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Eliminating the Effects of Hyperinflation in Iran at No Cost: Part 1

Wednesday, November 14, 2012

Interview with Nicolaas Smith
By: Kourosh Ziabari

Hyperinflation and depreciation of the national currency is a problem which not only the Iranians but even some of the world’s economists and accounting scholars are concerned about. On October 25, we published an interview with Johns Hopkins University professor of economics Steve H. Hanke in which he provided three solutions to end hyperinflation in Iran and avoid the consequences of the economic sanctions imposed on the country by the United States and its European allies.

A few days later, accounting expert Nicolaas Smith responded to statements made by Prof. Hanke in an article which Iran Review republished on October 31.

Accounting expert Nicolaas Smith was born in South Africa. He studied accounting at the Nelson Mandela Metropolitan University. He worked mainly in financial accounting at companies such as Cadbury´s, NCR and National Chemical Products (now Dow SA) and the Johannesburg Stock Exchange in SA. In 1990, he immigrated to Portrugal. He worked in Angola’s hyperinflationary economy from 1994 to 1997 at Auto-Sueco, the Volvo agents in that country, where he developed accounting dollarization in 1995 and implemented it as from 1 January 1996. He published the e-book “Constant Item Purchasing Power Accounting per IFRS” in July 2012 on Amazon.com.

Nicolaas Smith has proposed that he is willing to travel to Iran and talk to the officials at the Central Bank of Iran and accounting standards authority and help the country overcome the problem of hyperinflation.

The solution which he has suggested for Iran’s hyperinflationary economy is called the Daily Index Plan. He says that daily index is the common factor in maintaining both the monetary and constant item economies constant and is currently a fundamental economic reform plan.

“The Daily Index Plan is not simply a daily index like the URV was and it is also not exactly the same as the Real Plan. It is a combination of principles and concepts which includes principles that were used in both the URV daily index and in the Real Plan monetary reform. But it is neither simply the one nor simply the other and it is also not a simple combination of the two,” he says.

Nicolaas Smith took part in an in-depth interview with Iran Review and discussed his viewpoints about the problem of hyperinflation in Iran and provided a set of comprehensive solutions on how to overcome the current economic problems the country is facing. He says that with these solutions, the effects of hyperinflation will be eliminated overnight and at no cost.

What follows is the first part of Iran Review’s interview with Nicolaas Smith.

Q: In one part of your article, you refer to Ben Bernanke’s statement who has said that in     hyperinflationary economies, there aren’t generally price increases and that the price of goods and commodities stay the same in U.S. dollars during the hyperinflation period. This statement implicates the need for official dollarization. I mean, if the price of goods remains constant in dollars, then the best option would be to change the currency and adopt dollar as stable and viable currency, while you have argued that Iran does not necessarily need to select this option. Would you please explain more about that?

A: All my answers are from only an accounting point of view. All the concepts I will explain have equal applications in the world economy, not only in Iran’s economy. You are willing to listen to my suggestions in Iran because you have hyperinflation. A lot more is learnt about low inflation and much quicker during hyperinflation than during low inflation.

Yes, Dollarization would stop hyperinflation from the one day to the next. However, you would need enough US Dollars, or whichever stable currency you choose, from the one day to the next to change your money supply from your hyperinflationary rials to US Dollars overnight. Iran is quite a big economy. That would be the first problem. I do not think Iran has the required amount of US Dollars to Dollarize overnight.

It is reported that Iran has USD 90 billion in reserves. Let us assume that is what is required for Iran to Dollarize your economy overnight. I do not know what that required amount is. This is just an example to illustrate the point.

That would use up all your foreign exchange reserves overnight if you were to use it as the required amount to change your money supply from hyperinflationary rials to relatively stable US Dollars. I will explain the Daily Index Plan under which you would keep your foreign exchange reserves and have guaranteed removal of the effects of hyperinflation or inflation from your constant and monetary items (excluding from rial bank notes and coins).

Rial monetary items are rials held and other monetary items expressed in rials, being substitutes for rials held, e.g., rial loans, consumer loans, bank loans, student loans, housing loans, car loans, government bonds (loans to the government), commercial bonds (loans to companies), notes payable, notes receivable, the capital amounts of all money market and capital market instruments, etc. when these monetary items are not in the form of actual rials held. They are all substitutes of actual rials held.

The second fact is that Iran would lose monetary autonomy. US inflation (the US now has a 2 percent annual inflation target) would be the inflation in Iran – in general terms. The Central Bank of Iran would not be able to implement any independent monetary policies.

US Dollars are not monetary items outside the US economy. They are not monetary items in Iran. They are variable real value non-monetary items (variable items) in Iran. They are not affected by local inflation because they are not local currency units in Iran.

Daily Index Plan: guaranteed to stop the effects of hyperinflation in Iran

The existence or not of hyperinflation in Iran depends on who runs the rial printing process and who creates excessive rial monetary items in Iran. I only know how to stop the effects of hyperinflation in Iran from the one day to the next without Dollarization or a currency board and without using any of your foreign currency reserves.

The Daily Index Plan, which I suggest Iran uses, is guaranteed to remove the effects of rial hyperinflation from the one day to the next when it is implemented correctly in Iran . Rejecting the stable measuring unit assumption in both the rial monetary and constant item economies and the use of a totally transparent Daily Index are the crucial factors; i.e., they would guarantee the elimination of the effects of hyperinflation in Iran from the one day to the next. You cannot negate natural accounting and economic concepts and laws in Iran. You cannot negate maths in Iran. When you implement the measures I suggest correctly and they have the necessary legal backing, they will have the forecasted logical consequences in Iran. The Daily Index Plan is equivalent to Dollarization in Iran in terms of units of constant purchasing power: in constant rial terms.

When the US Dollar is used as substitute for the Daily Consumer Price Index then a constant (not nominal) rial is always exactly equal to the US Dollar as indicated by the US Dollar daily parallel rate. It is simply maths. The whole rial monetary and constant item economies would then be valued in terms of the US Dollar (any relatively stable foreign currency via cross rates) under capital maintenance in units of constant purchasing power in terms of the US Dollar daily parallel rate and daily inflation-adjustment of the entire rial money supply. As soon as correct and reliable rial CPI data are available again and the rial Daily CPI is properly used as the daily index, the rial monetary and constant item economies would be valued in terms of the consumer basket in Iran; the Daily CPI in Iran.

All political and other non-economic variables are correctly factored in by the use of a totally transparent Daily CPI or the US Dollar (any relatively stable foreign currency) daily parallel rate as substitute for the Daily CPI.

My proposal for Iran is, in principle, a copy of what Brazil did in 1994. This time the concepts are known and defined/identified beforehand. I think Brazil did it the way I did it in Angola: doing what is logical and common sense from your personal knowledge of direct involvement in the daily hyperinflationary economy.

It actually took them 10 years to beat their hyperinflation in their whole economy. I simply stopped the effect of hyperinflation in the constant items of the company where I worked. We avoided the effect of hyperinflation in the local currency (Kwanza) by not keeping any Kwanzas from one day to the next in our company. I only understood and could only define the concepts I implemented in 1995 and 1996 in Angola many years later. I think the same is true with the Brazilian Real Plan in 1994.

I completely stopped our fear of hyperinflation in our company in Angola with accounting dollarization in terms of the daily US Dollar parallel rate and zero daily balances of local currency. Iran can do the same and a lot more for the whole Iranian economy by implementing the Daily Index Plan as soon as possible.

To understand what I suggest for Iran (and all other economies especially Venezuela also currently in hyperinflation and Ethiopia, Mongolia, Tanzania, Angola and Argentina, all currently in high inflation), you first have to understand the background to my work; i.e., where these facts and fundamental concepts I suggest that Iran and other countries adopt, where they come from: how I came to these conclusions and whether they are valid and credible. For example, what the International Accounting Standards Board thinks about them.

Three Parts of the Economy: How to keep two of them stable in real values.

Most economists and accountants would tell you that the economy is made up of two parts: the monetary and non-monetary economy. That is not correct. The non-monetary economy is split in two: the constant real value non-monetary economy (constant item economy) and the variable real value non-monetary economy (variable item economy).

The generally accepted concept of measurement in units of constant purchasing power is used to define the two different non-monetary economies as follows: when non-monetary items can be measured in units of constant purchasing power it very logically means there are constant real value non-monetary items (constant items) in the economy: economic items with constant real values (constant purchasing power) over time. Then, logically: non-monetary items that are not constant items are variable real value non-monetary items (variable items). This definition is inferred in International Financial Reporting Standards by the statement that “financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power”.

You would be able to tell me a number of constant items: salaries, wages, and rents, for example. You know they are constant values. Salaries and wages are generally measured in units of constant purchasing power on an annual basis on a worldwide basis: they are updated annually. They are then mistakenly paid monthly in fixed nominal amounts again applying the stable measuring unit assumption.

Other constant items are, for example, companies´ capital and amounts owed for purchases on credit (trade debtors).
How do you keep them constant in real value? You measure them daily in units of constant purchasing power in terms of a Daily CPI – the parallel rate in Iran at the moment.

How are they currently being kept constant? Companies´ capital worldwide is measured in nominal monetary units under the traditional Historical Cost Accounting model! They are, in general, not being kept 100 percent constant.

Variable items are the easiest to deal with. Examples are property, plant, equipment, raw material and finished goods stocks, etc. Their values are determined in the free market. The market price set in a free market is the best price for a variable item. No-one, generally, disagrees with that.

Now we have the monetary economy left. Inflation and hyperinflation only erode the real value of money and other monetary items – nothing else. However, most economists and accountants would tell you that companies´ capital and invested profits are eroded by inflation and hyperinflation. US Financial Accounting Standards actually state that. That is completely wrong. They are constant real value non-monetary items. It is impossible for inflation and hyperinflation to erode their real values. They are eroded by the stable measuring unit assumption: by traditional Historical Cost Accounting.

So, of the three different parts of the economy, we do not have to worry much about the variable item economy. In very general terms, variable items´ real values are determined in their respective free markets. For example, the price of gold, oil, foreign currencies, shares on the stock market, rice, coffee, mobile phones, TVs, computers, etc. These prices are often determined minute by minute on a daily basis worldwide.

Now the constant item economy: Some constant items, e.g. salaries, wages, rents, etc. are measured in units of constant purchasing power on an annual basis. Their constant purchasing power is thus being maintained constant on an annual, not monthly basis – in very general terms. Debts for purchases on credit are mistakenly defined by almost all institutions as monetary items. They are constant items. They are all accounted applying the HCA model; i.e., it is assumed money is perfectly stable when they are measured. Their real values are being destroyed by the stable measuring unit assumption, very fast in Iran at the moment.

The same is true for the real value of companies´ capital. It is measured worldwide in nominal monetary units while it is, in fact, a constant item. So, only companies that maintain the constant purchasing power of their capital constant with the equivalent real value of their net assets, maintain the real value of their capital constant. Which are these companies? Not a single company in the world knows whether it is maintaining the constant purchasing power (real value) of its capital constant.

In Iran companies that do not maintain their capital constant with equivalent real value net assets are destroying the real value of that portion not covered by the real value of their net assets at 70 per cent per month at the moment – with the stable measuring unit assumption (Historical Cost Accounting). You really have a big problem.

Now you have some idea of the three parts of the economy and that inflation only erodes the real value of money and monetary items. Now what do I suggest for Iran.

I suggest that Iran follows the Daily Index Plan to beat the effects of hyperinflation as follows:

(i) Iran (the Central Bank of Iran) should very soon issue a New Currency with xx xxx rials being equal to one New Currency on a specific date. This would be to make Iranians forget about the very fast depreciating current rial. How will they have faith in the New Currency? You lock (maintain) monetary items´ (monetary loans, bank deposits, etc.) real values (not the New Currency’s real value) with daily updating in terms of a totally transparent Daily Index as follows:

(ii) On the same date, Iran should introduce a completely transparent Daily Index compiled mainly from the US Dollar / New Currency daily free market rate.

(iii) Iran (The Iranian Institute of Certified Accountants - if they are actually the accounting standard authorities in Iran) should then require (not optional) capital maintenance in units of constant purchasing power in terms of the Daily Index as from that date (you ban Historical Cost Accounting and the stable measuring unit assumption forever – one of the best things Iran can do for your population).

This would require all constant items always and everywhere to be measured daily in units of constant purchasing power in terms of the Daily Index and all monetary items (the entire money supply – except actual bank notes and coins) to be inflation-adjusted on a daily basis in terms of the Daily Index.

That is it. That would make the Iranian constant item economy operate in constant real value terms and the Iranian monetary economy operates in monetary items with constant real values (except bank notes and coins): something that has never happened in the world economy before. Iran would lead the world in financial reporting and effective monetary policy.

Excluding deliberate excessive creation of money and monetary items in Iran, inflation would immediately fall to very low levels as it happened in Brazil in 1994 because:

1- All New Currency monetary items would be inflation-adjusted daily in terms of the Daily Index. Result: All New Currency monetary items (excluding bank notes and coins) would have constant real values over time. No cost of or gain from inflation. Brazil inflation-adjusted many (not all) monetary items daily in terms of their daily Unidade Real de Valor and other government-supplied daily indices during 30 years of high and hyperinflation. Chile currently inflation-indexes 25 percent of its entire broad M3 money supply daily in terms of their Unidad de Fomento daily index.

2- All constant items, e.g., salaries, wages, rents, royalties, fees, companies´ capital, trade debtors, trade creditors, all non-monetary payables and receivables, taxes payable and receivable, provisions, etc. would be measured daily in units of constant purchasing power in terms of the Daily Index. Result: all constant items would have constant real values over time. Result: a relatively stable non-monetary economy, like Brazil had during 30 years of very high and hyperinflation, hopefully during low inflation after the introduction of the New Currency in Iran.

3- Variable item prices would, in general, be determined in the free market on a normal daily basis - maintaining all Iran’s social security programs. When they are not determined in the free market daily, they would be updated in terms of the Daily Index until the next time they are determined in the free market. Historical Costs would be updated daily in terms of the Daily Index. Historical Costs would never be measured in nominal monetary units since the stable measuring unit assumption is never applied under capital maintenance in units of constant purchasing power. The Historical Cost Accounting model would be banned in Iran.

4- The Daily Index would be completely transparent: anyone would be able to check its validity at any time.

If any institution in Iran were to print or create too much New Currency money it would automatically be reflected in the US Dollar / New Currency free market rate and consequently in the Daily Index, but because of daily indexing of all monetary and constant items, these items would remain stable in real value in the monetary and constant item economies, respectively, at whatever rate of inflation or hyperinflation. The Daily Index Plan is thus guaranteed to remove the effects of inflation or hyperinflation from the Iranian economy.

Brazil used their Unidade Real de Valor daily index in combination with their Real Plan to stop hyperinflation overnight very successfully in 1994. The above plan - not exactly the same in practice – is, in principle, the same plan used by Brazil to stop hyperinflation.

This plan can be implemented without a New Currency and with the Chinese Yuan or any other relatively stable foreign currency instead of the US Dollar free market rate.

What I am suggesting are not all completely new concepts: Chile currently inflation-adjusts 25 per cent of its money supply on a daily basis: I am saying: make that 100 percent on a daily basis under complete co-ordination (everyone doing it) and you eliminate the entire cost of inflation and hyperinflation from the economy. Certain constant items have been measured in units of constant purchasing power for many decades, namely salaries, wages, rents, etc., on an annual basis. I am saying: measure all constant items daily in units of constant purchasing power in terms of a daily index, especially companies´ capital because that would maintain Iran’s existing capital investment base constant for an indefinite period of time in all companies that at least break even in real value – all else being equal – at all levels of inflation and hyperinflation by implementing capital maintenance in units of constant purchasing power in terms of a daily index.

What is new is applying all the concepts together at the same time in terms of a daily index. The results are guaranteed and impossible to ignore.

Also, these measures are coming: The International Accounting Standards Board voted unanimously in May 2012 to submit a draft IFRS ´X` CAPITAL MAINTENANCE IN UNITS OF CONSTANT PURCHASING POWER (I submitted it to the IASB in January 2012) to research. This new IFRS (which I expect to be authorized in 6 to 8 years´ time after the IASB´s very thorough due process procedures) will require (not optional) capital maintenance in units of constant purchasing power in terms of a Daily Consumer Price Index or other daily rate in countries with annual inflation equal to or greater than 10 percent and cumulative inflation equal to or greater than 26 percent over three years.

I am simply saying to Iran: implement capital maintenance in units of constant purchasing power and daily inflation-adjustment of your entire money supply in terms of a daily index now instead of in 6 or 8 years time when at least the accounting part will be required, in any case, by the IASB – if you implement IFRS. The benefits of what I suggest are enormous and last for an indefinite period of time – forever.

If you do not do it now, you will now knowingly – completely unnecessarily - continue to suffer the full effects of hyperinflation in your economy. Your economic growth has already stopped according to press reports and it will only get worse under continued hyperinflation and Historical Cost Accounting implementing the stable measuring unit assumption in your economy – during hyperinflation!

Daily inflation-adjustment of all monetary items in terms of a daily index can be inferred from the fact that the stable measuring unit assumption is never implemented under capital maintenance in units of constant purchasing power. Thus, all these concepts and measured can be said to be accounting or financial reporting concepts and measures and do not need the intervention of the Central Bank. However, the effects of the daily inflation-adjustment of all monetary items would require the intervention of the Central Bank.

Q: The continued devaluation of Iranian rial and the increase in the price of consumer goods have considerably affected the people’s purchasing power. Is there any direct solution to increase the people’s purchasing power and improve the value of national currency? Would you please explain it in some plain terms?

A: The People’s Purchasing Power

Yes, there is a direct solution to maintain (not increase) the people’s purchasing power: ban Historical Cost Accounting and the stable measuring unit assumption: Get the Iranian Institute of Certified Accountants (if they are the accounting standard authorities in Iran) to immediately require a change-over to capital maintenance in units of constant purchasing power in terms of a daily index, currently the daily US Dollar parallel rate in Iran’s case.

An Iranian company, for example, is set up as follows: (Accounting dollarization being used. Convert all items below at the daily US Dollar parallel rate to know their nominal values in rials on a daily basis: they change every day in rials. Rial financial reports are only valid when they relate to values for that day. The next day they are out of date - useless - because the daily rate would have changed by then. The longer the time period from the original date of the financial reports – relating to one specific day - and the higher the rate of hyperinflation, the more worthless they are.)

Capital USD 100 000

A worker earns USD 750 and spends all of it on monthly consumables (USD 750).

Sales for the company are USD 10 000 per month

It is easy to see that as long as all the above values are maintained constant in real value by measuring them in rials in units of constant purchasing power in terms of the daily US Dollar parallel rate, then the worker will always have enough money to buy his monthly purchases – all else being equal. As nominal rial prices / values for the above items go up to keep pace with (simply being adjusted daily) the decrease in the real value of the rial under hyperinflation, his salary is also adjusted (increased in nominal value, but, the same in real value – USD 750) daily at the same rate. Nothing to worry about. That is exactly what I did in Angola in 1995 and 1996 in the company where I was responsible for financial reporting to workers´ salaries and to the whole company in 1996.

The constant purchasing power of all the above items would be maintained constant for an indefinite period of time (forever) as long as the company simply breaks even in real value (not nominal value) – all else being equal – at all levels of hyperinflation, low inflation, high inflation and deflation only under capital maintenance in units of constant purchasing power in terms of a daily index or at zero percent inflation, which has never been achieved in the past on a sustainable basis and is not likely to be achieved very soon in the future anywhere in the world.

Add daily inflation-adjustment of rials in terms of the daily US Dollar parallel rate and the worker could keep his rials in the bank. All 90 – day deposits in Chilean banks are inflation-adjusted on a daily basis today in terms of the Unidad de Fomento.

The Iranian National Currency: the rial

You want a direct solution to improve the current rial´s value. Well, here it is:

(1) Stop excessive rial printing and money creation in Iran. Get your Central Bank to state publically that it is an objective of the Bank to reduce the rial´s decline in real value by x percent over x period and then to state what measures it plans to take and to clearly and convincingly show that it is implementing the right measures to achieve the improvement in the rial´s real value.

The Central Bank of Iran can achieve this by announcing that it will very shortly implement the Daily Index Plan and explain the plan to the public. I have already sent it to Mr. Mahmoud Bahmani, the Governor of the CBI.

(2) Improve Iran’s relations with all members of the world community and world economy. Please don’t ask me how. I am not a political analyst. Otherwise, implement the above Daily Index Plan as soon as possible and create a new currency.

Key Words: Hyperinflation, Iran, Depreciation of Rial, Daily Index Plan, Real Plan Monetary Reform, Smith

More By Nicolaas Smith:

*A Response to Steve Hanke on Iran´s Hyperinflation: http://www.iranreview.org/content/Documents/A-Response-to-Steve-Hanke-on-Iran-s-Hyperinflation.htm

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