ECONOMYNEXT – When Taiwan came under KMT rule after communist rule started in China, there were severe balance of payments troubles, and the economy was strangled by import duties like the 20 percent tax that was slammed in Sri Lanka in 2025 to help ‘save reserves’.
The man who helped Taiwan fix its exchange rate and provided stability to take it on a path of industrial investment and exports was a Chinese-American economist called Sho-Chieh Tsiang, who had studied under Friedrich Hayek at the London School of Economics.
In fact, the first free trade zone near Kaohsiung port to escape import duties on inputs, was set up in Taiwan, around the same time as Jurong in Singapore, though the zone proper only took off after Singapore’s separation and free trade in 1968.
Hong Kong always had stable money, free trade and industry. FDI, including to Singapore, initially came from Hong Kong.
Chinese Inflation
Both mainland China and Taiwan had suffered very hyperinflation and high inflation during the war with Japan due to bad central banking.
Inflation also played a big role in bringing communists to power, leading Indian Economist B R Shenoy to advise Nehru not to use the central bank credit and ‘subsidize’ communism.
Taiwan in fact was a colony of Japan (ceded many years ago), which was given to the then Republic of China to administer after the Japanese surrender to the Americans after World War II.
The Japanese Governor Rikichi Ando handed over the island to mainland General Chen Yi on behalf of the Allies.
The KMT which ruled ROC then fled to Taiwan following the communist take-over.
After the Nationalists initially moved to Taiwan, there was massive inflation.
Money in the island was produced by the Bank of Taiwan, which also had commercial banking functions. In 1949, the New Taiwan Dollar was produced as part of a stabilization program exchanging old dollars for 40,000 to 1.
It is said in 1947 alone the price of rice went up 400 times. As inflation and economic controls hit the people, there was a Sri Lanka style ‘Aragalaya’ which was put down brutally.
Lost Generation Economics
However, the news money continued to depreciate despite US foreign aid, exactly in the same way as in post-war Japan which also got US subsidies and the people suffered until the German influenced Joseph Dodge was helicopter dropped to Tokyo to fix the yen.
https://fred.stlouisfed.org/graph/?id=FXRATETWA618NUPN,XRNCUSTWA618NRUG,#
Graph-x-rate-taiwan
As a result of central banking, Taiwan continued to have monetary problems in the 1950s and import taxes and import controls proliferated.
By the mid-1950s, five separated parallel exchange rates had emerged.
Due to Saltwater-Cambridge or as Hayek called ‘lost generation economics’, the US could not help. The IMF also cannot help Latin America (or Sri Lanka for that matter) despite repeated programs.
South Vietnam and Korea were also destroyed by US money doctors based on similar Keynesian ideas.
Related Sri Lanka fast on Korea path, interventionists get their malnutrition wish: Bellwether
Enter Hayek’s student CS Tang
C S Tsang who was working for the IMF at the time, and came to Taiwan on holiday, advocated unifying the exchange and removing the controls and ending import substitution.
Initially he could make no headway.
As problems worsened, Tsang and another economist Ta-Chung Liu, managed to convince K Y Yin (Yin Chung-jung/ Yin Zhong-rong) a senior bureaucrat who had moved from China to Taiwan with the KMT and had the confidence of Chiang-Kai-Shek.
As in all countries with bad central banks foreign exchange rationing and import licenses emerged. Those with licenses could make a killing.
On the other hand, exporters did not get the proper exchange rate, and were discouraged.
Reform efforts stalled after Yin resigned over the collapse of a state financed company. After Yin was exonerated, almost two years later, the liberalization resumed.
US indications that they will have to stop grant aid was another factor to change course.
The Taiwan dollar was then devalued twice to eliminate parallel exchange rates and fixed at 40 to the US dollar. The Bank of Taiwan was reformed with commercial banking functions eliminated and the interest rates were raised allowing the peg to be operated.
Free Port
However, the problem of import taxes hurting exports remained. To get over the problem, tax rebates were given for export firms.
Another person who helped change the economy was K. T. Li, a scientist who was hired by Yin, who advocated export processing zones.
In 1962 after a visit to Trieste, a free port in Italy, Li renewed his push to set up export processing zones (EPZ) in Taiwan, the first of which was opened in Kaohsiung in March 1965.
The EPZ could import inputs free of tax and therefore eliminated the problem other export firms were facing with import taxes on inputs.
The late 1950s devaluation of the Taiwan dollar to eliminate parallel exchange rates is an exact replica of what J R Jayewardene did in 1978.
But Sri Lanka continued to depreciate and trigger high inflation and social unrest, despite advice from Singapore’s economic architect, Goh Keng Swee not to print money and depreciate the currency.
Currency depreciation and inflation is simply an outcome of faulty central bank banking or an ingrained belief that inflation and depreciation bring prosperity and not social unrest, as in Sri Lanka.
East Asian Miracles
The Bank of Taiwan however maintained the fixed exchange rate like Singapore and Hong Kong and appreciated it as US policy deteriorated.
Hong Kong never had an activist central bank, and therefore had already become an industrial powerhouse much before any other Asian nation, outside of Japan. Japan industrialized after the Meiji restoration.
Singapore however was badly hit during Japanese rule with Banana money. Singapore benefited from Goh Keng Swee, who also studied at London School of Economics where Hayek had taught.
Tsang had won a prize for his Ph D thesis supervised by Hayek.
If the Bank of Taiwan did monetary activism like in this country, the same fate that befell Sri Lanka and also South Vietnam after World War II would have befallen Taiwan.
Yin briefly headed the Bank of Taiwan after the initial devaluation. Though this columnist had not been able to dig up any concrete evidence, probably carried out instructions from Tsang.
Shocking Regression to Mercantilism
Tsang’s knowledge of exchange rate pegs and balance of payments and avoiding ‘monetary policy’ is well known.
By the 1950s all knowledge of the balance of payments explained by those who developed economics (then called Political Economy) including by Hume, Ricardo, Smith, Torrence had been lost in the English-speaking West after the policy rate, open market operations, and the Great Depression.
It was the singular achievement of what Hayek later called ‘lost generation economics’.
How currency boards and fixed exchange rates worked were complete mysteries to Western academia and policy makers by then.
But as early as 1953 Tsang did a paper on how the Danish balance of payments operated, while working at the Special Studies Division of the IMF and saw classical economics working in the real world.
READ: The 1951 Improvement in the Danish Balance of Payments
Denmark still has a fixed exchange rate with the Euro.
What came to be known as the ISLM – BOP model proposed by Robert Mundell and Marcus Fleming came to be as something completely new. By then macroeconomists fully believed that BOP troubles came from current account deficits and inflation was cost pushed fully or partially, in a shocking regression to Mercantilism.
The knowledge was preserved in Germany, countries like Denmark and in East Asian nations influenced by Austrian and German economists. In Hong Kong alone British classical economics prevailed.
MAPB
Tsang pointed (as had Mundell) that the Monetary Approach to Balance of Payments was not new.
“The monetary approach to the balance of payments really began with Hume’s ‘price specie flow mechanism,’ as most proponents of the modern version of this approach are quick to point out,” Tsang wrote later.
“In the heyday of the Keynesian Revolution, however, this mechanism had come to be regarded as inoperative, as the quantity of money itself was regarded by the prevailing monetary theory as a matter of no consequence.”
“The elasticity approach that dominated the scene from the depression years to the early post-war days is primarily concerned with the effects of relative prices upon exports and imports under the assumption that domestic money wages and prices of non-traded goods somehow remain constant.”
“The subsequent Keynesian extension of its merely superimposes a multiplier analysis upon the primary change in trade balance under the usual Keynesian assumption of an infinitely elastic demand for money supply in addition to the assumption of constant wages and prices of domestic goods.”
Fortunately, Tsang and his colleagues knew better.
Under a fixed exchange rate, interest rates rapidly declined in Taiwan, as is usually when depreciation stops. When there was external trouble with US printing money, Taiwan was quick to raise interest rates.
After the collapse of the Bretton Wood and the imminent collapse of the Smithsonian agreement, the central bank bought large amounts of dollars, boosting fx reserves and domestic reserve money.
“Beginning in August 1972 the central bank began to sell to commercial banks its own certificates of deposits in one, three and six-month maturities,” writes Robert F Emery, a East Asia specialist who worked at the Fed for over three decades in a 1984 paper.
“This action was highly successful in reducing commercial bank’s excess reserves to levels that the central bank could deal with more easily.”
Amid further US Great Inflation, in February 1973, the New Taiwan dollar was appreciated to 38 from 40 dollars.
Dollars were also selectively sold to some banks to mop up money.
Trade Liberalization
One consequence of the deflationary policy and rising reserves was a sweeping liberalization of imports and import duties, and a sharp increase in exported products.
“When the initial liberalization efforts were made, no one had any inkling that a more prosperous growth epoch was in the making,” Douglas Irwin quoted Li as saying in a paper produced for the Petersen Institute of International Economics.
“The early efforts were not ideologically motivated by any clear vision of the advantages of externally oriented growth, and there was only a vague awareness of the benefits of comparative advantage.
“Indeed, the term externally oriented growth was coined by economists only after its epochal significance became apparent.”
“In the past, some people criticized me as an extreme interventionist; then, some people said that I had changed my mind and become an advocate of a free economy,” Yin was quoted as saying.
“As a matter of fact, my fundamental viewpoint is just “how to solve the problem efficiently and thoroughly in the practical circumstances.”
Like Singapore
Graph-SGD-NTD
The New Taiwan dollar which was revalued up to 38 in the late 70s as US inflation went and then floated up with higher interest breaking the fixed peg to counter US inflation.
Latin America and Sri Lanka currencies collapsed in those years.
Singapore also appreciated but much more aggressively. The steep appreciation up to around 1984, drew protests from exporters.
Unlike Sri Lanka’s inflationist macroeconomists who discredited JRs open economy, Goh told his colleagues that it was essential to appreciate the currency (otherwise there would be social unrest) but to help them he would reduce the social security contributions companies had to make.
Singapore had sky high EPF rates in the 1970s and 1980s.
It must be borne in mind macroeconomists in countries with balance of payments troubles, and inflation, escape accountability by not just rejecting economics, but by peddling outright lies.
A key Mercantilist falsehood peddled by macroeconomists and academics is that East Asia had a depreciating or competitive exchange rate. Depreciating currencies is an overt sign of monetary instability and tends to create social unrest and drive away investors.
What they actually had was monetary stability, backed by deflationary policy for the most part which kept domestic prices down and helped prevent social unrest.
The new Taiwan dollar which was devalued to 40 to the US dollar in 1960 is now 32 to the US dollar.
Sri Lanka’s rupee which was 5.7 to the US dollars is now 300 to the dollar. A stable exchange rate means the central bank has a practical operating framework which keeps the exchange rate at least as weak as the US and avoids destroying capital.
Sound money is not just a requisite for exports and free trade, it is necessary for social and political stability. This was well known in the classical period.
Our politicians are not bad. They have good ideas to drive the country forward, though some may be bad. There is no magic that Taiwan or Singapore has tried that Sri Lanka has not tried or is not capable of.
The problem with unsound money is that both good and bad ideas fail. The businesses cannot work and families cannot make ends meet when the blood is poisoned.
Even at this late stage, Sri Lanka and its parliament can learn and tame discretionary inflationist central banking allowing long term investments to be made and stop outmigration.
Continue Reading
