What can Macedonia's National (Central) Bank Learn from Israel

By: Sam Vaknin, Ph.D.

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As early as April 1998 I predicted in the various media that the denar - if not first devalued by the Central Bank - will be devalued by the people. I predicted a rate of 38 to the DM by the yearend.

Since then the Central Bank attacked me and labelled me "a charlatan", non-professional and irresponsible. I wonder what they say now, faced with the collapse of their flawed policies.

The Macedonian Central Bank has just announced a series of measures which might have a grave and lasting adverse impact on the Macedonian economy.

Step one: it has limited the amount of foreign exchange that people can buy. Thus the policy of liberal exchange rates regime has been dumped. What are people supposed to believe? Should they believe the Central Bank's statements that the denar will remain stable (which it has not, as I predicted) - or should they believe that the Central Bank is worried, as indicated by its latest measures? If there was no panic until now - this single misguided step can surely bring it about.

Step two: it intends to limit the amount of money supply. This decision is no less than bizarre. The Macedonian economy is one of the less liquid economies in the world. People do not get paid on time, enterprises owe each other mountains of souring debts, the default rates are fantastic and banks are crumbling under the weight of their own bad loans. Reducing the supply of money now is like bleeding to death a victim of severe haemorrhage. It is absolutely wrong.

Step three: subsidizing an unrealistically low exchange rate. Other countries - much stronger and much richer than Macedonia - tried and failed. Macedeonia will also fail. The denar needs to be devalued and it will be devalued. Either the Central Bank will do it in an orderly manner - or the Man in the Street will force the Central Bank to retreat and to devalue hastily (and to a much higher exchange rate).

The Macedonian Central Bank is one of the most autonomous in Central and Eastern Europe. It is also heavily influenced by current economic fashions. These fashions were propagated and disseminated throughout the world by the IMF in the last two decades with disastrous consequences. The IMF (and most central banks) are obsessed with the attainment of low inflation and macroeconomic stability. These goals are commendable - but when pursued too zealously they are deflationary, recessionary and contractionary. Naturally, inflation tends to be lower when the economy contracts. Perfect macroeconomic stability is achieved only in a graveyard. Coupled with free capital flows this recipe is downright dangerous. But the Macedonian Central Bank finds it convenient to hide behind the skirt of the IMF. IMF-ism replaced Communism and the instructions come now from Washington instead of Belgrade.

The sequence is simple and inevitable - but, luckily, fully reversible. Governments are inclined (justly) to increase deficit spending to reflate the economy in times of recession. This is a counter-cyclical Kenseyan reflex. Money is injected to a languishing economy through the budget. The central bank tries to counterbalance the "deficit poison" by applying an antidote of high interest rates. Money supply is reduced sharply. High interest rates attract speculative "hot" money. Where free capital flows are permitted - foreign speculative funds will drive down the exchange rates of the domestic currency versus foreign currencies. Where capital flows are more restricted, domestic corporations will borrow in foreign exchange and invest in high yielding domestic currency deposits and bonds. These effects are mercifully minimal in Macedonia due to its relative insulation from international capital flows.

A currency bubble followed the wrong policies of the Central Bank in Macedonia. When it bursts - the whole economy will suffer. Witness the Asian Tigers - now reduced to paper tigers.

The overvalued currency damages the economy twice: once while it is overvalued and once when it is sharply devalued by market forces. While overvalued, it encourages imports and discourages exports. It distorts the allocation of economic resources - investors prefer to speculate rather than to invest in industry or services. The high interest rates required to maintain the unrealistic exchange rate stifle all economic activity. True, inflation is held at bay by an influx of cheap imports and by a reduction in the money supply. Simply: less money available to buy goods and services translates to lower prices.

But this is artificial. the "missing" inflation is merely pent up. Ultimately, the economy is discernibly damaged by this policy and people begin to get rid of the domestic currency. As inflation is subdued, interest rates have to come down - making the currency much less attractive. A rapid devaluation followed by inflation are the results. The whole economy is destabilized.

For years, the central bank of Israel, headed by the venerable economist, Prof. Jacob Frenkel, has prescribed these medicines to the ailing Israeli economy. Interest rates were kept abnormally high. The New Israeli Shekel appreciated by 50% in real terms in four years.

Inflation went down from an average annual level of 18% to 4% currently. But the price was dear: a stubborn unemployment rate of c.10%, a financial bubble which burst with tremendous economic impact, the influx of c.10 billion USD in speculative "hot" money (including money from questionable sources), a current account deficit of 6-7% of GDP (discounting unilateral transfer from the USA and the World Jewry) and, in the last two years, a stagnant economy. Finally, the currency gave in: it depreciated from 3.72 to 4.32 to the USD in a matter of two weeks. Inflation will soon follow. So what was it all for?

This is the question that resounds now throughout the world. Fiscal austerity and monetary restraint are not an ideology to be applied dogmatically and intransigently. They are weapons in an arsenal. They should not be relied on exclusively. Otherwise, the battle is lost.

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