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Control High Inflation, Not Exchange Rates

by Anders Aslund, Peterson Institute for International Economics

Op-ed in the Moscow Times
August 26, 2009

© Moscow Times

It cannot be denied: Exchange rate policy around the world is confused and lacks theoretical ground. Although the degree of confusion varies, Russia is close to taking the prize.

Before World War I, it was easy. Just about everybody used the gold standard, and if any country faced too high prices they had to be reduced. In the interwar period, the gold standard broke down, and it was replaced by competitive devaluations, which amounted to severe protectionism.

After World War II, the Bretton Woods system restored fixed exchange rates based on the dollar and gold. But in the early 1970s, as US dominance began to decrease, the fixed exchange rates broke down, and monetary chaos contributed to stagflation (high inflation combined with little growth).

In the 1980s, US economist Milton Friedman, British Prime Minister Margaret Thatcher, US President Ronald Reagan, and the Bundesbank tried the cure of monetarism, or money growth targeting. They argued that central banks should set a target for monetary expansion that would determine both inflation and the exchange rate, but it did not work particularly well. The relationship between monetary expansion and inflation was too tenuous and uncertain to make it possible to check inflation with the money supply.

Economists talk about the impossible trinity: You can't have fixed exchange rates, free capital movement, and an independent monetary policy. One of the three has to give.

When communism crumbled across Eastern Europe from 1989 to 1991, two alternative ideas prevailed. One was that the exchange rate should be fixed to function as a nominal anchor to bring down inflation. The early successful stabilizers fixed their exchange rate for at least some time. They were Poland, the Czech Republic, Slovakia, Estonia, Latvia, and Lithuania.

The alternative was that reserves were insufficient to allow any fixing of the exchange rate, and thus the exchange rate had to float more or less freely. That was the situation that Russia and all the other post-Soviet countries had to face. Russia had too small reserves and too large of a budget deficit to allow itself to fix the exchange rate until the summer of 1995. The stable exchange rate attracted excessive international capital inflows in 1996 and 1997, which contributed to the financial crash of 1998, though the large budget deficit was the main cause.

Similarly, the East Asian financial crisis in 1997–98 was essentially caused by pegged exchange rates that led to large short-term capital inflows. Their counterparts were rising current account deficits and foreign debts. Sadly, the current Eastern European financial crisis is largely a repetition of the East Asian crisis. Once again, a number of emerging economies have sought the false safety of a pegged exchange rate. For most countries, it has resulted in large current account deficits and foreign debts exactly as in East Asia in 1997–98. Russia is not suffering from those problems thanks to its huge budget surpluses from 2000 until 2008, but its double-digit inflation persists.

The Russian illusion has been that by keeping down the nominal exchange rate through administrative controls, the country would stay competitive. But what really matters is the real exchange rate that includes inflation. Unlike China, for example, Russia has been unable to sterilize the current account surplus and capital inflows. For several years, Moscow has been one of the most expensive cities in the world because of the country's high inflation.

It matters little whether Russia pegs the ruble to the dollar, the euro, or a mixture of the two, or how broad the band is. The basic truth is that any pegging of the exchange rate undermines the country's control of its inflation. Economists talk about the impossible trinity: You can't have fixed exchange rates, free capital movement, and an independent monetary policy. One of the three has to give.

If the exchange rate is fixed and capital moves freely, a country can't pursue an independent monetary policy, because if it increases interest rates it attracts capital rather than cooling down economic activity. The consequence for Russia and other Eastern European countries with pegged exchange rates was negative real interest rates. That happened in Eastern Europe from 2006 to 2008, which led to the massive overheating and high inflation.

The obvious solution is to let the exchange rate float in order to focus monetary policy and control inflation with interest rates. In 1990, New Zealand pioneered so-called inflation targeting. It was a simple idea: The Central Bank should set a target of inflation that made sense, typically 2 percent a year, and the bank would try to steer inflation toward this target through its adjustment of interest rates and the usage of other monetary tools such as reserve ratios and bond sales.

It worked well, and about 20 developed and advanced emerging economies have adopted inflation targeting. They include Sweden, Norway, Poland, the Czech Republic, Australia, South Korea, Canada, Chile, and other key countries in Latin America—countries that have done well in the current crisis. In addition, many central banks, such as the European Central Bank, the US Federal Reserve, and the Bank of Japan are close to inflation targeting though somewhat heterodox.

One could make the argument that the main reason why Latin America has done so much better in terms of growth than Russia in the current financial crisis is that Latin America largely applies inflation targeting with floating exchange rates, while Moscow insists on controlling its exchange rates rather than inflation.

Although Russia's financial situation remains reassuring, the country could hardly have managed its exchange rate policy worse than in the last year. This is a time of global deflation, but Russia still has 11 percent inflation. The gradual devaluation from November through January caused a sharp decline in credit and money supply, which in turn led to a dramatic fall in gross domestic product of over 10 percent in the first half of 2009. On top of everything, the country lost more than $200 billion of international currency reserves.

The natural question is: How could such folly be allowed to rule economic policy and cause so much havoc to living standards? The answer most often heard is that the gradual devaluation was a very smart policy to bail out the big Russian corporations without making it evident. Well, that should not be the aim of public policy.

On the contrary, Austrian economist Friedrich Hayek lauded capitalist crises because they cleansed the economy from obsolete and inefficient enterprises. Needless to say, many of Russia's largest disabled corporations are nominally state-owned. Rather than using the crisis to restructure and improve the country's economy, the Kremlin has utilized exchange rate manipulation to conserve its friends at the expense of the people.

That is one more reason why Russia needs to let the ruble float and target low inflation.


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