Modern currency boards are not necessarily precluded from financing government spending and may feature only partial foreign reserve backing. The potential dangers are highlighted by the Cook Islands case, where accelerating rates of currency issuance, combined with rising government budget deficits, led to a crisis of confidence in 1994. It is unlikely that the seigniorage gained from the short-lived currency board experiment outweighed the costs associated with the swings in policy. In the end, delayed fiscal retrenchment was accompanied by an abrupt contraction in the money supply as the local currency was withdrawn in 1995 and full dollarization re-established.
A country that is willing to give up an independent monetary policy always has the option of simply adopting an established foreign currency (such as the U.S. dollar) as the local circulating medium and "dollarizing" the economy. This practice ordinarily offers no scope for government revenue from money creation, however, leaving all such "seigniorage" revenue to accrue abroad. An "orthodox" currency board, limited to issuing domestic notes and coins that are fully backed by holdings of a foreign reserve currency, still prohibits independent monetary policy but does allow for seigniorage revenue earned through investing the foreign reserve holdings in interest-bearing paper like U.S. Treasury bills. The implementation of such an orthodox currency board can allow even very small economies to enjoy seigniorage revenue without compromising the discipline afforded through being linked to the chosen foreign currency. (1) A case in point is St. Helena's currency board arrangement with the pound sterling that was launched in 1976 (Hanke and Sekerke 2003).
Not all currency boards operate in such an orthodox fashion, however. Many modern currency boards, as with Argentina's April 1991-January 2002 experience, have expanded functions that may include acting as a lender of last resort, regulating commercial banks, and financing government spending--while not always requiring 100 percent foreign reserve coverage (see, for example, Hanke 2002, Schuler 2005). Deviations from orthodoxy do not necessarily imply economic disruption. For example, the Republic of Ireland continued to enjoy almost identical price trends to those of the United Kingdom over the 1928-79 period--with the one-to-one exchange rate between the Irish pound and the pound sterling maintained throughout--even after the monetary authority's functions expanded well beyond those of an orthodox currency board (Honohan 1997). A less narrowly confined role for the monetary authority, however, means that in times of crisis there is at least some scope for currency emission serving as an escape valve.
In the Cook Islands case, money finance of the government's budget deficits, aided by reduced reserve backing for the Cook Islands dollar, allowed fiscal retrenchment to be delayed in the early 1990s. The lowered reserve backing meant that the discipline exerted by an orthodox currency board no longer prevailed in the Cook Islands case. The ultimate price of the increased monetary flexibility was a loss of confidence in the over-issued local money that forced the government to abandon the currency board entirely and restore full dollarization of the economy in 1995. This, in turn, entailed a sudden, and substantial, monetary contraction that exacerbated the economic downturn and demonstrates that the dangers of choosing a currency board instead of full dollarization are not limited to a possible loss of discipline. The adjustment costs involved in abandoning the currency board need to be considered as well, and the Cook Islands experience may well support the case for full dollarization as a better option for other small nations in the Pacific and elsewhere. (2)
Overview of the Cook Islands Case
The Cook Islands is a self-governing country in the South Pacific with the local government, and most financial activity, centered on the island of Rarotonga. …