Shock Therapy in Russia/Why a 'Currency Board' Would Be a Mistake for Russia
Jude Wanniski and David Goldman
January 2, 1992



It will take at least a few weeks before there is enough evidence to persuade Russia's President Yeltsin that his shock therapy will not work as he has been led to believe. Early reports indicate the same trickle of goods coming to market at much higher prices. I'm now planning to return to Moscow January 26, the week after the Washington Conference on Western aid arranged by Secretary of State Jim Baker, January 22-23. I'll be flying over with Ted Forstmann of Forstmann, Little & Co., Bill Mundell of the WEFA Group, Gueorgui Markossov of the Russian Embassy, and a few others, for meetings with President Yeltsin, Vice Premier Yegor Gaidar, et al., to discuss the Polyconomics/WEFA project and its alternative monetary stabilization. The "Action Plan" we circulated early last month has been amended to take into account the further deterioration of the ruble. Rather than burden you with it in this missive, we will include it with other related material in the coming "Recommended Reading." The accompanying critique of the monetarist alternative, by David Goldman, is a timely topic.

Jude Wanniski

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Sir Alan Walters, the British monetarist, proposes in a November 22 essay, "A Hard Ruble for Boris," that Russia establish a currency board to exchange new hard rubles for Western currency, to circulate alongside rapidly-depreciating old rubles. It is a variant of a plan, favored by Milton Friedman, Steven Hanke and other monetarists, now current as a solution to the inflation underway in the ruble orbit. It is the only visible alternative to the gold ruble convertibility plan recommended by Polyconomics. Sir Alan urges the Russians to pledge gold and other assets to accumulate a reserve for such a board, and (preferably) locate it abroad. The plan would do nothing for holders of existing rubles, though: 

There would be no wholesale currency conversion from old to new. The old rubles would continue to be printed by the central bank...[I]t is realistic to assume that the Russian republics will not reduce their massive budget deficits to manageable levels overnight or even over years...Granted the large deficits, this means there would be a continuing inflation, probably hyperinflation, in terms of old rubles.

 Instead, Sir Alan envisages the new ruble circulating as a parallel currency:

But as the new ruble becomes the accepted currency, so foreign capital would flood in to take advantage of the high rate of return and security of currency. Similarly, the large quantities of dollars, Deutschemarks, etc., which are at present in the mattresses or Swiss bank accounts of Soviet citizens would be disinterred, swapped for new rubles and invested or spent on Russian projects and goods.

Since the new ruble will be a parallel currency, "why not simply circulate the greenback?" Sir Alan asks. Indeed, the differences he cites are trivial (although there is one substantive one, namely that it is far easier to tax transactions in rubles than in foreign currency). Under the monetarist plan, Russian circumstances would resemble Latin American hyperinflations, where the dollar, freely circulating as a parallel currency, is the currency of choice for most important transactions. Two-thirds of all dollar cash circulates outside the United States, mostly due to Latin demand.

The difference, of course, is that private property prevails in Latin America, so that the diminution of wealth resulting from inflation affects only a portion of total wealth, whereas in Russia and the Republics virtually all private capital takes the form of currency. In a hyperinflation, debtors who own tangible assets benefit, e.g., German farmers in 1923. The propertied classes in Latin America ride the swell of hyperinflation, although the vast majority of the people suffer. Who would gain and who would lose from Sir Alan's plan? Ordinary citizens whose capital took the form of deposits and currency would lose everything. Those with foreign currency in Swiss bank accounts, as Sir Alan emphasizes, would gain, along with foreign investors. His currency board would turn the former Soviet economy over to the old Soviet criminal class, i.e., to those who accumulated foreign exchange illegally. Those in position to do so prominently include senior party and intelligence officials; the maximum benefit would thus accrue to the most corrupt elements of the old Soviet elite.

Wages would still be paid in the old, depreciating ruble, permitting the nouveau riche and foreigners to command the labor of Russians at extremely low rates. Under these conditions, some capital would probably flow in. The result, though, would further erode the incentives to ordinary Russians and produce little benefit to the economy. No plan which fails to secure the value of the savings as well as current income of ordinary citizens can hope for success, although it might be argued that a parallel hard currency is slightly better than none at all.

Sir Alan's argument against a general currency exchange rests on the supposed incurability of the Republics' budget deficits. The opposite is the case: a general currency exchange makes it possible to solve the budget problem. Budget deficits and their monetization form a vicious cycle, as expected inflation forces transactions out of the official market into barter and similar arrangements, further reducing tax revenues and increasing budget deficits. The deterioration of government finances under such circumstances is so rapid that no form of budgetary austerity, even of a sort exceeding the political tolerance of important constituencies, can break this vicious cycle.

The cycle can only be stopped at the monetary level. Once a stable currency is available, the government can recapture through taxation part of the drastic reduction in transaction costs associated with the transition from barter to a money economy. Individuals and enterprises will gladly pay a transactions tax, e.g., a value-added tax, in return for the advantages of operating within a money economy. Value-added taxes have the advantage of ease of collection, and appropriate revenue measures must be designed to accompany a currency reform. At the outset, a universal currency reform also would permit the republic governments to impose a progressive tax on amounts exchanged, yielding a one-time revenue windfall. In his December 26, 1982, Polyconomics paper, "Monetary Reform and Economic Boom: Five Case Studies 1792-1926," Alan Reynolds examined the monetary reforms of the U.S (1792 and 1879), England (1821 and 1925), and France (1926) and found several common threads, one of which was that "Government budget deficits were an acute concern, usually with a combination of deficits, growing interest expense, and tax resistance." Each reform involved a restoration of the gold standard, followed by economic expansion and declining budget deficits.

David Goldman