Let me bring the threads of this discussion together in the form
of a prescription for developing countries.
For most such countries, I believe the best policy would be to eschew
the revenue from money creation, to unify its currency with the
currency of a large, relatively stable developed country with which
it has close economic relations, and to impose no barriers to the
movement of money or prices, wages, or interest rates. Such a policy
requires not having a central bank.
The second best policy, but one which has far greater political
feasibility in the present climate of opinion, is to require a central
bank to produce a steady and moderate rate of monetary growth, using
the new money issued to finance part of government expenditures.
The emphasis on a “moderate” rate of growth is partly
to avoid so rapid an inflation that a large amount of real resources
are wasted in efforts to hold down cash balances, partly to avoid
creating pressures for government intervention to repress the inflation.
The emphasis on a “steady” rate is to minimise the economic
and social cost of erratic inflation, because if the inflation is
erratic it is nearly impossible for people to anticipate and adjust
But far and away the most important lesson of experience is that,
whatever the rate of monetary growth, the resulting inflation should
be permitted to be open. It should not be repressed.
As I have already emphasized, perhaps the greatest damage is done
by trying to repress exchange rates. Once a country seeks to peg
the exchange rate and then inflates, it is led to impose exchange
control, set up multiple exchange rates with special bonuses to
exports, impose quotas on imports, and so on and on, in an effort
that always proves vain to defend artificial rates.
A second set of prices that it is particularly desirable to avoid
repressing, and yet that is almost always subject to repression,
is interest rates. By now, one lesson that Irving Fisher tried to
spread some 75 years ago has been learned. There is an important
difference between nominal and real interest rates. A 25 per cent
rate when prices are rising at 15 per cent per year means a 10 per
cent real rate of return. As a result, every country that has had
substantial inflation has also had high interest rates.
Trying to repress interest rates is a particularly serious mistake
for developing countries. In most developing countries capital is
scarce. If the interest rate is pegged at an artificially low level,
or if, as in Israel, artificial interest rates are charged on special
kinds of loans or special kinds of investments, people who have
access to capital at these artificial rates, generally people with
political influence, will be encouraged to waste capital by using
it in ways that have a low yield. Capital that escapes the controls
will command an extremely high rate, much higher than the rate that
would prevail in a free market.
An additional cost of trying to repress or falsify interest rates
is that it leads to intervention into the development of financial
institutions as a means of enforcing the legal interest rate ceiling.
Yet under-developed countries have a great need for active and varied
financial institutions, particularly for institutions that can serve
small businesses. The best way to foster an effective and diversified
financial structure is to let the financial institutions develop
in response to market forces.
Repressing prices of goods and of labour, while no less frequently
attempted than repression of exchange rates and interest rates,
generally does less economic harm. The reason is that they are easier
to evade. However, they do great social harm. Given price controls,
black markets serve a socially useful purpose by preventing the
distortions that would otherwise develop. The effect of price controls
is therefore to make socially and individually beneficial action
which is morally repugnant because it involves breaking the law.
This conflict tends to undermine the moral capital of a nation.
Given favourable preconditions, good monetary policy can facilitate
development. Perhaps even more important, however favourable may
be the preconditions, bad monetary policy can prevent development.