Reviews of Monetary Policy, Currency Boards, and Country Experiences

With an Interview conducted by Petia Minkova with Steve H. Hanke and John Greenwood

By John Greenwood


MA and PhD, Edinburgh University, UK.


A head of Chapter 1 we feature an exclusive joint interview conducted by Petia Minkova, Deputy Editor in Chief of 168 Hours (a Bulgarian weekly publication) with Prof. Dr. Steve H. Hanke and John Greenwood .

Chapter 1 first traces the evolution of Milton Friedman’s views on fiscal policy from his early acceptance of the prevailing Keynesian orthodoxy to his later adoption of an entirely contrary view that fiscal policy played almost no role in macroeconomic stabilization. Until the late 1940s or early 1950s Friedman believed that fiscal policy should be the primary tool of government policy in macroeconomic stabilisation – the management of real GDP growth and inflation. However, by 1953 he had shifted to the diametrically opposite view that fiscal policy played almost no role in macroeconomic stabilisation and that as a result policymakers should rely principally on monetary policy. Second, the chapter explores some of the theoretical arguments Friedman used to defend his new position. Third, the chapter takes up a challenge that Friedman himself proposed to assess the relative importance of monetary and fiscal policies by comparing a series of episodes when fiscal and monetary policies were acting either in the same direction or in opposite directions. All the examples cited confirm Friedman’s finding that monetary policy invariably dominated over fiscal policy in determining macroeconomic outcomes, and particularly when the two policies were acting in contrary directions.

The purpose of Chapter 2 is to clarify the relation between money and interest rates. In section 1, the author examines the empirical validity of Keynes’s claims for his liquidity preference theory by looking at the relation between changes in interest rates and changes in the quantity of money. In section 2, the author considers Irving Fisher’s findings. Fisher, whose studies had mostly preceded Keynes, had shown that over any longer-term horizon the relation between money and interest rates was exactly the reverse of Keynes’ hypothesis of short-term liquidity preference. A reconciliation is proposed that treats Keynes’ theory as a short-term, liquidity effect, and Fisher’s results, which incorporate the effect of inflation or inflation expectations, as the longer-term determinant of interest rates. In section 3, the author applies the resulting combined theory of the relation between money and interest rates to five case studies in recent decades: two from Japan, and one each from the Eurozone, the U.K., and the U.S. The conclusion is that interest rates are a highly misleading guide to the stance of monetary policy; it is invariably better to rely on the growth rate of a broad definition of money when assessing the stance of monetary policy.

Chapter 3 features a eulogy of Milton Friedman, published soon after his death in 2006. Milton Friedman is widely known as a brilliant teacher and theoretical economist, but he was also intensely interested in the practical application of his theoretical analysis. In this eulogy, given at the Institute of Economic Affairs (I.E.A.) in London, the author recalls two striking examples of these aptitudes. First, anticipating the breakdown of the Bretton Woods system of fixed exchange rates, he advocated the introduction of currency futures by the Chicago Mercantile Exchange. These instruments have subsequently become indispensable for portfolio managers and currency traders around the world. Second, although Friedman was renowned for his advocacy of floating exchange rates, he was also at the same time an advocate of fixed exchange rate systems, or currency boards, for small open economies. This idea led to his direct involvement with the stabilization of the Hong Kong dollar after its collapse in 1983. Friedman’s mastery of academic economic analysis no doubt reinforced his confidence in the implementation of those ideas.

Chapter 4 is an analysis of the problems associated with the IMF’s proposed solution for the Argentine crisis of 2018.  Since the end of “Convertibility” in January 2002 Argentina has suffered from persistently rising inflation. From 5% in 2004, annual inflation increased to 40% p.a. by the end of 2014. The underlying source of the problem has been excessive fiscal deficits funded from the Central Bank of Argentina’s (BCRA’s) balance sheet by successive governments. This chapter starts with the key abuses of the BCRA’s balance sheet which have undermined monetary stability and proceeds to a wider view of the ingredients of Argentina’s current crisis. Despite the accession of the market-friendly President Mauricio Macri in December 2015, the situation had continued to deteriorate. After two and a half years in office, the administration had made little progress in solving the country’s macroeconomic problems. Faced with another episode of currency depreciation in May 2018 and rising inflation, the Argentine authorities appealed to the IMF in June for a $50 billion loan which they were successful in obtaining. The IMF’s Stand-By Agreement (SBA) came with numerous conditions attached: the SBA proposed to strengthen the BCRA’s autonomy, stop the direct financing of the government by the BCRA, while maintaining an inflation targeting regime and a freely floating peso. However, the author’s diagnosis was that the IMF’s SBA document implied the inflation targets and other reforms could be achieved by means of a gradual reduction of the fiscal deficit — without pain and without a deep recession. Meantime the growth of the monetary base and M3 growth were still far too high. In the author’s view the fiscal and inflation targets in the IMF plan were unattainable, and the plan would fail – as indeed turned out to be the case. This caused President Macri to lose the next election and ensured a return to populism for another decade.

During the 2016-17 bull market in the U.S., investors were subjected to two main market scares – the possibility of near-term inflation and the threat of an imminent recession, both spelling the end of the business cycle expansion. Chapter 5 examines first two commonly cited theories of inflation: the fiscal theory of the price level, and the Phillips curve (or output gap). Each is a form of reduced form analysis that omits any reference to the underlying monetary causes of inflation. The author shows that both in the US and more broadly across the OECD money and credit growth remain subdued. Since inflation is ultimately a monetary phenomenon, no sharp upswing in inflation can occur without a sustained period of faster money and credit growth. Second, the chapter reviews briefly the basis for an extended business cycle expansion. The shape of the yield curve, money growth and the health of private sector balance sheets all implied there was, in 2018, no basis for predicting an imminent recession. This justified the view that the prevailing expansion would continue for several more years with low inflation.

Chapter 6 explains why the Hong Kong dollar reached the lower end of its trading band in 2018, and how this was a normal feature of the operation of Hong Kong’s currency board mechanism. In the years since the Global Financial Crisis of 2008-09, the spot rate for the Hong Kong dollar had mostly traded near the upper end of its band, the Convertibility Undertaking of 7.75 set by the HKMA. After a year and a half of gradual weakening, the HK$ finally reached the weak side level of 7.85 on April 12, 2018, triggering US$ sales by the HKMA. The author explains first why the weakening of the HK$ is perfectly normal under the currency board system, posing no threat to the currency board mechanism. He also explains why it has taken so long for the weak side convertibility undertaking to be triggered, and why HK$ interest rates have lagged behind US$ rates. He also explains why Hong Kong dollar purchases by the HKMA at 7.85 would lead to a shrinkage of Hong Kong dollars in the money market , a rise of interest rates in Hong Kong, and a return of short-term interest rates in Hong Kong to approximate parity with short-term US$ interest rates.

Chapter 7 is an exploration of a parallel in monetary history. During the First World War Japan experienced large surpluses on its external accounts which, via monetary expansion, drove up prices to an uncompetitive level compared with other leading economies such as the US and the UK. Similarly, following China’s devaluation of its currency and exchange rate reunification in 1994 along with the adoption of a fixed rate against the US dollar, China gradually built up huge external surpluses in the early 2000s, which continued even after the 2005-14 appreciation of the currency. For Japan in the 1920s the result of the overvaluation was a decade of financial crises, slow growth, agricultural depression, and deflation. Only in December 1931 did the authorities finally abandon the fetish of returning to the pre-war exchange rate and devalue the yen, allowing Japan’s external accounts to return to equilibrium. In 2017, the author explains that China was faced with an essentially similar set of choices as Japan in the 1920s: undertake the prolonged process of internal economic and price changes that would eventually restore external equilibrium or allow the currency to adjust quickly to its equilibrium level.

Chapter 8 examines the tricky question of whether negative interest rates would provide satisfactory outcomes for Japan and the Eurozone in the period after the Global Financial Crisis. Since the Global Financial Crisis in 2008-09 four major central banks implemented Quantitative Easing (QE) programs. However, the types of QE implemented by the Federal Reserve and the Bank of England on the one hand and the Bank of Japan and the European Central Bank on the other have been very different. In the case of the Fed and the Bank of England, the QE operations were consistent with an expansion of deposits in the banking system, a reduction of leverage in the non-bank private sector, and the gradual normalization of growth, interest rates and inflation. By contrast, the QE operations of the Bank of Japan and the ECB have not been consistent with an expansion of deposits in the banking system or a reduction of leverage in the nonbank private sector, and hence they have failed to promote the gradual normalization of growth, interest rates and inflation. As a result, the monetary authorities in these two economic areas adopted lower and lower interest rates, eventually moving to negative interest rates. However, this is essentially a false solution. The right solution would have been to change the QE mechanism, adopting the US/UK model, and ensuring faster rates of monetary growth, which in turn would have promoted faster nominal GDP growth and higher nominal interest rates.



Prof. Dr. Steve H. Hanke and John Greenwood’s Exclusive Joint Interview conducted Petia Minkova, Deputy Editor in Chief of 168 Hours

1. Milton Friedman’s Views on the Interaction of Monetary and Fiscal Policy

2. Monetary Policy is not about Interest Rates; the Liquidity Effect and the Fisher Effect

3. Remembering Milton Friedman – A Eulogy

4. Prospects for Argentina under IMF Surveillance

5. Why Fiscal and Phillips Curve Theories of Inflation are not Working

6. Hong Kong: The Currency Board’s Autopilot Kicks in at 7.85

7. History Rhymes – A Comparison of China Today with Japan in the 1920s

8. Why Negative Rates are Not a Solution For Japan or the Eurozone


About the Editor

Chief Economist at INVESCO plc, John Greenwood OBE, is a graduate of Edinburgh University. He did economic research at Tokyo University and was a visiting research fellow at the Bank of Japan (1970-74). From 1974 he was Chief Economist with GT Management plc, based initially in Hong Kong and later in San Francisco. As editor of Asian Monetary Monitor he proposed a currency board scheme for stabilizing the Hong Kong dollar in 1983 that is still in operation today. John was a director of the Hong Kong Futures Exchange Clearing Corporation (1987-91) and council member the Stock Exchange of Hong Kong (1992-93). An economic adviser to the Hong Kong Government (1992-93), he has been a member of the Committee on Currency Board Operations of the Hong Kong Monetary Authority since 1998. He is also a member of the Shadow Monetary Policy Committee in England. John is a director of INVESCO Asia Ltd in Hong Kong, INVESCO Asset Management Singapore Ltd, and the Hong Kong Association in London.

In 1980 he translated Yoshio Suzuki’s book, “Money and Banking in Contemporary Japan” from Japanese. In 2007 he completed a book entitled Hong Kong’s Link to the US Dollar: Origins and Evolution which covers the collapse of the currency in 1983 and its subsequent restoration to stability under the plan he devised.



Date of Publication

June 28, 2022

File Size: 5193 KB
Length: xvii + 172 pages

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Other KSP Books