A plight to remember

Has London anything to teach Almaty?



Amid economic growth, prices have remained volatile in Central Asia since the turn of the century. A measure of dispersion, the standard deviation, was twice as volatile for prices in the region as for those in the United States from 2000 through 2009. Even Kazakhstan, which has the strongest economy in Central Asia, has suffered more inflation over the period than has the U.S., according to World Bank data.

Fluctuating rates of inflation induce buyers and sellers to err, because they cannot be sure whether the price changes they observe for some product are due to changes in its supply and demand or to inflation that has yet to affect other products. Such errors retard economic growth. Since long-run inflation usually occurs because of excess money in the economy, is it time for the National Bank of Kazakhstan to stabilize money supply rather than the exchange rate?

A similar debate in England almost two centuries ago may shed light on the National Bank’s predicament. In the early 1800s, the price of a typical bundle of goods in England -- the “price level” -- fell about as sharply as it rose, resembling a roller-coaster. The most influential critics of the Bank of England, called the “Currency School”, demanded that the central bank stabilize the money supply, which at that time comprised gold and silver as well as paper money. Led by Lord Overstone, the critics argued that the Bank’s fine-tuning of money had undermined its credibility. In a recession, speculators could anticipate that the bank would issue more paper money, effectively to try to stimulate spending. But because the new money was not backed by a commensurate increase in gold, a pound sterling would lose value. Speculators knew this, so they would try to profit in advance by selling pounds to banks in exchange for gold. The loss of gold reserves left the banks vulnerable to panicked withdrawals of yet more gold. Sooner or later, the banks would collapse. Rather than risk this scenario, the Bank of England should commit to a given level of money supply -- no matter what the commercial banks demanded -- in order to preserve confidence in banking. A few commercial banks would fail, because the Bank would not lend to them in emergencies; but this was better than losing the system of banks.

The friends of the Bank, called the "Banking School", thought the Currency medicine too harsh to swallow. The Bank should simply lend to anyone who was creditworthy, they argued. Because such people borrowed money only to increase output, the resulting economic growth would justify expansion of the money supply. (To buy more goods, we need more money.) The best way to stabilize the economy was to ensure that people could always get gold from banks in exchange for paper money (or near-money, like bills of exchange). Secure in that knowledge, they would not run on banks.


Taking chances


In 1844, Parliament bought the Currency argument. It compelled the Bank to back its paper money 100% with reserves of precious metals. To issue additional notes, the Bank would need additional gold. The Bank also had to separate its two main functions – managing the money supply and supporting commercial banks.

In a few years, the Bank was back in a jam. When English harvests failed, grain imports and prices rose. So did the demands for liquidity from commercial banks.  Before 1844, banks might have been able to make good on the withdrawals by drawing upon the reserves that they kept at the Bank of England. But the Bank’s Issue and Banking departments had been separated; the Issue department had plenty of gold in reserve, but the Banking department didn’t. So it balked at issuing notes.  In the liquidity crisis that followed, the government suspended the 1844 law and authorized the Bank to lend freely at an unusually high rate of interest (8%), noted an economic historian, John Wood.


Unfortunately, such largesse may bring on the crises that it was meant to prevent. Suppose that speculators anticipate that a crop failure will lead the Bank eventually to lend notes freely. They realize that this increase in money supply may lower the value of a note (in terms of the products that it can purchase). So, as soon as the crops fail, they will exchange their notes for gold while these are still worth something. Gold reserves at the banks will fall, stirring doubts about the value of the notes and paving the way to a panic.

The National Bank of Kazakhstan faces a similar conundrum today. Countries today are no longer on a gold standard, but the U.S. dollar plays a similar role, since it exchanges easily for most currencies. Should the National Bank maintain large reserves of dollars, in order to avoid lapses of public confidence in Kazakhstan’s currency? Or should it use the dollars to bail out troubled banks? Should it announce that it will permit the money supply to increase at only the rate of economic growth, no matter what the immediate demands for money may happen to be? Suddenly, London is no longer so distant from Almaty. – Leon Taylor, tayloralmaty@gmail.com


Good reading

Walter Bagehot. Lombard Street. Various publishers. 1873. A classic tract of monetary economics by the editor of The Economist.

Anna J. Schwartz. Banking School, Currency School, Free Banking School. In John Eatwell, Murray Milgate and Peter Newman, editors, New Palgrave Dictionary of Economics: Money. Norton. 1987.

John H. Wood. A history of central banking in Great Britain and the United States. Cambridge University Press. 2005. Lively and informative.


References

World Bank.  World Development Indicators.  http://www.worldbank.org/