The word "Lebanon" has become synonymous with political anarchy and a failed state.  It's been that way since the 1970s, when the country slid into years of civil war.  Even though Lebanon has long been at peace, it has never been able to climb out of its hole.  It is chronically buffeted by one setback after another.  Today, it is mired in a general economic crisis.  It's been without a government for 18 months, the economy is in free fall, nobody knows what the Lebanese currency is worth, and the youth are desperate to emigrate.

Religious group distribution in Lebanon.
Credit:  Sergey Kondrashov CC BY-SA 3.0 license.

The situation is so acute that one observer has ventured that Lebanon should volunteer itself to be placed under a United Nations trusteeship.  That would mean foreign experts would come in and run things the Lebanese can't seem to run themselves.  That may be a bridge too far, especially for Hezb'allah, the powerful Shiite Muslim militia backed by Iran, which would not want foreigners poking around.  Still, the idea echoes a theme often heard whenever the Lebanese talk about their predicament: if we can't solve our problems ourselves, then bring in the foreigner who can do it for us.

Ironically, there is a way Lebanon can bring in an authority that would stabilize the economy and stop the downward spiral of the Lebanese pound.  It is something the Lebanese can do themselves.  All it takes is a decision: Lebanon must set up a currency board.  That idea has long been on the table, but the government, paralyzed by political and sectarian divisions, has never acted on it.

A currency board is a monetary authority whose only purpose is to fix the value of one currency to that of another currency.  In Lebanon's case, it would mean fixing the value of the Lebanese pound to the U.S. dollar.   In the last 18 months, the pound has lost 90 percent of its value, resulting in a dizzy spiral of soaring prices.  According to Steve Hanke, an economist at Johns Hopkins University, Lebanon has become the first Middle East country to experience hyperinflation.  It's now in the same category as other monetary basket cases like Venezuela and Zimbabwe.

For decades, the U.S. dollar commonly circulated alongside the Lebanese pound, and even small merchants would think nothing of making change from one currency into the other.  No more.  Today, Lebanon is a real-time experiment demonstrating the truth in Gresham's Law, the old adage that holds that bad money drives out good.  Dollars have disappeared from the market; the Lebanese are hoarding them.  Black-market moneychangers have emerged to satisfy the demand of those who need dollars.

By contrast, currency boards have been used with great success around the world, most notably in Hong Kong and in several East European countries (see here).  "There has never been a currency board that has failed," says economist Hanke.  To this one might add: as long as it adheres to the rules.  But the rules are automatic and simple:

— If the Lebanese pound decreases in value against the U.S. dollar, the currency manager would sell dollars (or bonds denominated in dollars) on the open market.  The pounds would then be taken out of circulation and extinguished, thus reducing the supply.

— If the Lebanese pound rises in value against the U.S. dollar, the manager would buy dollars (or bonds denominated in dollars).  This would inject pounds into the system, thus increasing the supply.

— If the Lebanese pound is stable against the dollar, do nothing.

That's basically how a currency board would work.  The mechanism requires an official price for the two currencies so that the currency manager can measure if the Lebanese pound is gaining or loosing value.  Parity can be established in as little as a month after the government moves to set up the currency board.  During that time, the currency-managers would review the price action to fix the exchange rate when operations begin.  They would also need to be funded with reserve assets — debt instruments in both pounds and dollars — in order to buy and sell.  The currency board could be part of Lebanon's central bank, or it could be set up apart from it.  It would be up to the Lebanese government to decide where to locate it and how to fund the initial balance sheet, but the important thing here is to understand what went wrong in the past and how a currency board can fix it.

In the old system, the Lebanese pound was merely "pegged" to the dollar.  For years, the wise men at Lebanon's central bank told everybody they could buy dollars at the bank at a certain rate.  But all pegged exchange rate systems are fragile and prone to failure.  When the public sensed that the central bank could not indefinitely maintain the peg, the Lebanese pound began to weaken until the whole system collapsed.  The missing piece in all this was the failure of the central bank to take pounds out of the system when they were sold for dollars.  Lebanon's wise men did not properly adjust the money supply.  A currency board fixes that.  It would remove Lebanese pounds from the system whenever citizens signal they prefer to hold dollars.

A currency board is not like central bank.  It does not make loans to the government or fiddle with interest rates or worry about trade imbalances.  It has no discretionary monetary policy at all.  It performs only one task: to buy and sell Lebanese pounds and U.S. dollars so that the marketplace is cleared at the parity price.

Here is where the "external actor" comes in.  If you stop to think about it, a currency board would mean that the Lebanese people would "outsource" monetary policy to the U.S. Federal Reserve Bank.  The "pound" and the "dollar" would then be two different words signifying the same underlying reality.  They would be interchangeable at the parity price.  In this way the rate of inflation and the interest rates experienced in the U.S. would be the same inflation and interest rates in Lebanon.

Nathan Lewis, the economist and gold standard advocate, would remind us that a currency board is only as effective as the target currency it's linked to.  Today, it cannot be said that the U.S. dollar itself is a stable store of value, with the Federal Reserve injecting a tsunami of dollars into the global economy.  A currency board would succeed in linking the Lebanese fiat currency to the American fiat currency.  It would be like riding in a small boat on the open sea towed by a big ship without a compass.  The passengers don't know where they're going, but they're all going there together.

James Soriano is a retired Foreign Service officer.  He has written previously for American Thinker on monetary affairs.

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