The Ruble Problem: A Competitive Solution
Annelise Anderson
Senior Research Fellow
The Hoover Institution
The most critical challenge for the republics of the former
Soviet Union and for the Commonwealth of Independent States is
the creation of a monetary system that will serve economic reform
and the transition from socialism and central control to the
market economy.
The purpose of this essay is to present the case for
competitive currency issue by private banks as the best solution
to the current monetary and economic crisis. This objective is
at once less demanding than presenting the theoretical case for
competition in currency issue as the ideal monetary system for
all countries at all times, and at the same time more demanding,
because it is a specific policy recommendation about what real
people in real trouble should do in their current circumstances;
and what they do will matter.
The criterion for evaluating this policy option is whether
or not it is the best option for facilitating economic recovery
and growth in the next one to five years in the context of the
effort to make the transition to a market economy.
The Current Situation
The current situation is therefore relevant. Trade both
within and among the republics has broken down because of the
absence of acceptable means of exchange. Hyperinflation is
partly responsible; the difficulties of making contracts and
planning for the future when inflation is high and variable, and
of perceiving relative price signals amid overall price
increases, are of course a problem. But the heritage of a
Leninist banking system is also taking its toll.
Ruble deposits of enterprises are not freely convertible to
currency; under central planning, the use of currency was limited
primarily to the payment of wages. Payment for materials and
supplies had to be made by bank transfer. The presidium of the
Russian Parliament reinstated these restrictions, which had been
breaking down, in late January 1992. Writing in mid-1990, while
inflation was still in double digits, the authors of the 500-Day
Plan noted this lack of "fungibility," commenting that the
exchange ratio of deposits for currency was often 3 to 1.
Similar exchange ratios continue to exist for transactions on the
new commodity exchanges.
The purpose of the state bank under central planning was not
to make and collect commercial loans (or even to control the
money supply) but to ratify the orders of the central planners by
extending such credit as was consistent with plan fulfillment.
Output was delivered to the state and the state in turn supplied
inputs; it ran a central barter system. Ministries co-owned the
deposits of enterprises.
After the failure of one attempt, initiated in July 1987, to
create commercial (but still state-owned) banks by transferring
loan assets of the state bank to new banks, in 1990 ministries
and state enterprises began to create banks. These banks are
designed to lend to their owners and are not likely to function
as independent commercial banks in business for profit; the state
bank can make inter-bank loans to them. Thus the financial
system does not yet shift the investment decision from the
government to the market. The new cooperatives--many of which
have been created within state-owned enterprises--have
established a number of cooperative banks. They also lend to
their owners, but have a greater potential for competitive
operation.
In one of the more bizarre episodes of central banking, as
of late 1989 the individual republics had established their own
"central" banks, at least some of which added to the supply of
rubles by financing the deficits of their respective republican
governments. The head of the state bank claimed that the Russian
republic was a major offender. It seemed as though the
republics were competing to issue rubles as fast as they could
before the rubles lost their value. Meanwhile the Union
government was financing its own deficits by printing rubles.
Whether or not Russia or the Commonwealth has in fact
regained centralized control of the creation of rubles, one
motive other republics, especially Ukraine, have expressed for
issuing their own currencies is to preclude an influx of rubles
from Russia. Ukraine began issuing coupons in January 1992 that
could form the basis of a national currency. The future of this
scenario is a Ukraine with its own eventually stable currency
trading against an eventually stable ruble, at which time inter-
republican trade will be able to revive. The future may be a
long time coming.
The current legacy of the Communist banking and trading
systems and hyperinflation is barter, which is now legal. A
major aircraft manufacturer has begun making aluminum pots and
other consumer items so that it has something to trade for the
supplies it needs. Meat can be exchanged for almost anything, as
enterprises want meat to feed their employees. High value items
like automobiles are sometimes quoted on the commodity exchanges
in units of wheat. Coal miners in the Kuzbass spent weeks in
the winter of 1991-92 trying to negotiate an exchange of coal for
sugar. Associations of private farmers barter produce and meat
for flatbed trucks and cinderblock. Even non-drinkers stock
vodka for its use in exchange. Both enterprises and consumers
want to be in goods rather than rubles; hoarding is standard.
Trade among the republics is especially important in the
ruble area because of the excessive concentration of industry,
where often one supplier in the entire territory of the former
Soviet Union accounts for 85-100 percent of output of a product.
Single producers account for 100 percent of sewing machines,
color photography paper, freezers, tram rails, locomotive cranes,
sucker rod pumps, hosts for coal mines, coking equipment, and
hydraulic turbines. In 1988 a single producer accounted for all
deliveries to the central authorities of 87 percent of 5,885
products included in the machine building sector. In July 1991
a small enterprise in Russia's Far East reported that it was
having difficulty obtaining materials to build water heaters; and
yet it was the only plant in the Far East making water heaters
and supplied not only that region but the entire country with
water heaters. Inter-republic trade exceeded 30 percent of
output for all republics except Russia in 1988, and over 40
percent for 12 of the 15.
Like other economies in hyperinflation, the U.S. dollar and
other hard currencies are being used in trade. The holdings of
the population of dollars and other hard currencies are variously
estimated at $2 billion to $10 billion or more. The distrust of
government on monetary matters is summed up in the February 1992
statement of a Russian travelling in the United States on
official business: "I keep my hard currency at home." The
desirability of dollars is reflected in their high purchasing
power in comparison to the ruble at current rates of exchange,
both legal and black market. At the same time, the successor
states of the Soviet Union have inherited a hard currency debt of
over $60 billion.
In conclusion, the republics are suffering from the absence
of effective means of exchange within and among them. They need
money that works as a means of exchange internally and across
their borders; they need it quickly, to enable them to utilize
the economic resources currently available to them; they need a
commercial banking system; and they should make use of the hard
currency resources held by their citizens.
Free Banking: The Record
The characteristics of a free banking system are freedom of
entry and freedom of note issue with minimal government
regulation. The role of the government (beyond enabling
legislation) is the enforcement of contract and of laws against
fraud and other criminal activity. A free banking system has no
central bank and no lender of last resort.
Since F. A. Hayek's publications on competitive currencies
in 1976 and 1978, the history and record, as well as the theory,
of competitive private currency issue has received renewed
attention from Western economists. Historical examples continue
to come to light. In most of these cases the monetary
standard--the reserve money into which the notes were
convertible--was the same for all the banks in the system. What
Hayek proposed was competition among currencies denominated in
different units. He foresaw the possibility that such
competition would lead to a monetary standard kept constant in
terms of the values of a group of commodities. The essential
point he and others have made is that government monopoly of
currency issue and the monetary standard has been so pervasive
that the market has never had the opportunity to experiment with
providing the kinds of money consumers might want.
Whatever the characteristics of the ultimate competitive
monetary system, the historical record demonstrates what can be
expected of competitive private currency issue, whether or not
all banks used the same monetary standard.
The most important historical experience with free banking
is that of Scotland between 1716, when the monopoly of the Bank
of Scotland lapsed, and 1845, when legislation leading to a
monopoly of note issue by the Bank of England was passed. White
summarizes this experience and compares it to that of England.
No barriers were erected to entry into Scottish banking. All but
three banking firms were established as unlimited liability
enterprises whose owners were called upon to meet the claims of
deposit and note holders in the event of a failure. As of 1765
small note issues were prohibited, the law required that notes be
redeemed on demand, and the option clause (giving a bank the
option of redeeming notes in six months with payment of interest
rather than immediately) was outlawed. These were the only
regulations.
"The Scottish free banking system in its heyday," White
notes, "thus had evolved the following features to which free
banking advocates in England and elsewhere pointed. There were
many competing banks; most of them were well capitalized by a
large number of shareholders; none was disproportionately large;
all but a few were extensively branched. Each bank issued notes
for œ1 and above; most banks' notes passed easily throughout the
greater part of the country. All the banks of issue participated
in an effective note-exchange system. All offered a narrow
spread between deposit and discount (loan) rates of interest."
England, by contrast, forbade banks to issue their own notes
if the bank had more than six partners during most of this time
period; after 1826 for a time banks could issue notes if more
than 65 miles from London. The failure rate was over four times
that in Scotland and losses often fell on note holders, whereas
in Scotland losses were almost entirely covered by partners.
In the United States "free" banking meant freedom of entry
without a specific act of the state legislature, rather than free
enterprise. The U.S. experience is in fact multiple experiences
with different state laws, some of which worked well and some of
which were disastrous. In general branch banking was forbidden
even within a state. Several states used the banks as a market
for their bonds, requiring them to purchase state bonds as
collateral for note issues but valuing the bonds at par rather
than market. Note issues were restricted to the legal value of
the bonds; if the legal value exceeded the market value, an
immediate profit could be made (even as the bank failed) by
issuing notes supposedly backed by state securities. This is,
according to Rockoff, the origin of wildcat banking, which
occurred in some states and not others; it was also the origin of
the inability of banks to redeem notes as values of state bonds
fell, since their assets were thus not well diversified and
subject to the problems of the states whose bonds they held.
Some states also failed to close down banks unable to meet their
obligations.
New England, however, established a stable system that
evolved in the same direction as the Scottish system--competitive
note issue, notes circulating at par, and clearing arrangements
(started by the Suffolk Bank in Boston) among the banks.
New York, the nation's leading center of commerce and
industry, also established a stable system. As of 1840 New
York's free banking law made the market value of bonds backing
note issues the legal value. It specified limited liability
unless expressly given up. A minimum paid-in capital was
required, and if any of the original capital was withdrawn while
debts of the bank remained unsatisfied, no further dividends or
dispersions could be made to the owners until the capital was
restored; if such dispersions were made the bank could be
liquidated. New York's law also required a 12.5 percent specie
reserve against notes and bills circulating as money, and
provided damages for note holders whose notes were not redeemed
on demand.
In Sweden privately owned commercial banks with unlimited
liability (enskilda banks) issued their own bank notes from 1830
until they were forbidden to do so in 1904; currency issued by
the government bank circulated at the same time. One of these
banks played an especially important role in the development of
new Swedish industries. Sandberg attributes Sweden's economic
success--including the highest per capita GNP growth rate in
Europe between 1870 and 1914--in part to its banking system.
No bank failed.
The cantons of Switzerland permitted banks to issue their
own notes between 1826 and 1850, an example of interest because
Switzerland had not adopted a single monetary standard at the
time. The banks were therefore free to decide in which monetary
standard their notes would be denominated. Eight banks of
various forms of ownership were established using four different
standards. The bank in Basel, which issued currency denominated
in French francs, and the bank in Zurich, which denominated its
notes in brabanterthaler, accepted each other's notes at a rate
of exchange specified by the issuing bank. No failures occurred;
some suspensions of convertibility by private non-bank issuers of
currencies did happen from time to time. Regulations limiting
note issue and reserve requirements did not affect the behavior
of the banks as their note issues were well below the permitted
amount and reserves were on average considerably higher.
The record of free banking in a number of countries over
periods of time exceeding, in the case of Scotland, a century,
and in the states of the United States between 1838 and 1860, is
far better than the Wild West's wildcat banking stories would
alone suggest. Nevertheless one of the essential lessons in the
historical record should be how to avoid the conditions that lead
to wildcat banking (that is, banks established with fraudulent
overissue as the prime purpose).
The theory of free banking, which has developed side-by-side
with the historical re-examination, addresses the significant
free banking issues, generally concluding that a free banking
system is not inflationary (leading to systematic over-issue of
currency) and would not lead to an infinite or indeterminate
price level, does not lead to monetary disequilibrium or
fluctuations in the value of money, would not be unstable
(subject to runs and panics) and would use resources
efficiently.
Both the historical record and theory support the market as
an efficient and effective supplier of money. The historical
record also demonstrates that when governments decide to end a
free-banking regime, they (unfortunately) have no problems doing
so, and they do so for their own purposes--in order to obtain the
benefits for themselves of monopoly issue and the ability to
inflate the currency.
A Free Banking System for the Republics
Under a free banking system each of the states of the
Commonwealth, at its own option, would pass legislation
permitting private banks to accept deposits of hard currency,
gold, or other valuables and to issue notes and establish
deposits convertible into a hard currency or a basket thereof,
gold, or the current market value of one or more internationally
traded commodities such as oil.
Each state would further specify that no restrictions would
be placed on the use of the deposits or notes of these banks in
transactions or contracts, and that the government would provide
specific-performance enforcement of these contracts in the same
manner and with the same care it enforces contracts in the ruble
or any currency issued by or under the auspices of the
government; and that it will also enforce laws concerning fraud,
counterfeiting, and the like as it does for its own currency
issues.
A license or charter to create such a bank would be based on
meeting certain specific and minimal requirements--the names,
addresses, and character of the owners (people with a criminal
record under current law could be excluded), a copy of the by-
laws of the bank representing its contractual commitments and
relationships to shareholders, depositors, and note holders, and
the names and addresses of its auditors. Each bank could be
required to include in its name a standard phrase, such as "non-
state," indicating that the bank was not government-owned or
backed and its deposits and notes were not insured by the
government. The states of the Commonwealth might choose to make
foreign individuals and enterprises eligible for bank licenses,
either as sole or partial owners of a bank.
The enabling legislation in each state would require that
contractual commitments to note holders and deposit holders be
met; in the event they were not, the government would close down
the bank according to pre-established rules on the bankruptcy of
private banks and the bank's own by-laws on priority of claims.
Each republic could require that every bank provide frequent
(perhaps even daily) audited public information on the condition
of the bank in accordance with a defined format, posted in all
public offices of the bank and made available to the financial
press for publication. A further public-information requirement
would be that the banks post and inform the government of the
quantity of all bank notes printed; and that all enterprises
printing bank notes for such banks also be required to inform the
government and the public of the printing of such notes. The
provision of public information would probably evolve even if not
required by regulation. The assumption here is that a specific
requirement can eliminate the time period over which market
participants generate the demand for the kind of information they
need to evaluate private banks.
Beyond the initial licensing and public information
requirements, the governments of the republics would not further
regulate these banks. No restrictions would be placed on
branching or other geographical activity or the financial
services that could be provided (including clearing house
activities). No reserve requirements would be established and no
limits placed on interest rates on deposits or loans, the amount
of reserves a bank must hold, or the kinds of loans (or even
equity participations) a bank could make. (The banks should not
be precluded from lending to state enterprises or accepting their
deposits, but the government, as owner of state enterprises, may
forbid all or some state enterprises to borrow from private banks
or hold accounts in them.)
No limitations other than minimal licensing requirements
would be placed on entry into the industry (with the possible
exception of minimum capital), since competition is the essential
regulator of a free banking system. No restrictions would be
placed on the conversion of deposits to currency or the use of
devices such as checks, electronic transfers, teller machines,
and the like. Nor would restrictions be placed on the nature of
the bank's contractual commitments to deposit and note holders,
including whether or not it was created as a limited or unlimited
liability joint stock company. A bank might or might not choose
to issue currency with a delayed redemption clause--one that
permits the bank to redeem within six months, for example, rather
than immediately. A bank might or might not choose to honor
currencies issued by various other banks at one time or another;
clearing houses would also be free to make judgments about the
banks they would accept as members. Currencies issued by banks
would trade freely against each other and the ruble.
To encourage the development of the system the governments
of the Commonwealth states might find it desirable to institute
an amnesty, possibly temporary, for depositors of dollars and
other hard currencies with respect to the origin or sources of
their funds. The state governments may also need to issue
guarantees against confiscation or monetary "reform" in which
deposits are written down. But the government would not
guarantee deposits or the redeemability of bank notes. Nor would
it require the banks to hold any particular assets--especially
not government debt or bonds.
The governments of the republics might be tempted to specify
or limit the backing for the deposits and notes of private banks.
The dollar is the obvious current choice, but it is not at all
clear that it would be the choice throughout the ruble area or at
the end of the decade. The Deutsche-mark in the west, the yen in
the east, the Finnish marka in the St. Petersburg area, and
eventually the ecu are all contenders. Leaving the choice open
also allows for gold and for a currency convertible into, for
example, dollars but based on the spot price of oil. As Milton
Friedman wrote recently, "Let a common money develop the way a
common language has developed, by voluntary cooperation...there
is more hope for a viable common money by voluntary cooperation
through a market process than by government-enforced cooperation
through a political process." New forms of money such as that
envisioned by Hayek and others might also emerge.
The Commonwealth of Independent States formed by eleven of
the republics of the former Soviet Union has considered monetary
issues; Russia wants to keep the ruble and try to establish it as
a sound currency, while other republics--especially and
critically, Ukraine--are interested in establishing their own
currencies. Whether or not the Commonwealth states continue to
have the rubble in common, they could agree to permit the use of
currencies issued by private banks across state borders by
individuals and enterprises at their option; to determine state
by state whether to accept the notes of banks of other republics
for tax purposes; whether to permit local branches of banks
headquartered in other republics; and whether to provide
enforcement of contracts written in the currencies of banks of
other republics (a contract would always be enforceable
somewhere). Given such an agreement, private bank notes
redeemable in hard currencies would serve as a medium of exchange
among the states of the Commonwealth whether or not the ruble (or
any new currency issues of the republics) was sound and whether
or not individual republics also decided to establish currency
boards.
In fact, the Commonwealth might adopt the statement F.A.
Hayek proposed in 1976 for the European Common Market:
The countries of the [Commonwealth] ...
mutually bind themselves by formal treaty
not to place any obstacles in the way of
the free dealing throughout their territories
in one another's currencies (including gold
coins) or of a similar free exercise of the
banking business by any institution legally
established in any of their territories.
For their part, the banks would exchange hard currencies for
their own deposits or notes. A bank would agree to redeem
deposits and notes for its selected reserve currency (say
dollars) on demand (or after a specified period of time). Its
hard currencies would be converted, in this example, to dollars
and invested in (generally) short-term dollar-denominated
securities--U.S. Treasury bills or commercial paper. In a
competitive system, banks would pay interest on most deposits.
The bank would make loans in its own currency, thus
increasing the money supply. But as the deposits were converted
to notes and spent, or transferred to others by check, the bank
would have to pay out reserves or satisfy claims against it by
claims it had acquired on other banks--notes it had accepted or
checks to be cleared, thus limiting the expansion of its
liabilities to amounts people were willing to hold. Eventually
an organized clearing system would develop among the banks, and
the clearing house or individual banks would make loans to banks
temporarily in difficulty.
The Wild East
The free banking system proposed for the states of the
Commonwealth differs from historical experience in several
respects.
First, in all the known historical instances of private bank
note issue except that of Switzerland, the notes issued by the
various banks were all redeemable in the same reserve medium--
generally either gold or silver coin, or possibly a government
bank note in turn redeemable in gold or silver coin. There was
thus a single monetary standard or unit of account. A free-
banking system would be expected to converge on a favored
standard, although this standard might vary geographically (the
Soviet Union covered eleven time zones) and over time, and might
take a number of years to emerge. The confusion of money
denominated in rubles, dollars, marks, yen, and perhaps even more
currencies is not, however, particularly different from the
current situation; it would simply make it legal and open rather
than covert.
The legalization of transactions in different monetary
standards should move these transactions out of the black market
and make them easier to observe and thus to tax. How to tax is
more complicated, but the convenience of the government should
not be grounds for rejecting an otherwise beneficial policy. If
revenues exceed expenses (or value added is positive) in each
monetary standard in use, taxes can be paid at the required rate
in each standard. If not, however, each tax-paying entity could
be required to select a unit of account and convert transactions
in other currencies to that unit, either at actual purchase
price, an average for the period, or a value at the end of the
period. Alternatively, a republic could require that its
official currency remain the unit of account and the currency of
tax payments. An ideal problem for technical assistance from the
IMF.
Another second major difference with historical experience
is the recommendation that free banking legislation go into
effect while the ruble (and other currencies that may be issued
by other republics) continue to exist. The government of Russia
appears committed to the ruble as its currency (and if possible,
that of the Commonwealth) and to the effort to make it sound.
The question then arises of the fate of the ruble in the
event free banking is successful and currencies convertible into
dollars, marks, yen, gold, or whatever are successfully issued
and circulate. Leland Yeager, discusses a transition to a
different kind of system in the United States: "The appearance
of attractive alternatives would collapse the demand to hold
money of the present type." White, on the other hand, tends to
think that government fiat "outside" money would not immediately
lose its value if private substitutes were permitted. Hayek
comments that "For government....the chief task would be to guard
against a rapid displacement and consequent accelerating
depreciation of the currency issued by the existing central bank.
This could probably be achieved only by instantly giving it
complete freedom and independence, putting it thus on the same
footing with all other issue banks, foreign or newly created at
home, coupled with a simultaneous return to a policy of balanced
budgets, limited only by the possibility of borrowing on an open
loan market which they could not manipulate."
The ruble is already challenged by foreign hard currencies.
The ends of four major hyperinflations of the post World War I
period (Austria, Hungary, Poland, and Germany) occurred not when
the central banks of these countries reduced their note issues,
but when their governments made credible commitments to not
finance their deficits by central bank borrowing and to bring
their budgets into balance. "The essential measures that ended
hyperinflation in each of Germany, Austria, Hungary, and Poland
were, first, the creation of an independent central bank that was
legally committed to refuse the government's demand for
additional unsecured credit and, second, a simultaneous
alteration in the fiscal policy regime." Presumably it is the
same circumstances that are critical to the ruble, and not the
absence of alternative currencies or stabilization funds provided
by international financial institutions.
Russians to whom I have spoken are convinced that
alternative means of exchange would lead to the further erosion
of the value of the ruble. But the source of this erosion will
be the government's unwillingness to give up its power to finance
its deficits by monetary creation and to redistribute income by
selectively raising wages or other payments. Under a free
banking system the greater availability of money redeemable for
hard currencies would put downward pressure on the ruble/dollar
exchange rate. If the government succeeds as well in controlling
the issuance of rubles, the ruble should stabilize against
foreign hard currencies and bank notes convertible to these
currencies. As the government acquires redeemable bank money
through tax payments, it can use these notes to purchase and
retire rubles. The total money supply would include, of course,
the notes and deposits of private banks as well as government-
issued rubles; but the money supply already includes foreign
currencies, and loans issued by private banks should reduce the
demand for ruble loans.
Third, circumstances in the ruble area differ from those in
Scotland or Switzerland or Sweden or the United States during
their respective free-banking eras. One obvious difference is
that modern communications--radio, television, electronic
transmissions--exist, even though not as pervasively as in
Western Europe or the United States. Information need not travel
by post, nor bank notes by pony express rather than air.
Although Russia (and even more so, the Commonwealth) is vast, it
can be assumed that notes would come back to the issuing bank
relatively quickly even if circulated at a distance, and
information on the condition of various banks would be available
throughout the area where notes might circulate. Modern
communications mitigate against Friedman's concern that
"individuals may be led to enter into contracts with persons far
removed in space and acquaintance, and a long period may elapse
between the issue of a promise and the demand for its
fulfillment."
Another difference is that the principle of private wealth
is not as established or secure as it was in Scotland when the
unlimited liability of owners protected so well the deposit and
note holders of Scotland's banks; in the United States some
states passed unlimited liability requirements for owners of
banks and consequently made a dead letter of their banking laws.
The alternative may be a paid-in capital requirement, not to
protect customers against any possible overissue or errors in
lending decisions, but to ensure that owners have something of
their own at risk and thus have an incentive to make the bank
successful.
The problems of establishing confidence in a bank--and its
owners--in the republics of the former Soviet Union are also
likely to differ from those encountered elsewhere. In this
challenging process, the republican governments would be wise not
to ensure the public that private banks are safe, or in fact to
take the responsibility for their safety, but only to ensure that
information about them is readily available. The first private
banks may need to be established by foreign banks of recognized
name and reputation or by individuals recognized for their acumen
and integrity.
Why A Currency Board Is Not Enough
I have no objections to currency boards, and a government-
issued currency convertible into one or more foreign hard
currencies would be a useful adjunct to a free banking system.
Without new banking legislation, however, the convertible
currency would become entrapped in the existing banking system
with its restrictions on conversion of deposits to currency, its
credit and interest rate controls, and its ownership by state-
owned entities. What is needed is not only a parallel currency
or currencies, but a parallel banking system.
The minimal system would permit the establishment of banks
under the regime described above but without the power to issue
their own notes; the currency issued by the board would be the
sole currency other than the ruble. The restriction on note
issue would be an artificial restriction on the demand of the
public to hold currency in an environment in which the public is
not accustomed to using checks and bank transfers are slow.
A more liberal system would permit private banks to issue
their own currencies backed by the currency issued by the board.
This provides additional flexibility in the supply of circulating
currency, but still requires that banks tender hard currencies to
the currency board to obtain reserves. Private banking may
attract more hard currency deposits (and thus more rapidly
eliminate the seniorage now enjoyed by foreign governments whose
currencies are held in the states of the Commonwealth) if there
is no currency board to which a bank is likely to turn over hard
currency deposits. This point rests on the possibility of public
distrust of a currency board. A currency board is, after all, a
creature of the government that creates it, and Soviet history
provides many examples of the use of confiscation as a tool of
monetary policy. The risk is that the government could seize the
assets of the currency board and declare its notes to be legal
tender (final payment for debts public and private) inconvertible
to the reserve currency. (A currency board run by the IMF would
eliminate this risk.)
Competitive currency issue with freedom to choose the
monetary standard is no more risky than competitive currency
issue limited to a currency board issue as the sole monetary
standard and ultimate reserve currency. The advantage of free
banking with the right to select the monetary standard as well as
issue notes is that it allows competition among alternative
reserves. The preferred monetary standard is likely to differ
geographically and to change over time, and competing banks are
likely to respond more quickly and effectively to changes in
demand than a currency board. The variety of monetary standards
that would at least initially exist would facilitate trade among
the states of the Commonwealth and with the nations of Eastern
Europe. A fully free banking system might also attract more new
entrants, both foreign and domestic, and thus more rapidly re-
monetize the economies of the Commonwealth and provide resources
to new private enterprises. Finally, free banking offers the
potential of developing monetary standards not based on other
countries' currencies. Gold is a possibility, as well as the
variety of standards having constant commodity purchasing power
envisioned in the theoretical literature.
The Transition
The standard approach of Western economists to the
transition of a centrally controlled socialist economy to a
market economy is to propose conversion of existing institutions
of the command economy to their presumed counterparts in a market
economy. Take the state bank and turn it into a two-tiered
banking system: an independent central bank and competing
commercial banks. Convert the defense establishment to
competitive producers of consumer goods. Turn state-owned
monopolies into joint stock companies, compensate the managers on
the basis of profits, and hope the enterprises behave like
competitive private corporations. Sell the flats in government-
built housing and call them condominiums. Take the organization
that mediates disputes among enterprises with the objective of
meeting the goals of the central plan and transform it to a court
hearing commercial disputes among private enterprises.
These conversions may or may not work. A parallel approach
would permit and facilitate the development of the institutions
of a market economy "from scratch." Then if conversion fails the
old institutions can eventually be shut down, torn down, written
off, liquidated, or simply allowed to wither away as new
institutions take their place. Money and banking are a good
place to start.
Footnotes
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Copyright 1992 by the Baord of Trustees of the Leland Stanford
Junior University. Material contained in this essay may be
quoted with appropriate citation.