Monday, 3 December 2012

Daily Index Plan removes country risk from exchange rate

Daily Index Plan removes country risk from exchange rate

The 17 countries in the European Monetary Union are, in practice, “Dollarized” in terms of the Euro. They have stable monetary economies (one third of their economies: the non-monetary economy being made up of the constant and variable item economies), but their central banks have no independent monetary policy capability. The European Central Bank is not a federal central bank: in principle, it is the German Bundesbank in disguise. The Euro is a monetary policy straight-jacket for 16 EMU countries, not for Germany. As long as the 17 balance (or get close to balancing) their government spending with receipts, the Euro is stable and first level Euro countries like Germany and Holland can grow, while – at the exact same time - countries like Greece and Portugal are in recession to the great detriment (maybe for the next 10 to 15 years) of the populations of these countries as a result of no federal political system in the European Union which most probably will never come about (e.g., Portugal and Greece are not East Germany who received 100 billion Euros per annum in development funds for years). The Euro is good for Germany in all respects, not for Portugal and Greece in expansionary monetary policy capability which is zero under the current EMU set up. The Euro is simply the Deutche Mark in European colours.

The central banks of Portugal, Greece and Ireland cannot implement the very successful US and Japanese policy of unlimited credit (what Portugal and Greece actually need now) during an economic crisis or monetary easing like the US does or create 6 percent inflation (the upper inflation target in a growing economy like South Africa, for example) via simply, sovereignly creating new money on a temporary basis (to be removed later on from the money supply: see US quantitative easing) in their monetary economies. Portugal and Greece would be able to do that if we were to first adopt the Daily Index Plan and then leave the European Monetary Union while remaining in the European Union like the United Kingdom.

In exactly the same way as Belgium can have no government for two years (completely secure with a completely open economy in the heart of the Europe Union), so can Portugal and Greece leave the Euro Monetary Union after first implementing the Daily Index Plan while staying in the European Union. The IMF is always there in the background as a backstop to avoid sovereign default. The ECB and the European Commission are not critical for this purpose: see the mission of the IMF.

The individual EMU country risk has thus been removed from the Euro exchange rate by “Dollarizing” EMU countries in terms of the relatively stable Euro. The individual country risk is now reflected in the individual country´s government bond interest rate: the new country risk paradigm.

The same would happen under the Daily Index Plan in any economy with a Daily CPI fully reflecting a currency´s foreign exchange exposure during low inflation or the US Dollar daily free-market exchange rate being used as the actual Daily Index during high and hyperinflation. With daily indexing the entire constant item economy and daily inflation-indexing of the entire monetary economy, the monetary economy and constant item economies would be “Dollarized” in terms of a constant (not nominal) local currency unit always being exactly equal to the US Dollar when the USD free-market exchange rate is used as the Daily Index during high and hyperinflation, but the local Central Bank would have completely autonomous monetary policy capability.

Whenever the foreign exchange rate (USD parallel rate during hyperinflation) would change it would immediately be fully reflected in the entire economy by all constant items and all monetary items automatically being indexed to the new foreign exchange value via the Daily CPI or the actual US Dollar daily exchange rate being used as the Daily Index (as Brazil did for 30 years with their daily indices). It would make no difference to stability in the local economy: all constant items and monetary items would be automatically indexed on a daily basis: in principle, what Brazil did for 30 years in their constant item economy and part of their monetary economy (Brazil did not inflation-adjust their entire money supply during the referred period) from 1964 to 1994 during very high inflation and hyperinflation.

This would remove the country risk from the exchange rate: the constant and monetary economies would be “Dollarized” in terms of a constant (indexed) local currency unit, with a Central Bank with full monetary policy capability. The country risk would be reflected in the government bond interest rate as it is now (2012) happening in Greece, Portugal and Ireland in the EMU.

Two countries (or monetary regions) both implementing the Daily Index Plan would have an almost permanently fixed foreign exchange rate between the two countries with their individual country risks being reflected in each government´s bond interest rate.

The Daily Index Plan would thus generally lead to very low inflation immediately after its introduction – all else being equal - in hyperinflationary countries because of the use of the daily US Dollar free-market exchange rate as the Daily Index in the entire economy (as it happened, in principle, in 1994 in Brazil with the Real Plan).

(The EU part of this article is obviously influenced by my Portuguese self-interest.)

Nicolaas Smith

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