currency.
When the new Afghan government came to office in 2002, they had as a top priority the issue of a single national currency. Fortunately some work had already been completed by the Taliban, including preliminary designs of various denominations, which significantly shortened the time needed to launch the new currency. The Afghan government announced the new currency plan on September 4, 2002, with the conversion process to begin on October 7, 2002.
Replacing all banknotes in a post-conflict country like Afghanistan within a fairly short period posed tremendous logistical challenges. Many parts of the country are isolated due to the mountainous terrain and a terrible road system. Extraordinary preparations and allowances for the currency exchange were needed, such as air-lifting cash by helicopter to remote exchange points, and allowing sufficient time for all Afghans – many of them traveling on foot -- to bring in old currency to exchange for new. Careful preparations were also needed to ensure that the old currency, once exchanged, was secured and destroyed so that it did not find its way back into the exchange process. Treasury technical advisors collaborated with the Afghan authorities, the U.S. Agency for
I visited Afghanistan in September 2002 and reviewed the plans for the currency exchange that was to begin after the first week in October. I recall that some high-level government officials were worried that there had not been sufficient preparation. Some noted that the currency destruction equipment had not been delivered yet. A significant potential problem was that the Afghan began to depreciate in value. Some wanted to postpone the exchange date. I met with a number of currency traders and business people and concluded that there were no serious confidence or speculation issues. At the request of the government I issued a statement saying that the plans for the currency exchange were on track, and that there was every reason to expect that it would go well.
In the end the exchange was successfully completed in January 2003. The exchange was conducted without any major security incidents. The exchange rate of the Afghani has remained broadly stable since then, reflecting the confidence in the new currency, with the exception of one period shortly after the introduction of the new currency when the afghani appreciated sharply.
Once the currency conversion was complete, the next step was to develop a framework for monetary policy. After considering the alternatives, the Afghan government decided on a floating exchange rate, though in practice, the central bank has aimed to limit exchange rate volatility.
Regarding the policy instrument, the central bank aims to control the money supply. The ability to target inflation through the domestic money supply is complicated, however, by the widespread use of foreign currencies.
Moreover, without a functioning banking system or money market, the only way to change the domestic money supply has been by selling foreign exchange through foreign exchange auctions. We are now working with the Afghan government to help them strengthen the banking sector and develop additional instruments for the conduct of monetary policy.
The Introduction of a New Currency For Iraq In 2003 And 2004
When the decades-long Baathist domination of Iraq ended in the spring of last year, the country had a fragmented monetary system, a central bank under the control of the Ministry of Finance, and a legacy of monetary mismanagement and inflation. Two separate currencies existed, old Iraqi (or "Swiss") dinars in the Kurdish region and "Saddam" dinars in the rest of the country.
The stock of Swiss dinars had not increased since the embargo of the early 1990s, while the stock of Saddam dinars had soared as Saddam's Baathist regime issued money in volume to finance its budget. Excess bill printing led to a sharp depreciation of the Saddam dinar relative to the Swiss dinar. To compound the problem, only two denominations of the Saddam dinar (250 and 10,000 dinar notes) and three denominations of Swiss dinars (one, five, and ten dinar notes) were in circulation. The absence of many security features and very low quality of Saddam dinar notes made them ripe for counterfeiting.
It was clear to us as early as December 2002 that a new unified, stable currency would be needed in Iraq, and we therefore developed a contingency plan. After the fall of regime, the difficult job of economic reconstruction in Iraq began. The situation was complex because the recognized governing authority of Iraq was the transitional Coalition Provisional Authority (CPA). While the CPA could issue an order establishing a new currency, the currency conversion process demanded Iraqi input and buy-in throughout and required that the Iraqi public embrace the new currency.
After an enormous amount of policy analysis, options memos, and diplomacy by U.S. Treasury staff, I flew to Baghdad in June 2003 to review the currency situation with the CPA officials and our Treasury staff. Shortly thereafter, the CPA announced, in early July 2003, that a new currency would be introduced. The new currency would have six denominations and would be based on designs that had been used historically for the old Iraqi dinar, in a more glorious era when Iraq was seen as an advanced nation in the Middle East. The currency conversion period was to last three months, from mid-October 2003 through mid-January 2004.
At the same time as the new currency was announced, the CPA issued an order making the Central Bank of Iraq (CBI) independent of the Ministry of Finance. The CBI had suffered from a long period of domination by the Baathist regime and isolation from the international community, and needed much assistance to rebuild. The CBI's monetary policy function required special attention. It lacked a modern statute to facilitate monetary stability, a coherent framework for conducting monetary policy aimed at achieving price stability, and corresponding instruments for implementing monetary policy.
The CPA and other coalition governments responded by assessing the needs of the CBI and providing technical assistance. Treasury sent a large team of experts to Iraq and provided reach back through a newly created Task Force in Washington. The Treasury team worked with the CBI to develop: (1) a monetary framework that emphasized growth of the monetary base; (2) systems for producing necessary monetary data; and (3) new monetary instruments. The consumer price index (CPI), produced by the Ministry of Planning, also has a major role in assessing price movements, but has serious weaknesses. As a result, Treasury advisors helped the CBI interpret price trends and recommended improvements in CPI methodology.
Just ahead of the currency conversion, in early October 2003, the CBI began holding daily currency auctions. Meanwhile, a new central bank law, based on international best practices, was completed. The law established price stability as the primary objective of monetary policy and authorized a wide array of policy instruments to achieve that goal.
The printing of the new Iraqi dinar in the time frame announced by the CPA was an enormous and unprecedented undertaking, involving printing facilities in seven countries. Indeed, the original order of 2 billion notes filled more than twenty-five 747 airplanes.
With the currency printing completed on schedule, the conversion to the new Iraqi dinar went remarkably well, especially considering the tenuous security situation. This largely owed to careful planning and diligent project management, again with significant input from the Treasury team.
Iraqi citizens have welcomed their new currency, and the exchange value of the dinar appreciated about twenty-five percent over the fall and early winter, even as growth in the new currency was brisk. The exchange value of the dinar has been quite stable over recent months, despite further growth in quantity. The earlier strength in the dinar helped hold down prices over the first several months of this year, and it seems quite likely that inflation will end up low this year, especially compared to the double-digit or higher rates that had characterized the Saddam era. This stability is providing the basis for much-needed public confidence in the management of its currency.
Still, major challenges lie ahead for the CBI. It is now the independent central bank of a sovereign Iraq. It has a new governing board that has a daunting agenda in the months ahead, and must build on the gains made to date. To foster its monetary policy mission, it needs to implement a number of new policy instruments to complement the daily currency auction, like the capacity to conduct regular open market operations in Iraqi government securities. And all of this needs to be done in the context of a very difficult security environment. We are continuing to provide assistance to the CBI to help it put in place a sound monetary policy.
Concluding Remarks
In sum, I hope these four examples from my recent experience at the U.S. Treasury illustrate how monetary theory plays an essential role in monetary policy analysis even in very unusual operational situations.
In designing plans for the Iraq currency exchange, economic theory was used to determine the exchange rate between the Swiss dinar and the new dinar, to estimate how much currency would be needed, to interpret movements in the exchange rate during the exchange, and in countless other ways. Eliminating the multiple currencies in Argentina and Afghanistan benefited from similar monetary analyses. And developing a plan to end the bank run in Uruguay required monetary analysis to diagnose the problem and to determine the size and nature of the backing.
In all these countries, our goal ultimately is a monetary policy that follows the same principles that are used at successful modern central banks, whether the Federal Reserve in the United States or the Central Reserve Bank of Peru, including a commitment to price stability and a transparent, credible method to achieve it.
Thank you for the opportunity to speak here today, and thank you for this award.
REPORTS