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Tuesday, 6 November 2012

The Daily Index Plan: Guaranteed to stop the effects of hyperinflation in Iran overnight at no cost


The Daily Index Plan: Guaranteed to stop the effects of hyperinflation in Iran overnight at no cost

Prof. Steve Hanke, from John Hopkins University in the United States, suggested to Iran to stop their current hyperinflation overnight with official Dollarization, spontaneous Dollarization or a currency board.

I certainly would never suggest spontaneous Dollarization to any country. That normally happens after severe hyperinflation as it happened in Zimbabwe. I would never suggest severe hyperinflation to any population.

Yes, official Dollarization or a costly currency board would stop hyperinflation in Iran from the one day to the next. Under official Dollarization Iranians would need enough US Dollars, or whichever relatively stable currency they choose, from the one day to the next to change their money supply from their hyperinflationary rials to US Dollars overnight. Iran is quite a big economy. That would be the first problem. I do not think Iran has the required amount of spare US Dollars to Dollarize overnight.

It is reported that Iran has USD 90 billion in reserves. Let us assume that is what is required for Iranians to Dollarize their economy overnight. I do not know what that required amount is. This is just an example to illustrate the point.

That would use up all their foreign exchange reserves overnight if they were to use it as the required amount to change their money supply from hyperinflationary rials to relatively stable US Dollars. I will explain the Daily Index Plan under which they would keep their foreign exchange reserves and have guaranteed removal of the effects of hyperinflation or inflation from their constant and monetary items (excluding from rial bank notes and coins). The Daily Index Plan is based on the Unidade Real de Valor daily index and the Real Plan used by Brazil in 1994 to stop hyperinflation.

Rial monetary items are rials held and other monetary items expressed in rials, being substitutes for rials held, e.g., rial loans, consumer loans, bank loans, student loans, housing loans, car loans, government bonds (loans to the government), commercial bonds (loans to companies), notes payable, notes receivable, the capital amounts of all money market and capital market instruments, etc. when these monetary items are not in the form of actual rials held. They are all substitutes of actual rials held.

With Dollarization Iran would also lose monetary autonomy. US inflation (the US now has a 2 percent annual inflation target) would be the inflation in Iran – in general terms. The Central Bank of Iran would not be able to implement any independent monetary policies under Dollarization.

US Dollars are not monetary items outside the US economy. They are not monetary items in Iran. They are variable real value non-monetary items (variable items) in Iran. They are not affected by local inflation because they are not local currency units in Iran.

The Daily Index Plan: guaranteed to stop the effects of hyperinflation in Iran overnight at no cost

The existence or not of hyperinflation in Iran depends on who runs the rial printing presses and who creates excessive rial monetary items in Iran. I only know how to stop the effects of hyperinflation in Iran from the one day to the next without Dollarization or a currency board and without using any of their foreign currency reserves.

The Daily Index Plan, which I suggest Iran uses, is guaranteed to remove the effects of rial hyperinflation from the one day to the next at no cost when it is implemented correctly in Iran. Rejecting the stable measuring unit assumption in both the rial monetary and constant item economies and the use of a totally transparent Daily Index are the crucial factors; i.e., they would guarantee the elimination of the effects of hyperinflation in Iran from the one day to the next at no cost. Iranians cannot negate natural accounting and economic concepts and laws in Iran. Iranians cannot negate maths in Iran. When Iranians implement the measures I suggest correctly and they have the necessary legal backing, the Daily Index Plan will have the forecasted logical consequences in Iran. The Daily Index Plan is equivalent to official Dollarization in Iran in terms of units of constant purchasing power: in constant rial terms with no Dollars or a currency board required. Official Dollarization and a currency board are made obsolete as solutions to hyperinflation by the Daily Index Plan.

When the US Dollar is used as a substitute for the Daily Consumer Price Index then a constant (not nominal) rial is always exactly equal to the US Dollar as indicated by the US Dollar daily parallel rate. It is simple maths. The whole rial monetary and constant item economies would then be valued in terms of the US Dollar (any relatively stable foreign currency via cross rates) under capital maintenance in units of constant purchasing power in terms of the US Dollar daily parallel rate and daily inflation-adjustment of the entire rial money supply. As soon as correct and reliable rial CPI data are available again and the rial Daily CPI is properly used as the daily index, the rial monetary and constant item economies would be valued in terms of the consumer basket in Iran; the Daily CPI in Iran.

All political and other non-economic variables are correctly factored in by the use of a totally transparent Daily CPI or the US Dollar (any relatively stable foreign currency) daily parallel rate as a substitute for the Daily CPI.

The Daily Index Plan is, in principle, a copy of what Brazil did in 1994. It is not exactly the same as the Real Plan and it is also not simply a daily Index like the URV. This time the concepts are known and defined / identified beforehand. I think Brazil did it the way I did it in Angola: doing what is logical and common sense from your personal knowledge of direct involvement in the daily hyperinflationary economy. It actually took them 10 years to beat their hyperinflation in their whole economy. I simply stopped the effect of hyperinflation in the constant items of the company where I worked. We avoided the effect of hyperinflation in the local currency (Kwanza) by not keeping any Kwanzas from one day to the next in our company. I only understood and could only define the concepts I implemented in 1995 and 1996 in Angola many years later. I think the same is true with the Brazilian Real Plan in 1994.

I completely stopped our fear of hyperinflation in our company in Angola with accounting dollarization in terms of the daily US Dollar parallel rate and zero daily balances of local currency. Iran can do the same and a lot more for the whole Iranian economy by implementing the Daily Index Plan as soon as possible.

To understand what I suggest for Iran (and all other economies especially Venezuela also currently in hyperinflation and Ethiopia, Mongolia, Tanzania, Angola and Argentina, all currently in high inflation), it is first necessary to understand the background to my work; i.e., where these facts and fundamental concepts I suggest that Iran and other countries adopt, where they come from: how I came to these conclusions and whether they are valid and credible. For example, what does the International Accounting Standards Board think about them?

Three parts of the economy. How to keep two of them stable in real values.

Most economists and accountants would state that the economy is made up of two parts: the monetary and non-monetary economy. That is not correct. The non-monetary economy is split in two: the constant real value non-monetary economy (constant item economy) and the variable real value non-monetary economy (variable item economy).

The generally accepted concept of measurement in units of constant purchasing power is used to define the two different non-monetary economies as follows: when non-monetary items can be measured in units of constant purchasing power it very logically means there are constant real value non-monetary items (constant items) in the economy: economic items with constant real values (constant purchasing power) over time. Then, logically: non-monetary items that are not constant items are variable real value non-monetary items (variable items). This definition is inferred in International Financial Reporting Standards by the statement that “financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power”.

Constant items are, for example, salaries, wages, and rents. We all know they are constant values. Salaries and wages are generally measured in units of constant purchasing power on an annual basis on a worldwide basis: they are updated annually. They are then mistakenly paid monthly in fixed nominal amounts again applying the stable measuring unit assumption.

Other constant items are, for example, companies´ capital and amounts owed for purchases on credit (trade debtors).

How do you keep them constant in real value? You measure them daily in units of constant purchasing power in terms of a Daily CPI – the parallel rate in Iran at the moment.

How are they currently being kept constant? Companies´ equity worldwide is measured in nominal monetary units under the traditional Historical Cost Accounting model!!! It is, in general, not being kept 100 percent constant.

Variable items are the easiest to deal with. Examples are property, plant, equipment, raw material and finished goods stocks, etc. Their values are determined in the free market. The market price set in a free market is the best price for a variable item. No-one, generally, disagrees with that.

Now we have the monetary economy left. Inflation and hyperinflation only erodes the real value of money and other monetary items – nothing else. However, most economists and accountants would state that companies´ capital and invested profits are eroded by inflation and hyperinflation. US Financial Accounting Standards actually state that. That is completely wrong. They are constant real value non-monetary items. It is impossible for inflation and hyperinflation to erode their real values. They are eroded by the stable measuring unit assumption: by traditional Historical Cost Accounting.

So, of the three different parts of the economy, we do not have to worry much about the variable item economy. In very general terms, variable items´ real values are determined in their respective free markets. For example, the price of gold, oil, foreign currencies, shares on the stock market, rice, coffee, mobile phones, TVs, computers, etc. These prices are often determined minute by minute on a daily basis worldwide.

Now the constant item economy: Some constant items, e.g. salaries, wages, rents, etc. are measured in units of constant purchasing power on an annual basis. Their constant purchasing power is thus being maintained constant on an annual, not monthly basis – in very general terms. Debts for purchases on credit are mistakenly defined by almost all institutions as monetary items. They are constant items. They are all accounted applying the HCA model; i.e., it is assumed money is perfectly stable when they are measured. Their real values are being destroyed by the stable measuring unit assumption. Very fast in Iran at the moment.

The same is true for the real value of companies´ capital. It is measured worldwide in nominal monetary units while it is, in fact, a constant item. So, only companies that maintain the constant purchasing power of their capital constant with the equivalent real value of their net assets, maintain the real value of their capital constant. Which are these companies? Not a single company in the world knows whether it is maintaining the constant purchasing power (real value) of its capital constant.

In Iran companies that do not maintain their capital constant with equivalent real value net assets are destroying the real value of that portion not covered by the real value of their net assets at 70 per cent PER MONTH at the moment – with the stable measuring unit assumption (Historical Cost Accounting). They really have a big problem.

Now we have some idea of the three parts of the economy and that inflation only erodes the real value of money and monetary items. Now what do I suggest for Iran?

I suggest that Iran follows the Daily Index Plan to beat the effects of hyperinflation as follows:

(i) Iran (the Central Bank of Iran) should very soon issue a New Currency with xx xxx rials being equal to one New Currency on a specific date. This would be to make Iranians forget about the very fast depreciating current rial. How will they have faith in the New Currency? By locking (maintaining) monetary items´ real values (not the New Currency’s real value – it is impossible during inflation and hyperinflation while bank notes and coins have their nominal values permanently printed on them) with daily updating in terms of a totally transparent Daily Index as follows:

(ii) On the same date, Iran should introduce a completely transparent Daily Index compiled mainly from the US Dollar / New Currency daily free market rate.

(iii) Iran (The Iranian Institute of Certified Public Accountants - if they are actually the accounting standard authorities in Iran) should then require (not optional) capital maintenance in units of constant purchasing power in terms of the Daily Index as from that date (Iran would ban Historical Cost Accounting and the stable measuring unit assumption forever – one of the best things Iran could do for the population).

This would require all constant items always and everywhere to be measured daily in units of constant purchasing power in terms of the Daily Index and all monetary items (the entire money supply – except actual bank notes and coins) to be inflation-adjusted on a daily basis in terms of the Daily Index.

That is it. That would make the Iranian constant item economy operate in constant real value terms and the Iranian monetary economy operate in monetary items with constant real values (except bank notes and coins): something that has never happened in the world economy before. Iran would lead the world in financial reporting and effective monetary policy.

Excluding deliberate excessive creation of money and monetary items in Iran, inflation would immediately fall to very low levels as it happened in Brazil in 1994 because:

  1. All New Currency monetary items would be inflation-adjusted daily in terms of the Daily Index. Result: All New Currency monetary items (excluding bank notes and coins) would have constant real values over time. No cost of or gain from inflation. Brazil inflation-adjusted many (not all) monetary items daily in terms of their daily Unidade Real de Valor and other government-supplied daily indices during 30 years of high and hyperinflation. Chile currently inflation-indexes 25 percent of its entire broad M3 money supply daily in terms of their Unidad de Fomento daily index.
  2. All constant items, e.g., salaries, wages, rents, royalties, fees, companies´ equity, trade debtors, trade creditors, all non-monetary payables and receivables, taxes payable and receivable, provisions, etc. would be measured daily in units of constant purchasing power in terms of the Daily Index. Result: all constant items would have constant real values over time. Result: a relatively stable non-monetary economy, like Brazil had during 30 years of very high and hyperinflation. Hopefully during low inflation after the introduction of the New Currency in Iran.
  3. Variable item prices would, in general, be determined in the free market on a normal daily basis - maintaining all Iran’s social security programs. When they are not determined in the free market daily, they would be updated in terms of the Daily Index until the next time they are determined in the free market. Historical Costs would be updated daily in terms of the Daily Index. Historical Costs would never be measured in nominal monetary units since the stable measuring unit assumption is never applied under capital maintenance in units of constant purchasing power. The Historical Cost Accounting model would be banned in Iran.
  4.  The Daily Index would be completely transparent: anyone would be able to check its validity at any time.

If any institution in Iran were to print or create too much New Currency money it would automatically be reflected in the US Dollar / New Currency free market rate and consequently in the Daily Index, but because of daily indexing of all monetary and constant items, these items (except bank notes and coins) would remain stable in real value in the monetary and constant item economies, respectively, at whatever rate of inflation or hyperinflation. The Daily Index Plan is thus guaranteed to remove the effects of inflation or hyperinflation from the Iranian economy.

Brazil used their Unidade Real de Valor daily index and their Real Plan to stop hyperinflation overnight very successfully in 1994.

The Daily Index Plan can be implemented without a New Currency and with the Chinese Yuan or any other relatively stable foreign currency instead of the US Dollar free market rate.

What I am suggesting are not all completely new concepts: Chile currently inflation-adjusts 25 per cent of its money supply on a daily basis: I am saying: make that 100 percent on a daily basis under complete co-ordination (everyone doing it) and you eliminate the entire cost of inflation and hyperinflation from the economy. Certain constant items have been measured in units of constant purchasing power for many decades, namely salaries, wages, rents, etc., on an annual basis. I am saying: measure all constant items daily in units of constant purchasing power in terms of a daily index, especially companies´ capital because that would maintain Iran’s existing capital investment base constant for an indefinite period of time in all companies that at least break even in real value – all else being equal – at all levels of inflation and hyperinflation by implementing capital maintenance in units of constant purchasing power in terms of a daily index.

What is new is applying all the concepts together at the same time in terms of a daily index. The results are guaranteed and impossible to ignore.

Also, these measures are coming:  The International Accounting Standards Board voted unanimously in May 2012 to submit a draft IFRS ´X` CAPITAL MAINTENANCE IN UNITS OF CONSTANT PURCHASING POWER (I submitted it to the IASB in January 2012) to research. This new IFRS (which I expect to be authorized in 6 to 8 years´ time after the IASB´s very thorough due process procedures) will require (not optional) capital maintenance in units of constant purchasing power in terms of a Daily Consumer Price Index or other daily index in countries with annual inflation equal to or greater than 10 percent and cumulative inflation equal to or greater than 26 percent over three years.

I am simply saying to Iran: implement capital maintenance in units of constant purchasing power and daily inflation-adjustment of your entire money supply in terms of a daily index now instead of in 6 or 8 years time when at least the accounting part will be required, in any case, by the IASB . The benefits of the Daily Index Plan are enormous and last for an indefinite period of time – forever.

Daily inflation-adjustment of all monetary items in terms of a daily index can be inferred from the fact that the stable measuring unit assumption is never implemented under capital maintenance in units of constant purchasing power. Thus, all the above concepts and measures can be said to be accounting or financial reporting concepts and measures and do not need the intervention of the Central Bank. However, the effects of the daily inflation-adjustment of all monetary items in terms of a daily index would ideally require the collaboration of the Central Bank.

Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

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