The Choice of Exchange Rate Mechanisms: The Case of Iraq
In the 2000 presidential election campaign, George Bush stated that it was not the
business of the United States to build nations, a position resulting from the dreadful U.S.
experience in Somalia and the extended use of military personnel in Bosnia. His views on nation
building changed, however, with the terrorist attacks on September 11, 2001.
Since the Taliban regime in Afghanistan had been sheltering the Al Queda terrorist
group, the Bush administration took quick action and removed the Taliban from power. The
United States worked through the loya jirga, or grand council, to establish a new government
under President Hamid Karzai.
Next, the U.S., enforcing United Nations Resolution 1441, invaded Iraq and toppled the
regime of Saddam Hussein. As official occupiers of Iraq, the U.S. and its coalition partners
established the Coalition Provisional Authority to run the country until an interim government
could be selected.
In both of these situations, the countries were in tatters and their economies needed to be
reformed or perhaps even reestablished. Under the influence of the U.S., both of these countries
established new currencies and new exchange rate systems.
As Krugman and Obstfeld’s
International Economics textbook states, “Exchange rate stability is more important for the
typical developing country than for the typical developed country” (712). Hence it is important
to analyze the choices available to the United States and Iraq and Afghanistan when deciding the
appropriate exchange rate regime.
The purpose of this paper is to analyze how the United States organized the currency and
exchange rate regimes for the nations that it built since 2001. We find that when the United
States rebuilds a nation’s economy, it sets up a currency system based on its own system in place
at the time. In Germany and Japan following World War II, the U.S. established the Deutche
Mark (DM) and placed both the DM and the Yen in the Bretton Woods financial system. In
Afghanistan and Iraq, we set up independent central banks with floating exchange rate regimes.
The paper will proceed as follows: Section II describes the possible types of exchange
rate systems, Section III gives a description of historical nation building experiences for the
United States; Section IV illuminates the various examples of currency systems in developing countries; Section V describes the main options the U.S. had for Afghanistan and Iraq and
explains the systems chosen; and Section VI provides some concluding remarks.
Types of Exchange Rate Systems
The first objective of this analysis is to define the major types of exchange rate systems.
There are three major types of exchange rate regimes in existence today: the orthodox currency
board, the hybrid currency board (or a fixed exchange rate with a central bank), and a floating
exchange rate. We will describe the three systems and discuss some of the advantages and
disadvantages of each system.
A. Orthodox Currency Boards
An orthodox currency board system is one where there is an established exchange rate
between the local currency and an “anchor” currency. The currency board uses the nation’s
foreign reserves to keep the exchange rate at that same level.
Under the system, there is
absolutely no role for a central bank.
As an example, suppose the Iraqi dinar is pegged to the U.S. dollar at an exchange rate of
2000 dinars = $1. If there is a loss of confidence in the dinar and investors want to sell their
dinars, then the currency board would have to buy those dinars at the board rate. Thus, in a strict
currency board system, the board must theoretically hold enough of the anchor currency (dollars)
to cover all of the domestic currency (dinars) in print.
The result of a loss of confidence in the local currency is typically a reduction in the
domestic money supply. Investors losing confidence in the dinar would exchange their dinars
for dollars. This would result in the board (who bought the dinars) holding less foreign reserves.
Since the currency board would then be holding more dinars, the supply of dinars in circulation
in Iraq would fall. This would presumably have a contractionary effect on the domestic money
supply and the Iraqi economy, perhaps leading to even less confidence in the economy. This
cycle is partially offset in Iraq, however, because dollars are also in common use as currency.
Instead of the usual decrease in money supply, we would simply see a shift from one form of
accepted currency to the other.
The purpose and goal of a currency-board system is a “way to import anti-inflation
credibility from the country to which the domestic currency is pegged” (Krugman and Obstfeld
2000). So, for example, in countries with a history of hyperinflation or countries with limited or
no history with monetary policy (e.g. Baltic countries), this may be a way of boosting initial
international confidence in their economies.
However, in this type of system, there is no monetary policy to speak of since the board
does not hold or deal in any domestic assets. In times of financial distress, there is no central
bank to lend currency to domestic financial institutions. In a financial crisis, the government
would have to have an expansionary fiscal policy.
It could do this by spending money or
possibly having deposit insurance for its banks. This would mean that if the banks went under,
the government would have to use its taxation power to pay back depositors.
B. Hybrid Currency Boards
Hybrid currency boards, on the other hand, are basically currency boards with a central
bank. The local currency is again pegged to an anchor currency such as the dollar; however, the
central bank is able to keep the money supply in the local country at a certain level by sterilizing
the currency board’s transactions.
According to Krugman and Obstfeld in International Economics, “Central Banks
sometimes carry out equal foreign- and domestic-asset transactions in opposite directions to
nullify the impact of their foreign exchange operations on the domestic money supply” (473).
To continue with the example previously mentioned, when there is a loss of confidence in the
Iraqi economy, investors will reduce their holdings of Iraqi dinars, thus causing the domestic
money supply to decrease. However, with their increased holdings of dinars, the central bank
could purchase government bonds or other government assets. This would pump the dinars back
into circulation, thus sterilizing the effect of the loss of investor confidence.
C. Floating Exchange Rates
In the system of floating exchange rates, the value of a currency is solely determined by
the supply of and demand for that particular currency. Unlike the currency board system, this
system does not limit the ability of central banks to influence the value of a currency through
open market operations.
With a floating exchange rate system, central banks can intervene in the currency markets
and influence the value of the world’s currencies. Even though the value of a currency such as
the dinar can move, the movement can be limited by the central bank of Iraq or the U.S. Federal
Reserve. The exchange rate can be managed in order to maintain a relatively stable exchange
rate in tumultuous times, as we will see later in the paper.
The danger of having a central bank is the prospect of political influence in the currency
process. In order to fund its programs, the government may be forced to print money. The
undisciplined printing of money can lead to tremendous bouts of inflation. With high inflation
comes increased incentive to print more money, causing a vicious cycle.
Now that we have looked at the three most common types of exchange rate systems we
can look at what the United States has done in the past when faced with the opportunity to set up
a monetary system in a different country.
Historical Nation Building Currency Systems
The United States had the opportunity to set up currency systems in both Germany and
Japan following World War II. In 1944, world leaders met at Bretton Woods, New Hampshire
and established a new world currency and exchange rate system. This system would come to be
known as the Bretton Woods system of fixed exchange rates. In addition, at Bretton Woods, the
leaders also created the International Monetary Fund (IMF) and the World Bank. The leaders
created the IMF specifically in order to manage the system of fixed exchange rates which they
The Bretton Woods system of fixed exchange rates would survive from 1945 until 1971,
when the United States left the gold standard and let the dollar’s value float against other
currencies. (This occurred mainly due to the persistent balance of payments deficit by the United
States which led to investors decrease their holdings of dollar assets.)
The basics of the Bretton Woods system were as follows: the U.S. dollar was adopted as
the main currency in the world (i.e. the reserve currency); the value of a dollar was set at 1/35 of
an ounce of gold; and exchange rates between the dollar and the various world currencies were
fixed at specific levels.
The United States had the lead role in setting up the new German and Japanese currency
systems, in 1944 and 1949 respectively, and sought to bring those two currencies back into the
world economy as soon as possible. In order to do that, the U.S. brought both countries into the
newly established Bretton Woods system.
In order to avoid a repeat of the hyperinflation seen during the interwar period, the
occupying powers, led by the United States, decided to establish a new currency, the Deutsche
Mark (DM), to replace the existing Reichsmark. The occupying powers wanted to give Germany
a fresh start by creating a brand new currency. The U.S. transitioned Germany to this new
currency by establishing a fixed exchange rate between the old and new currencies. This was set
at one-to-one, and everyone in Germany was given a starting sum of 40 DM. In addition, the
Bretton Woods system set the exchange rate between the dollar and the DM as well.
The decision to place Germany on a fixed exchange rate system seemed obvious: during
the interwar years, Germany had had a floating exchange rate, allowing hyperinflation to roar out
of control. This resulted from a lack of confidence in the governing regime and the exorbitant
amount of currency that was printed in order to fund the government. The U.S. believed that
including Germany in the fixed exchange rate system would bring Germany the economic
stability that it did not have in the interwar years.
With the Dodge Plan of 1949, the United States did for Japan what the Marshall Plan did
for Europe. The U.S. brought Japan out of occupation and into the world system of Bretton
Woods, with a fixed exchange rate set at $1 = ¥ 360.
Current Developing Country Currency Systems
We now need to look at some of the systems currently in use by developing countries to
give us reference points from which to examine the viable options the U.S. had in choosing
exchange rate regimes for Afghanistan and Iraq. Specifically, we will explore the systems of
Bosnia-Herzegovina and Argentina.
Under the Dayton/Paris Treaty, the currency and exchange rate system in Bosnia most
closely resembles a true or orthodox currency board system. Recall that in orthodox currency
board systems, central banks do not have the ability to sterilize currency fluctuations.
The Bosnian currency board system was established on 1 August 1997 with a fixed
exchange rate of one convertible mark (BAM) to one Deutsche Mark (DM). At the introduction
of the euro, this equated to 0.511, an exchange rate still in effect today.
In Argentina, Economy Minister Domingo Cavallo introduced reforms in 1991 which
pegged the Argentine australes to the U.S. dollar at a rate of 10,000 australes to one dollar. In
January of 1992, Argentina converted to a new currency, the peso, which was exchanged at
10,000 australes. Thus, the government established the peso at one-to-one with the U.S. dollar
(U. S. Congress, 4).
The economic crisis in Mexico in 1994 initially lead to worries that Argentina would
devalue the peso, just as Mexico did with their peso. This particular threat to the convertibility
system subsided, but the system was not able to survive its next shock. The Asian financial
crisis started in 1997 with many small Asian countries suffering attacks on their currencies. This
prompted an attack on Russia’s currency, the ruble. The currency crises made investors less
confident about investing in developing countries in general.
On the heels of the Russian crisis, Argentina’s neighbor Brazil initially withstood a
currency crisis of its own. However, in 1999, a new currency crisis hit Brazil, causing the
Brazilian government to float their currency, the real. The real then quickly depreciated against
other world currencies. That, in combination with the increasing strength of the dollar, led to a
dramatic decrease in competitiveness of Argentine products on the world market. Some experts
suspect that these problems were then exacerbated by the unconstructive policies of successive
Argentine governments, leading to the dramatic crisis of 1999 and beyond.
On 21 June 2001, Domingo Cavallo, again acting as Economy minister under Fernando
de la Rua, received approval from the legislature to change the mix of currencies to which the
Argentine peso was pegged. Instead of being pegged at one peso per dollar, the peso would be
pegged to a 50-50 mix of dollars and euros.
At the time, global investors were worried that that such a switch would be the equivalent
of a currency devaluation, since the dollar was stronger than the euro. However, the policy
would not take effect until the euro reached parity with the dollar, which occurred in July 2002.
On 6 January 2002, the government of Eduardo Duhalde ended the convertibility system
of fixed exchange rates and allowed the peso to float freely against other currencies.
exchange rate currently stands at 2.92 pesos to the dollar (as of March 2005).
In summary, under the currency board system of Argentina in the 1990s, the exchange
rate was never truly fixed, but was instead pegged to the dollar. There was, however, some room
for flexibility in the exchange rate. Now we will look at what the U.S. decided to implement in
Afghanistan and Iraq.
Current Nation Building Experiences
In January 2003, the government of Afghanistan established a new currency called the
afghani. The exchange rate from the old afghani to the new afghani was 1 new afghani equal to
approximately 110.45 old afghanis.
In addition, the government, in collaboration with the
United States, adopted a floating exchange rate regime for the country.
According to the Memorandum of Economic and Financial Policies between the
Afghanistan government and the International Monetary Fund of 24 March 2004, “The
government believes that a floating exchange rate regime remains the appropriate choice for
Afghanistan, given the potential for large structural changes in the near future and the associated
difficulties in projecting demand for the Afghani.”
However, ever since January of 2003, the exchange rate between the afghani and the
dollar has been 42.785 afghanis = $1. This leads us to presume that the Afghan Central Bank
(and presumably the U.S. Federal Reserve) have been very active in the foreign exchange
markets keeping the afghani stable. In fact, in the same Memorandum of 24 March 2004, the
Afghan government states, “DAB’s [Da Afghanistan Bank, Afghanistan’s central bank] weekly
auctions will primarily focus on achieving the monetary growth targets, but will try to prevent
large and undesirable exchange rate movements. B. Iraq
With Iraq, there appeared to be three possible ways to manage the currency: use a
currency board system, dollarize (establish the dollar as the local currency), or let the currency
float against other currencies.
The first option the Coalition Provisional Authority (CPA) had for Iraq was a currency
board system. In this case, there would be a currency board which would manage the exchange
rate between the Iraqi dinar and a particular anchor currency.
As was briefly stated above, the major aspects of a orthodox currency board system are:
“1) a fixed exchange rate with an anchor currency, 2) no restrictions on exchanging currency
board currency into the anchor currency at that exchange rate, nor discriminatory exchange rates,
and 3) net foreign reserves equal to 100 percent or slightly more of the currency board’s
liabilities of a monetary nature” (Argy, 19).
There are a few problems with using a currency board to manage the Iraqi currency.
First, it would not allow flexibility in using monetary policy to solve the country’s economic
woes. Second, as Jeffrey Frankel states in the 13 June 2003 edition of the Financial Times, “it
means giving up the automatic depreciation that a floating currency would experience at times
when the world market for the country’s exports were weak.” In the case of Iraq, this would
involve the price of oil. When the price of oil falls, investors have the incentive to remove their
investments from the exporting country’s currency, causing it to depreciate and thus making all
of that country’s exports relatively cheaper and more attractive. In the case of rigidly fixed
exchange rates, the currency would not be allowed to fall and the country would not be allowed
to become more competitive on the world market.
In that same vein, fixing the dinar to the dollar (or even the euro) would allow for the
possibility of one of the same problems experienced in Argentina described above. If the dollar
or euro increased in value, that would force the dinar to appreciate and Iraq would lose
The second option the CPA had was to “dollarize” the economy. This would entail using
the U.S. dollar as the sole currency of Iraq.
Like an orthodox currency board, this wouldeliminate monetary policy as a tool. In addition, the Iraqi government would lose seignorage,
which would instead go to the United States, since the U. S. would be printing the dollars.
A further disadvantage of the dollarization strategy is that it could spread fears of U.S.
imperialism. With all the instability and anti-Americanism in the Middle East, having the dollar
as the currency of Iraq might make matters worse. Furthermore, if there were an increase in
interest rates in the U.S., that could lead to slower economic activity in Iraq and possibly, a
However, a major benefit of dollarization would be reduced currency risk. With the
dollar as the currency, interest rates would be kept low. This would be extremely beneficial to
the Iraqi population due to the increased likelihood of investment in infrastructure and business.The system that the CPA eventually chose was a floating exchange rate system.
practice, the system appears to be a managed float. In this system, the Iraqi dinar is free to move
against all other currencies according to the laws of supply and demand. A report on the Iraqi
economy by the International Monetary Fund in October 2003, states “The Iraqi economy’s
heavy reliance on oil (a commodity that is subject to wide price variations), the near complete
openness of the economy as well as the uncertainty surrounding the fiscal picture and the limited
availability of foreign exchange reserves suggest that, as a long term strategy, a flexible
exchange rate regime is appropriate in these circumstances” (19).
The IMF opinion definitely has merits, although the problem of limited foreign reserves
could definitely be overcome by the U.S. Federal Reserve. Since the introduction of the new
Iraqi dinar in October 2003, the exchange rate with the dollar has been remarkably stable. In
fact, from 21 January 2004 to about 21 January 2005, the exchange rate had basically been fixed
at $1 = 1460 dinars. Since the end of January 2005, the dinar has been allowed to float a bit
more, with an average exchange rate of $1 = 1524 dinars.
In summary, in both Afghanistan and Iraq, the U.S. has established floating exchange rate
systems with significant central bank interventions in order to maintain stable exchange rates
with the dollar.
After looking at the evidence for how the United States sets up currency and exchange
rate systems in newly established regimes, it appears that in each case they set up the system in
place in the U.S. at the time. In Germany and Japan at the end of World War II, it was the
Bretton Woods system of fixed exchange rates. In Afghanistan in 2002 and Iraq in 2003, it was
an independent central bank with floating exchange rates (and significant central bank
The major worry the United States has to deal with in the Iraq exchange rate system is the
confidence of international investors. Now that the United States has handed over sovereignty to
the interim Iraqi government in June 2004 and elections have taken place in early 2005, security
will be critical for maintaining investor confidence. If the transition does not go well, or there is
internal instability, the value of the currency could plummet unless the Federal Reserve is
prepared to buy a significant amount of dinars to keep the currency from falling. So far, the
currency has held its value
A Tricky Operation. The Economist. 26 June 2004. pp. 73-74.
Argy, V. International Economics. 1994 Routledge: New York.
DeRosa, David. Iraq’s Central Bank Faces Stability Question. Bloomberg.com. 27 February
Frankel, J. (2003). A Crude Peg for the Iraqi Dinar. Financial Times, 13 June.
Hanke, S. H. (2003). An Iraq Currency Game Plan. The International Economy. 17(3). 81-83.
Hanke, S. H. On Dollarization and Currency Boards: Error and Deception. Journal of Policy
Reform 5(4). 203-222.
Hanke, S. H., and Schuler, K.
A Monetary Constitution for Argentina: Rules for
Dollarization. Cato Journal 18 (3). 405-419.
Krugman, P. and Obstfeld, M. International Economics, 5
Edition. Harper-Collins: New York.
United States Congress,
Joint Economic Committee (2003).
Argentina’s Economic Crisis:
Causes and Cures.http://www.cbiraq.org/cbs2.htmhttp://www.cbiraq.org/cbs6.htmhttp://afgha.com/?af=article&sid=14687