While it is increasingly clear that the `rouble zone' is no longer a suitable institution for the conduct of macroeconomic policy in most of the former Soviet Union (FSU) and is expected to give way to a system of individual currencies, there has been little systematic or comparative research on the experience with new currencies to date. A conference on `The Economics of New Currencies', held in Frankfurt am Main on 28/29 June, provided an opportunity for central bankers and academic researchers to assess the performance of new currencies. The conference was organized by Peter Bofinger, Professor of Economics at the Universität Würzburg and Research Fellow in CEPR's International Macroeconomics programme, and Richard Portes, CEPR Director and Professor of Economics at Birkbeck College, London. Financial assistance provided by the German Federal Ministry of Economics, the Ford Foundation and the Commission of the European Communities under its SPES programme and the generous hospitality of the Landeszentralbank in Hessen are gratefully acknowledged. A volume of papers presented at the conference is now available from CEPR.*

Peter Bofinger, Eirik Svindland (Deutsches Institut für Wirtschaftsforschung, Berlin) and Benedikt Thanner (Ifo-Institut für Wirtschaftsforschung, München) opened the conference with `Prospects of the Monetary Order in the Republics of the FSU'. They noted that coordination problems arising in the `rouble zone' now require a choice between establishing a currency union or introducing new currencies in each republic. The FSU is certainly not an `optimal currency area' either in terms of the traditional criteria of that theoretical approach or with respect to the credibility of monetary policy, stability of money demand or control of the republics' domestic credit expansion, which is impeded by their lack of financial market structures. The authors considered alternative forms of inter-republican monetary cooperation with independent currencies based on an `ERM-type' system and a payments union. They criticized the planned Interstate Bank, which perpetuates the status quo and is based on the unstable Russian rouble.

Holger Schmieding (IMF) rejected the authors' proposed economic criteria and stressed the role of political authority in defining an optimal currency area, which can only be found in the individual republics. Also, experience in Latvia and Estonia runs against the view that financial market imperfections prevent the conduct of sound macroeconomic policy. John Flemming (European Bank for Reconstruction and Development) suggested that IMF programmes should consider the consolidated public sector deficit rather than the fiscal deficit; non-performing assets could then be removed from bank balance sheets without increasing the deficit figures.

Thomas Wolf (IMF) presented `Introducing New Currencies in the Republics of the FSU: A Survey' by Ernesto Hernandez-Cata, which described how the coexistence of fully-fledged national currencies, parallel currencies to the rouble and a `rouble zone' has aggravated inflation in the republics, which must now choose a a common monetary policy or separate currencies. He enumerated the steps required for such currencies to establish monetary stabilization and efficiency and argued that reducing inflation will require tight fiscal control irrespective of the exchange rate system. Finally, he discussed the implications of pegging at a fixed rate and adopting intermediate targets under a float.

John Flemming argued that monetary centralization without adequate capital markets would require fiscal centralization and a surrender of the republics' political autonomy. A predetermined crawling peg may also improve on a fixed rate as a nominal anchor; it is less sensitive to the initial parity, less prone to speculation, and entails less tension with the IMF-supported commitment to positive real interest rates. Current account convertibility with strongly negative rouble real interest rates also leads to `internal capital flight', since exporters are permitted to retain proportions of their hard currency earnings. Pekka Sutela (Bank of Finland and University of Helsinki) stressed the role of political factors; the Estonian example shows that a new currency may make stringent stabilization policies more acceptable. Daniel Gros (Centre for European Policy Studies, Brussels) explained that rouble zone membership had been attractive to other republics, since it allowed them access to cheap Russian oil and low-interest credits.

Presenting `The Estonian Kroon: Experiences of the First Year', Ardo Hansson (Stockholm School of Economics and Bank of Estonia) first described how the kroon was introduced with a one-off exchange for roubles and then pegged by law at a fixed rate to the Deutschmark. There was a steep GDP decline and inflation fell more slowly than expected, but Hansson nevertheless judged the post-reform macroeconomic policy an overall success in its achievement of stability and convertibility. There is already a resurgence of economic activity, but certain conditions specific to Estonia its large gold reserves, small size and balanced budget imply that only a few republics of the FSU can copy its example.

Adam Bennett (IMF) emphasized that these positive effects also reflect trade and price liberalization. Nominal interest rates should eventually converge towards the German level as enterprise creditworthiness improves, but inflation will still remain higher on account of the fast productivity growth expected in manufacturing and other export industries. Peter Bofinger stressed the output costs of tight monetary policies; the real GDP decline is much more pronounced in the Baltics than elsewhere in the FSU or Central and Eastern Europe. Michael Bruno (Hebrew University of Jerusalem and CEPR) noted that Estonia's economic transformation was a classic textbook case of a successful stabilization programme based on political and social consensus, immediate and credible fixing of the currency, reduction of inflation to a low but sustainable level and a safety cushion of foreign exchange reserves.

In `The Break-up of the Rouble Zone and Prospects for a New Ukrainian Currency: A Monetary Analysis', Marcus Miller first described how Russia's loss of control over rouble zone monetary policy had led other republics to issue their own currencies. The `free rider' problem which arises as each seeks the `local' benefits of deficit spending requires centralized fiscal control or a new currency in each republic. Focusing on the latter case, Miller described a monetary model of the linkages among deficits, money creation and inflation which he used to consider how the republics' current and expected deficits determine their inflation and exchange rates. This approach pointed to the close link between monetary and fiscal policies; introducing a new currency will only succeed if fiscal deficits are reduced.

Heiner Flassbeck (Deutsches Institut für Wirtschaftsforschung, Berlin) stressed the importance of incomes policies in transition, without which de facto wage indexation may impede macroeconomic stabilization. Holger Schmieding maintained that there is no such wage problem in Ukraine, and many participants noted that indexation does not play a major role in Russia; tight credit policies may therefore suffice for stabilization.

Joze Mencinger (University of Ljubljana) then presented `The Experience with the Tolar in Slovenia', in which he first related Yugoslavia's disintegration to the federal government's failed stabilization policy. Independent monetary policy required the conversion of the dinar into the Slovenian tolar, which took place at a 1:1 rate to minimize technical problems and incentives to counterfeit the new notes. Slovenia possessed no foreign exchange reserves and therefore could not credibly peg the tolar to a stable currency or install a currency board; it therefore adopted a floating rate. Stringent central bank control of domestic credit caused foreign currency transactions to become the main channel of money creation. The independent central bank has been very successful so far in pursuing its monetary policy and reducing inflation.

Saul Estrin (London Business School) criticized Mencinger's lack of attention to fiscal policy, which had also contributed to the success of stabilization. Slovenia is also a very special case of transition, since it has benefited from a significant influx of foreign investment, its level of economic development was the highest in the former communist world, and its trade orientation already very westward before 1990.

In `The Experience with the Latvian Rouble and the Lats', Einars Repse (Bank of Latvia) focused on the reform of the banking system and the introduction and stabilization of a new currency. The Latvian rouble was introduced to cope with a shortage of Russian rouble banknotes, and it also brought greater independence from the Russian authorities. The Latvian rouble was first stabilized and then gradually replaced with the sovereign currency, the Lats, and both now coexist. Repse stressed that the introduction of the Lats was not a separate currency reform, but a simple substitution for banknotes denominated in Latvian roubles.

Discussion focused on the lack of clear rules in the Bank of Latvia's monetary policy. Michael Bruno emphasized that a strategy of targeting reserve money could prove too tight if there is a strong substitution from foreign exchange deposits into the national currency. Peter Bofinger asked why the Bank of Latvia had allowed a nominal appreciation of the Latvian rouble vis-à-vis the Deutschmark. Repse replied that a stable Deutschmark exchange rate would have resulted in higher Latvian inflation.

In the concluding panel discussion on `How to Make Inconvertible Currencies Convertible', Peter Bofinger emphasized the need to consider the real costs of different stabilization strategies in transition. There has been remarkably little monetary cooperation among countries issuing new currencies to date, while macroeconomic stabilization in Russia is essential to any institutional arrangements to enhance it. Michael Bruno noted that Israeli experience shows that stability is more important than convertibility. With unstable money demand, only the exchange rate can provide an adequate nominal anchor, although many transforming economies initially adopted floating rates since they lacked foreign exchange reserves. Daniel Gros advocated the Interstate Bank as a second-best solution for those countries that cannot achieve immediate convertibility. This would stop monetary disintegration and allow multilateral clearing of trade transactions and a more efficient inter-republican payments system. Dariusz Rosati (UN Economic Commission for Europe, Geneva) stressed the need for early convertibility to allow the import of an undistorted price structure and foreign competition and to enhance the overall credibility of macroeconomic policy. A strong devaluation and high interest rates are essential to the initial peg's credibility and the establishment of equilibrium.

* This volume also contains selected discussions, an introduction by Peter Bofinger, and a report of the concluding panel discussion. To order your copy of The Economics of New Currencies, please send remittance for £15.00/$30.00 to: CEPR Discussion Papers, 90-98 Goswell Road, London EC1V 7RR.