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May 1, 2002

Federal Reserve Bank of Cleveland

Why Is Stable Money Such a Big Deal?
by David E. Altig

n Wednesday, July 10, 1940,
Adolf Hitler’s Luftwaffe attacked
British air bases along the coasts of
Scotland and eastern and southeastern
England. Four months later, the Battle
of Britain was over, bringing an end
to German hopes of direct military
conquest of the British Isles.

rency, and eventually, the counterfeiting
program shifted toward financing various clandestine Nazi activities outside
the United Kingdom. Ironically, this
shift in the operation’s focus was made
possible precisely because the initial
goal of undermining the pound’s value
was not realized.

But the end of the air raids would not
end the attack on the United Kingdom.
Shortly after their defeat in the Battle of
Britain, the Germans began to produce a
new weapon that, while less obviously
violent than Luftwaffe bombs, was recognized as no less virulent. That weapon
was counterfeit British pounds.

Operation Bernhard is a particularly
interesting example of the use of counterfeiting as warfare, but it is by no
means unique or unprecedented. One of
the earliest known instances of counterfeiting as a weapon occurred during the
city-state conflicts of Renaissance Italy
(the historical period that would inspire
Machiavelli’s The Prince). The instigator in this case was one Galeazzo Sforza,
a Milanese duke, who in 1470 (when
Machiavelli was an infant) attempted to
undermine the economic well-being of
his enemies in the rival city-state of
Venice by adding counterfeiting Venetian currency to the corpus of general
treachery that he regularly practiced.
(History records the duke as a particularly odious character, whose cruelty led
to a successful assassination plot by
Milanese elites in 1476.)

Operation Bernhard, as the counterfeiting enterprise would be known, was
named for Bernhard Kruger, the SS
officer who oversaw the production of
the bogus notes by slave labor in the
Sachsenhausen concentration camp near
Berlin. By contemporary accounts, the
plan resulted in the manufacture of
about £150,000,000 in counterfeit notes
of various denominations—in the neighborhood of $7 billion by today’s standards. Kruger’s operation enlisted the
support of known counterfeiters as well
as professionals and skilled tradesmen
among the camp’s population. It incorporated production techniques that ran
the gamut from detailed material analyses to the manual labor of prisoners who
“seasoned” the bogus bills by passing
them from one another, folding and
soiling them to give them a realistic
worn appearance.
The objective was simple, devious, and
pernicious: To undermine public confidence in the pound and, by so doing,
irreparably damage the British economy.
In the end, the plot did not succeed in
destroying confidence in Britain’s curISSN 0428-1276

There are many, many more examples—
some of them listed in table 1—extending through to modern terrorist aggressions. The ubiquitous impulse to
undermine the value of, and confidence
in, the currency of one’s enemies is
testament to the indispensable role of a
stable and reliable monetary standard in
modern economies. In fact, so broad
and deep is the potential damage of a
successful counterfeiting campaign,
some reports indicate that professional
German military officers initially
opposed Operation Bernhard partly on
the grounds that it constituted an unacceptable attack on civilian populations.

What do attempts to counterfeit an
enemy’s currency during wartime
have in common with decisions to
adopt another country’s currency
during peacetime? Both are inspired
by the power of a stable monetary
standard and, conversely, the consequences of losing it. Both illustrate
why preserving the value of the
nation’s currency is a central bank’s
most important responsibility. This
Commentary is based on a speech
given (jointly with Mike Bryan) to the
Cleveland City Club New Leaders
group on February 19, 2002.

■

Buying Credibility

Counterfeiting as weaponry is a powerful illustration of the value of stable
money, but it may not be the most uplifting example. More hopeful lessons may
be found, not in the attempts of those
who would steal monetary credibility,
but in the aspirations and efforts of those
nations who seek it.
Until recently, Argentina was held out
as one such example. The protracted
downturn of the Argentine economy and
recent dissolution of its currency board
have contributed to a chorus of commentary that is critical of both the objectives
and methods for economic revival
adopted by the Argentine government
in the early 1990s.
But the country’s recent travails obscure
the remarkable early successes of the
monetary reforms implemented at the
onset of the last decade. Between March
1989 and March 1990, the rate of inflation in Argentina exceeded 20,000 percent. The government responded by
promising to fix the value of the peso
such that it would trade one-for-one

with the dollar. This was much more
than a simple commitment to target the
exchange rate. By adopting the currency
board, the government promised to back
circulating pesos with dollar-denominated assets, providing a constraint on
money creation and the inflation that
follows from too much of it.
The cost that establishing a currencyboard-like institution entails bears
emphasizing. To back pesos with dollardenominated assets, the government has
to acquire them first. There is really
only one way any country can accumulate the currency of another country, and
that is to give up real goods and services
in exchange. Normally, a country that
exports more than it imports today will
do so only if it anticipates being compensated with imported goods and services sometime later. But not so with
the creation of a currency board, for the
receipt of the dollar assets today is not
intended to finance the purchase of
future goods and services. The assets
instead remain in reserve to fund the
currency board, and the exports traded
for dollars today are simply the price of
buying credibility.
For years Argentina’s purchase of credibility appeared to be a wise one. The
country’s inflation rate plunged almost
immediately, and by 1998 inflation was
a mere 1 percent. Furthermore, after
stagnating for decades, the economy
expanded at a pace of over 41/2 percent
per year.

■

Necessary, but Not Sufficient

Even at the height of success, however,
there were indications that the currency
board was not an absolute panacea. The
perception that the peso remained a relatively risky bet was hard to shake, and
investors in peso-denominated securities
demanded higher interest rates as compensation for bearing this risk. What’s
more, the magnitude of the risk premia
tended to be quite volatile, suggesting
that the economy remained susceptible
to speculative attack.
In January 1999, then-President Carlos
Menem proposed complete dollarization, in effect eliminating the peso
entirely. Although dollarization would
have had little technical advantage over
the existing currency board arrangement, many proponents of dollarization
argued that markets had retained some
residual doubt about the long-run
viability of the board, doubts that only

complete elimination of a circulating
peso would vanquish.
But the drive for dollarization was not
to be, and the fears that the currency
board would prove unstable were all too
prophetic. As of February 11, the peso
was wholly untethered from the dollar,
and the last vestiges of the currency
board, in the process of being dismantled
since late last year, were finally reduced
to rubble.
The advocates of dollarization may have
seen it coming. Argentina had begun the
recession from which it has yet to
recover in mid-1998, as fears mounted
that the faltering Brazilian economy
would place irreparable strains on the
Argentine economy. The problems of the
country, however, appear to be more fundamental than the details of its monetary
arrangements. Writing in the January 9
edition of the Wall Street Journal, the
Cato Institute’s Brink Lindsey quoted a
survey conducted by Harvard University
and the World Economic Forum’s 2000
Global Competitiveness Report showing
that, of 59 countries studied, Argentina
ranks “40th in frequency of irregular
payments to government officials; 54th
in the independence of the judiciary;
55th litigation costs; 45th for corruption
of the legal system; and 54th in the reliability of police protection.” (The questions of the survey were asked such that
high numbers are bad.)
These statistics reveal an overwhelming
fault in Argentina’s political infrastructure. It is not surprising that truly independent central banking could not be
sustained in such an environment. As if
to underscore the point, the disintegration of the currency board took shape in
May 2001 when Fernando de la Rua dismissed Pedro Pou, the central bank governor, for resisting attempts to weaken
the country’s promise of peso parity with
the dollar.
In the case of Argentina, the reforms that
gave rise to the currency board were not
sufficient in the absence of broader institutional reform. But that fact should not
mislead us into the false belief that longterm prosperity can be achieved in
Argentina (or any country) without a
strong, stable, and credible monetary
standard. A currency board, dollarization, or the like may not be a sufficient
condition for prosperity, but it is certainly a necessary one.

■

A Sacred Trust

The story of Operation Bernhard—but
one example among many instances of
counterfeiting in times of war—gives us
an idea of the perceived damage that can
be inflicted on an economy by undermining confidence in the country’s ability to maintain a stable purchasing
power of money. So crucial is this confidence that counterfeiting attacks appear
to be nearly as common a weapon in
warfare as bombs and bullets.
The example of Argentina underscores
the large gains that price stabilization
can bring. But it also illustrates how difficult it can be to obtain credibility when
it is absent, and how tenuous its footing
can be once attained.
Central bankers often emphasize that
their core long-run responsibility is protecting the purchasing power of money,
and that maintaining price stability is the
primary way that monetary policy can
contribute to sustainable long-run
growth. It can be difficult, perhaps, to
appreciate the power of these sentiments
in an environment where the value of
money does not appear to be seriously at
risk. But to consider the alternative—to
consider the motivations of nations that
would steal that value from their enemies and the distress of those nations
that lose it—is to understand why protecting the credibility of an economy’s
monetary standard is the mission of a
central bank.

■

Changing to Stay in Place

The issue is not one of trading the gains
of price stability against other objectives
of monetary policy. The key point is that
none of those other objectives can possibly be met if the public isn’t convinced
that the central bank will fulfill its
responsibility to protect the purchasing
power of money.
Unfortunately, the perception that monetary policy objectives conflict with one
another is held by too many too often. In
particular, people believe that containing
inflationary pressures requires a central
bank to restrain economic growth. This
perception is reinforced, I think, by a
general misunderstanding of federal
funds rate decisions, the monetary policy actions that are most visible to the
public. Specifically, people are confused
about the distinction between changes in
the federal funds rate that are designed
to engineer changes in the real economy
versus changes that are reactions to

TABLE 1 EXAMPLES OF COUNTERFEITING IN WARFARE

Conflict

Entity engaged in
counterfeiting

Italian city-state conflicts (1423–1508)
American Revolution (1775–83)
Napoleonic Wars (1805–12)

Milan
Britain
France

Mexican–American War (1846–48)
U.S. Civil War (1861–65)
World War I (1914–18)
Bolshevik Revolution (1917–21)
World War II (1939–45)

Mexico
United States
Britain
White Army
Britain

Germany

Japan
United States

Bay of Pigs Invasion (1961)
Vietnam War (1964–73)
Terrorist activities (1990–96)

United States
United States
Unknown

Currency counterfeited
Venetian ducat
Colonial currencies
Austrian Banco script notes
Russian rubles
Republic of Texas dollars
Confederate States of America dollars
Turkish lira
Russian rubles
Burmese rupees
Chinese yuan
German reichsmarks
Malaysian dollars
British pounds
French francs
Hungarian pengos
U.S. dollars
Yugoslav dinars
Chinese yuan
Burmese rupees
German reichsmarks
Japanese yen
Cuban pesos
North Vietnamese dong
U.S. dollars

Sources: Counterfeit Notes of War, <http://currency_den.tripod.com/War_Counterfeits/war.html>,
accessed April 8, 2002; “Counterfeit U.S. Currency Abroad: Observations on Counterfeiting and U.S.
Deterrence Efforts.” 1996. Testimony of JayEtta Z. Hecker to the House Subcommittee on General
Oversight and Investigations, Committee on Banking and Financial Services, GAO/T-GGD-96-82,
U.S. General Accounting Office.

changes in the real economy. Chairman
Greenspan made these distinctions clear
during his March 7 testimony before
the Senate Committee on Banking,
Housing, and Urban Affairs.
“We did raise interest rates in 1999, and
the reason we did is, real, long-term
rates were beginning to rise because the
economy was beginning to accelerate.
Had we not raised the federal funds rate
during that particular period, we could
have held it in check only by expanding
the money supply at an inordinately
rapid rate...”
To put the idea in a slightly different
way, in some circumstances changes in
the federal funds rate are nothing more
than the adjustments required to strike a
neutral stance in monetary policy. This
is the theme of the Chairman’s comments above, a theme explored at length
in the economic essay of this year’s Federal Reserve Bank of Cleveland Annual
Report. It is a motivation for central
bank interest rate policy that needs to be
better understood.

■

You Don’t Know What
You’ve Got ‘til It’s Gone

The day will come when the Federal
Open Market Committee will again see
fit to raise the federal finds rate. The
magnitude, timing, and precise rationale of these changes are, of course,
uncertain. But the basic issues are not.
Nations attack their enemies by attempting to undermine confidence in their
adversaries’ currency. Governments pay
tangible costs in goods and services to
attach themselves to credible foreign
monetary standards, and pay yet more
when those arrangements prove insufficient to instill confidence in the country’s currency. All of this is everywhere
and always about the purchasing power
of money, and the role that sustaining it
plays in promoting economic prosperity.
The public is sometimes confounded by
the willingness of central banks to act
in times when the threat of inflationary
pressures does not appear imminent.
Some of this reflects an underappreciation of the fundamentally defensive

nature of many changes in policy rates,
such as the federal funds rate. Many
times, changes in these rates are mere
reactions to the evolving pressures on
interest rates more generally, designed
to maintain the existing thrust of policy
rather than to “tighten” or “ease.”
But even in those cases where a more
activist stance is implied by particular
policy choices, it ought to be remembered that, ultimately, economic growth
and price stability are not in competition, and that a relaxed attitude toward
preserving the value of money can
quickly devolve into trouble. In the
middle and later parts of the 1960s, stable inflation expectations were taken
for granted and even exploited, ultimately to ill effect. Arguably, the inflationary problems of the 1970s can, at
least in part, be traced to an overly sanguine attitude toward the fragility of
price stability in the 1960s. The proof
that faith in an economy’s monetary
standard is a precious commodity is in
our history, and the history of others,
from Renaissance Italy to Nazi Germany to the United States in the 1970s
to the present situation in Argentina.
The goal of central banks all over the
world is to avoid relearning this lesson.

■

Full text of Economic Commentary (Federal Reserve Bank of Cleveland) : Why Is Stable Money Such a Big Deal?, May 1, 2002

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