Money Mischief_ Episodes in Monetary History - Milton Friedman [91]
Israel retained the peg to the dollar for only thirteen months. In August 1986, the shekel was pegged instead to a basket of currencies of Israel's major trading partners, followed by devaluations at irregular intervals to offset the difference between the roughly 20 percent inflation in Israel and the lower inflation of its trading partners.* However, the thirteen months during which the shekel was pegged to the dollar was also the period of the most rapid depreciation of the dollar. By August 1986, the dollar had already depreciated by 32 percent from its peak value in early 1985.†
Never underestimate the role of luck in the fate of individuals or of nations.
Why Is Pegging an Unreliable Policy?
The examples of Chile and Israel help to illustrate the difference between two superficially similar but basically very different exchange rate arrangements.
One such arrangement is a unified currency: the dollar in the fifty states of the United States and Panama; the pound sterling in Scotland, England, and Wales and, at an earlier date, Ireland as well.
A slightly more complex example is the Hong Kong dollar. Before 1972 it was unified with the pound sterling by means of a currency board that stood ready to convert Hong Kong dollars into pounds at a fixed rate, keeping in reserve an amount of sterling equal to the sterling value of the outstanding Hong Kong dollar currency.* Since the currency reform of 1983, the Hong Kong dollar has been unified with the U.S. dollar through a similar currency board mechanism.
Likewise, under the pre-World War I gold standard, the pound, the dollar, the franc, the mark were simply different names for specified fixed amounts of gold, and so they constituted a unified currency area.
The key feature of a unified currency area is that it has at most one central bank with the power to create money—"at most" because no central bank is needed with a pure commodity currency. The U.S. Federal Reserve System has twelve regional banks, but there is only one central authority (the Open Market Investment Committee) that can create money. Scotland and Wales do not have central banks. When Hong Kong unified its currency with the dollar, it left open the possibility of giving the currency board central-bank powers, and, before the Tiananmen Square episode in China, the Hong Kong authorities were contemplating the introduction of changes that would in effect have converted the currency board into a central bank. One of the few good effects from what happened in China has been the derailment of that project.
With a unified currency, the maintenance of fixed rates of exchange between the different parts of the currency area is strictly automatic. No monetary or other authority need intervene. One dollar in New York is one dollar in San Francisco, one pound in Scotland is one pound in Wales, plus or minus perhaps the cost of shipping currency or arranging book transfers—just as under the late-nineteenth-century gold standard the rate of exchange between the dollar and the pound varied from $4.8865 only by the cost of shipping gold (yielding the so-called gold points). Similarly, 7.8 Hong Kong dollars is essentially just another name for 1 U.S. dollar, plus or minus a minor amount for transactions costs. It requires no financial operations by the Hong Kong currency board to keep it there, other than to live up to its obligation to give 7.8 Hong Kong dollars for 1 U.S. dollar, and conversely. And it can always do so because it holds a volume of U.S. dollar assets equal to the dollar value of the Hong Kong currency outstanding.
An alternative arrangement is the one adopted by Chile and Israel: exchange rates between national currencies pegged at agreed values, the values to be maintained by the separate national central banks by altering ("coordinating" is the favorite term) domestic monetary policy appropriately.
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