A tale of two city-states By Scott Sumner

It was the best of times; it was the second best of times. It’s natural to want to compare Hong Kong and Singapore. They are among the very richest non-oil producers in the world, at least among economies having more than 5 million people. They are both quite small, and mostly ethnic Chinese. They score #1 (Hong Kong) and #2 (Singapore) on both of the major economic freedom indices. Neither is completely laissez-faire, but then no country in the entire world is even close to being laissez-faire. For instance, in Hong Kong the government dominates the all important real estate industry.

But there is one difference that’s worth thinking about—monetary policy. Hong Kong has had a currency board since 1983, and Singapore has a monetary regime that uses exchange rates (rather than interest rates or the money supply) as the monetary instrument. The Singapore approach could be viewed as somewhat market monetarist, as we oppose using the interest rate because of the zero bound problem.

If Singapore does have a more effective monetary regime than Hong Kong, then I’d expect less cyclical instability due to demand shocks, and hence less of a “Phillips Curve” type relationship. I already knew that Hong Kong exhibited a highly significant Phillips curve, because it meets all three conditions necessary for the Phillips curve model to work:

1. Stable inflation expectations and an unstable actual inflation rate.

2. Demand shocks more important than supply shocks.

3. A stable natural rate of unemployment.

The first and second point reflect the fact that pegging the Hong Kong dollar to the US dollar meant stable expectations after 1985, because America had low and stable inflation expectations. However, Hong Kong had more unstable actual inflation than the US, because it was hit by major shocks, such as the East Asian crisis of 1997-98. And unlike Western European countries, it has a stable natural rate of unemployment, because the government is not heavily involved in regulating the labor markets.

Here is the (very impressive) Hong Kong Phillips curve:

Notice the R2 of 0.826. They don’t make Phillips curves like that anymore! (I believe the US would show almost no correlation over that period.) But a good Phillips curve is a bad monetary policy. The central bank is creating procyclical inflation, and hence making the business cycle worse. A central bank with a dual mandate would create countercyclical inflation. Most don’t achieve that, but some come close.

Also note that inflation is extremely volatile. I’ll give Hong Kong credit for flexible labor markets. If the US or Europe had that sort of inflation instability, our unemployment rate would be far more unstable, with horrific levels of unemployment during years of 4% deflation. But can’t we do even better? Yes, we can.

Here’s Singapore’s (unimpressive) Phillips curve:

The R2 is now only 0.227. Also notice that Singapore avoids the extreme levels of inflation and deflation experienced by Hong Kong, although it was subject to the same sort of shocks. For instance, Singapore could devalue in 1997-98, and thus avoid the worst of the East Asia crisis. As a result, Singapore also had less unemployment rate instability than Hong Kong.



Conclusion: Singapore has a very good monetary regime. The use of exchange rates as a policy instrument avoids the zero bound problem, and hence fiscal stimulus is not needed. (I’m not sure if it was used.) By adjusting the exchange rate to minimize demand shocks, Singapore has much less cyclical instability than Hong Kong. The Hong Kong government argues that the dollar peg provides security for investors, helping Hong Kong maintain its position as a financial center. But Singapore is also a very successful financial center. Hong Kong should adopt Singapore’s monetary regime.

PS. Think of Hong Kong as like a superbly conditioned athlete that lives in a flimsy house. During storms he is bombarded with branches, tossed by the wind. He survives, but only due to the fact that he’s in much better shape than his friend Argentina, who was severely injured by the hurricane of 1998-2001. Singapore’s also in excellent shape, but not quite as good as Hong Kong. But Singapore lives in a much sturdier house, and received only modest damage in the storm.

After 2002, Argentina crawled into a much safer house, but then adopted some really bad habits, and his health eventually deteriorated as he lay on the sofa all day eating high cholesterol steaks.

PS. Travel today—replies to comments may be delayed.