These considerations make it worth contemplating the possibility
of refraining from using inflation as a method of taxation. So I
want to talk a little about what is, in the present state of opinion
in most of the world, an extremely hypothetical possibility, namely,
the possibility that a government will deliberately refrain from
inflation and will try to develop without inflation.
Though this is highly unrealistic, contemplating it serves a useful
intellectual purpose by providing a standard with which we can compare
current practice. It thereby will give us a greater degree of perspective.
The surest way to refrain from using inflation as a deliberate method
of taxation is to unify the country’s currency with the currency
of some other country or countries. In this case, the country in
question would not have a monetary policy of its own. It would,
as it were, tie its monetary policy to the kite of the monetary
policy of another country, preferably a more developed, larger and
relatively stable country.
Hong Kong is an obvious example. It has no central bank, no independent
monetary policy. It has a currency closely linked to the British
pound sterling. Through a Currency Board, printing of paper currency
requires the deposit of British currency in stated ratio. The quantity
of deposits is then indirectly controlled by the banks by the necessity
for banks to keep deposits convertible into currency.
This system which I’ve described for Hong Kong was essentially
also the system used by the United States in the nineteenth century
after the U.S. return to gold in 1879. Though technically the currency
was linked to gold, it could equally well be described as unified
with the British pound sterling. The U.S. had no central bank, it
had no independent monetary policy. The quantity of money in the
United States had to be whatever sum was necessary in order to keep
U.S. prices in line with world prices. The policy I’ve described
is also the one that was used by Japan in the period from the Meiji
Restoration to World War I.
A system of this kind—a unified currency—must be sharply
distinguished from a system that superficially looks the same, but
is basically very different, namely, a national currency subject
to national control, but linked to other countries by pegged exchange
rates. For example, different states in the United States, like
Illinois and New York, have a truly unified currency. Both use the
same dollar. There is no central bank in Illinois, there is no central
bank in New York that can interfere with the flow of funds between
them. If Illinois residents buy more from New York residents than
New York residents buy from Illinois, and if Illinois residents
finance their balance of payments deficit by drawing down their
cash balances, then, so far as this goes—neglecting all other
transactions—the quantity of money goes up in New York and
it goes down in Illinois. And nobody can interfere with that process,
because the only way in which the citizens of Illinois can pay for
their excess purchases is by transferring the money. And the number
of dollars by which the quantity of money increases in New York
will be dollar for dollar equal to the number by which it decreases
Though Hong Kong and the United Kingdom use currencies with different
names, essentially the same thing is true. They too have a unified
currency with a fixed rate of exchange between them.
That kind of a unified currency is very different from national
currencies linked by a pegged rate, say the U.S. dollar and the
Israeli pound. There is a fixed rate of exchange—4.18 pounds
to the dollar—but there are also central banks in the United
States and Israel that can, and do, interfere with the flow of funds.
If U.S. residents convert dollars into Israeli pounds, to finance
an excess of purchases in Israel, or to make payments to or investments
in Israel, the Federal Reserve System can prevent that conversion
from leading to a reduction in the U.S. monetary stock, and the
Bank of Israel can prevent it from leading to an increase in the
Israeli monetary stock—they can “sterilise” the
deficit or surplus in the jargon that has developed. Of course,
they may not do so. In the past six or nine months, as I understand
it, this process has led to a very rapid increase in the quantity
of money in Israel because the Bank of Israel did not in fact sterilise
the inflow of foreign exchange. But it could have done so, and I
doubt very much that the U.S. Federal Reserve System refrained from
sterlising the outflow.
As a result, the rate of exchange between Israel and the United
States is a pegged not a free market price, and is subject to substantial
change from time to time. A unified currency has a truly fixed exchange
rate. National currencies linked by pegged rates have jumping exchange
rates. When a pegged exchange rate changes, it changes by a jump,
as yours jumped a few months ago.
Technically speaking, a nation could refrain from using inflation
as a method of taxation without going so far as to unify its currency
with other currencies. A nation that succeeded in developing and
that kept its prices constant, or in line with the price level in
one or more major countries, would require a larger money stock
to match its growing output. If it unified its currency with other
currencies, whether through an intermediary like gold or directly,
the increase in the quantity of money would have to come through
a surplus in the balance of payments (defined to include all interest-bearing
loans but not literal money).
Instead of doing this, the country could use a national currency
and increase that national currency by the requisite amount, i.e.,
it could use a printing press or the central bank’s bookkeeper’s
pen. The amount of increase in the national currency would have
to be just sufficient to avoid a balance of payments surplus without
departing greatly from the assumed path of prices. The national
money would simply replace the inflow of foreign money.
While such a process is technically possible, under present conditions
it is highly unlikely to be followed for very long. Even if the
central bank itself tried to follow such an austere, self-denying
policy, political pressures are almost sure, sooner or later, to
lead to irresistible demands to go further, either to stabilise
the economy or to provide the government with funds.
The experience of Thailand provides a recent clear example. For
many years Thailand followed the policy I have described. It had
a national money, and it increased the national money just enough
to keep prices in line with world prices. It had a “hard”
currency. But the government in power finally realized that printing
money was a fine source of revenue. An excellent Governor and Deputy-Governor
of the Bank of Thailand were kicked out or kicked upstairs. The
Deputy-Governor, who happened to be a very able woman, is now at
the International Monetary Fund or at the World Bank, I’ve
for-gotten which. New people were brought into the bank, and the
bank is now departing from its former austere policy and behaving
like most other central banks, which means that it is inflating
I conclude that the only effective way to refrain from using inflation
as a method of taxation is to avoid having a central bank. Once
a central bank is established, the die is likely to have been cast
for inflation. I hasten to add that this does not imply any judgment
about the vices or virtues of central bankers, only about the pressures
on the central bank that are almost certain to develop.
While the use of a unified currency is today out of fashion, it
has many advantages for development, as its successful use in the
past, and even at present, indicates. Indeed, I suspect that the
great bulk, although not all, of the success stories of development
have occurred with such a monetary policy, or rather an absence
of monetary policy.
Perhaps the greatest advantage of a unified currency is that it
is the most effective way to maximize the freedom of individuals
to engage in whatever transactions they wish. In addition, while
the major countries are capable of policies that seem unwise to
many of their residents and to professional economists, yet they
are likely to have far stabler and less erratic policies than the
smaller, newer, less-established developing countries.
As many of you know, I have myself been a strong critic of monetary
policy in the United States. Yet, the inflation of the post-war
period in the United States has been far less severe than the inflation
in most developing countries. We have had inflation, but at the
maximum, our inflation, and then only for a brief time, was in the
neighborhood of 6 per cent. For most of the period it has been much
lower than that. We should do still better but the standards you
use must vary depending on the alternatives considered.
If it’s true that the larger country is likely to have a more
stable monetary policy than the smaller one, then a unified currency
is likely to reduce the possibility of unwise governmental policy.
Finally, a unified currency assures a maximum degree of integration
of the country in question with the greater world.
However great these advantages may be, the brute fact is that few
countries are willing to accept the discipline of a unified currency
and to refrain from the expensive luxury of establishing a central
bank. So I turn to the question of the desirable monetary policy,
given that a central bank exists, and that money creation is going
to be used as a method of government finance.