How to establish a credible Iraqi Central Bank: the argument for inflation targeting.

• Author: Cecchetti, Stephen G.
• Position: The World

The vaults of the Central Bank of Iraq have played a role in some colorful news stories that have appeared in recent months. First, there is the claim that on the night of March 18, 2003, one of Saddam's sons made what has been euphemistically described as the "illicit withdrawal" of $900 million in $100 bills, 100 million [euro] in euro notes, and an indeterminate amount of gold bullion. If this actually happened, it was surely quite a job to load this into the three tractor-trailer trucks that it took to cart the money away. And then there is the story of the jewels and gold of the 2,800-year-old Assyrian Treasure of Nimrod that was rescued after workers pumped nearly 700,000 gallons of water out of the flooded main central bank vault in Baghdad.

THE NEW CENTRAL BANK OF IRAQ

If the Iraqi financial system is to develop smoothly, and the Iraqi economy is to rejoin the modern industrialized world, the new Central Bank of Iraq will have to be much more than a storage facility for currency and priceless objects. Together with the post-war occupation government, the central bank will need to manage a transition, crafting the necessary market-based institutions, and then it will have to set in place a framework capable of delivering stable long-term growth.

Before getting to the substance of what the new Central Bank of Iraq needs to do and how it will have to do it, there is an important precondition for success. Every successful financial and economic system is predicated on the idea that investors can keep the fruits of their investments. For this to happen, there has to be a government making and enforcing laws to protect property rights. The Babylonian ancestors of modern-day Iraqis were the first westerners to figure this out when, around 1750 B.C., King Hammurabi created the first recorded rules governing financial operations. What was true four thousand years ago is still true today.

With the legal foundations in place, the central bank will need to focus on meeting two principle objectives. First, it must create an environment in which financial institutions can flourish, insuring stability of the entire system. A banking system that is constantly in crisis is worse than useless. Second, the new Central Bank of Iraq must operate a monetary policy that keeps domestic Iraqi inflation in check. Inflation makes doing business difficult by increasing risk to both borrowers and lenders, and making prices unreliable signals. Low inflation is...