What monetary regime for Iraq?

The choice between a central bank, a currency board, "dollarization," or any other monetary regime may hardly seem worth talking about, especially when Iraq has so many other more palpable problems.

But this choice is fundamental to Iraq's transition to a market economy, which will occur when administered prices are allowed to be driven by market forces. Which monetary regime will be best equipped to curtail persistent rises in the general level of prices once prices are freed?

With the question posed in this way, there does not seem to be a prima facie case for "tying one's hands," as many economists denote the fixed exchange rate regime option. If one is to "fight" inflation, it is better to have weapons than to be bound and gagged!

As counterintuitive as it may seem, a fixed exchange rate regime—either a currency board or official "dollarization"—is the best way for Iraq to contain inflation. There are several reasons why.

First, there are issues of technical feasibility associated with various monetary regimes. A central bank (with a floating exchange rate) needs securities markets, interbank markets, highly trained staff, calibrated models, and timely economic data to operate in a way that is rational and developmentally benign.

None of these prerequisites are met in Iraq. Therefore a central bank would have little scope for action and would be unable to conduct credit policy, manage the exchange rate, or even learn from its mistakes.

In contrast, a fixed exchange rate regime is relatively easy to implement, and its non-discretionary character makes Iraq's technical shortcomings a moot point.

Secondly, different monetary regimes interact with fiscal policy and the banking sector in different ways. A central bank runs the risk of playing lender of last resort to the government if its budget doesn't balance, or to the banking sector if banks are illiquid or insolvent.

When this occurs, more money goes into circulation, and inflation follows. In fact, inflation can follow if the public merely expects that this will happen! The Iraqis, in this respect, will surely put two and two together: The government is straining to make ends meet and the banking sector is bankrupt.

With no obligations to either the government or the banking sector, fixed exchange-rate regimes don't vomit cash when fiscal policy hemorrhages or the banking sector ossifies.

Finally, a floating exchange rate is unlikely to help Iraq avoid "Dutch disease" responses to terms-of-trade shocks or alleviate external imbalances. Rather, it will merely be a nuisance to fiscal policy. The budget is extremely sensitive to exchange rate appreciation because most revenue is in dollars and most expenses are in dinars.

In fact, if the dinar/dollar rate remains at the 1000:1 level attained this weekend, this year's budget deficit will balloon by six trillion dinars!

There will be great pressure on a central bank, therefore, to manage the exchange rate—taking away the flexibility that started the discussion—although there are no signs that the central bank will actually be able to pull this off.

The recent turbulence in the foreign exchange market only serves to reinforce our conclusion: A central banking regime will be unable to attain price stability or manage a floating exchange rate.

We have made a detailed alternative proposal for a currency reform in our paper Monetary Options for Postwar Iraq (available at http://www.cato.org/pubs/fpbriefs/fpb-080es.html).

We hope that the Iraqi authorities will take note of our case and put a system in place that will produce low inflation, discipline the government budget, compel the financial system to bear and manage its risks prudently, and lay the foundation for development.

In short, Iraq should follow the example of Bosnia (1997) and Montenegro (1999) and choose a fixed exchange rate system.