Up to 2019 it was circulating happily in the Lebanese economy. Sure, Lebanon was consistently importing far more than it was exporting, and as a consequence, money was consistently flowing out of the country. But, luckily, Lebanon had a massive banking sector that was able to attract money far and wide and invest that back into the economy. So… from a monetary perspective, everything was just fine, and the central bank was able to maintain a steady value of the Lebanese Pound versus the U.S. Dollar…. until… it wasn’t … the banks could no longer borrow, and the Lebanese pound collapsed with devastating consequences for the economy.
If you prefer to consume this story in video format, check it out here:
In this blog, I’ll not only explore why this happened but also how it can be fixed.
Alright, let’s start with a brief history of the Lebanese pound, also known as the Lebanese Lira.
The Lebanese Pound was created in 1939, when it was formally separated from the Syrian pound. And since then, it has always been linked to some other currency. First, when Lebanon was under French control, it first remained linked to the Syrian pound, then to the French Franc, the British pound and then again then the French franc until 1949. Then, after French domination ended, the Lebanese pound became part of the famous Bretton Woods monetary system and was therefore linked to both Gold and the U.S. dollar. It was during these decades, that the Economy of Lebanon prospered and its capital Beirut became one of its most prominent banking centres of the middle east, similar to the role that Dubai plays today.
However, then, in the 1970s Lebanon entered its extended civil war that would last until the 1990s.
As you can imagine, this had a devastating impact on the Lebanese pound.
To illustrate just how far the pound fell, before the Civil War, you would only need 3 Lebanese pounds to get 1 U.S. dollar. While after the civil war, in 1992, you would need a whopping 2500 Lebanese pounds to obtain that same dollar.
And then, even though the political situation in Lebanon remained tense… to say the least… the economy recovered to a certain extend. The city centre of Beirut was rebuilt, and the Lebanese pound recovered somewhat to the point where you would need roughly 1500 pounds to obtain a single U.S. dollar. And so, in 1997, the Lebanese pound was pegged to the U.S. dollar at 1 dollar to 1507.5 pounds. As currency pegs often do, this helped bring back to some economic stability to Lebanon and, importantly, it helped its banking sector to thrive once more. Partially, by managing the money of the millions of Lebanese who lived and work abroad, also known as the diaspora.
But also partially, Lebanon’s banking sector thrived thanks to Lebanon’s banking secrecy law, similar to the one that Switzerland became famous for. As you can imagine, in a neighbourhood dominated by dictatorships corruption and war, a banking sector that can keep the origins of your money a secret is bound to attract lots of money….. and it seemed that Lebanon had successfully gone back to its old economic model of being the banker of the middle east.
In fact in 2017, the chief central banker of Lebanon was confidently proclaiming that the Lebanese banking system had proven itself so resilient that there was no way this would change in the future.
Crisis, crisis, crisis
He…. Was wrong.
But, to his credit, the Lebanese banking system was seemingly hit by the perfect storm.
And yeah, this term … the perfect storm is often overused … but in this case… I really think its justified.
The start of it was the massive and prolonged civil war in big neighbour Syria. This disastrous war not only meant that a substantial amount of Lebanese banking loans and investments got shot to pieces it also meant that the Lebanese government had to take in over a million refugees, putting huge financial pressure on the banks biggest borrower.
Then, in October of 2019, the world finally lost confidence in Lebanon’s banks and foreign investors started to withdraw their money. This led to huge pressure on the fixed exchange rate. In response, the banks cut back lending to the Lebanese economy, leading to a recession.
And you know what happens to government finances in a recession right?
They go down the drain… because tax incomes go down and social security payments go up….
So, on March 7th, 2020, the government defaulted on its debts, marking the first ever government default for Lebanon. This was especially problematic since the Lebanese banks held the majority of government debt.
And so, the government and banks entered what economists call the doom loop, in which the banks couldn’t finance the government, which in turn couldn’t repay the banks, making it even harder for the banks to fund the government and so forth.
But then… since it was 2020, Covid-19 hit and the economy had to go into full lockdown in the middle of this massive economic crisis….
And if you then think that was the end of Lebanon’s bad luck, you are sorely mistaken because then… this happened.
Now, normally, a single explosion like this is not a problem for an economy….
However, in this case the explosion badly damaged Lebanon’s main port, which handled 70% of its imports, meaning that the price of many essential good skyrocketed. So sick of the governments mishandling of all of these crisis, the people of Lebanon went into the street, demanding change, and the government… did the responsible thing and resigned.
However, that was over a year ago… and Lebanon still has no new government… and with Covid-19 still raging, it seems like the Lebanese pound is bound to fall even further …. But, that begs the question… Even if there was a government, what can it do to fix this? Well to answer this question, we first have to disentangle the economic problems of Lebanon that led to the crisis in the first place..
Core economic problems
You see, while the Syrian war, Covid-19, and the explosion were economic disasters of epic proportions, they were not the root causes for the fall of the Pound, they merely accelerated it.
If we take a step back, I think there are two core underlying problems of the Lebanese economy that led to this crisis.
Now, the first problem was the one I mentioned in the introduction.
Namely that as a whole, Lebanese firms, households, and the government consistently import way more than they export. As a consequence, there is consistent downward pressure on the country’s currency.
However, as is often the case with countries with outsized banking sectors, the consistent inflow of money offsets that downward pressure. The good news here was that the link between the Lebanese pound and the U.S. dollar could easily be maintained. The bad news however was that, even though Lebanon’s export sector was not competitive, the currency could not be devalued… preventing them from becoming competitive.
Now on its own… this wouldn’t have to be a problem … a small economy like that of Lebanon … can specialize and become a sort of banker and safe haven in the area… given that there is some political stability…
However, Lebanon is hardly known for its political stability. .And this brings us to the second major problem of the Lebanese economy … a government that consistently spends much more than it earns, with a deficit that consistently reached up to 10% of GDP.
But, okay, hold on, I’m not one of those pseudo-economists that compares government spending to that of a household.
Unlike a household, a government can consistently spend more than it earns… However, it is still important that this money is spent productively, such that the economy grows, which in turn keeps government finances sustainable. However, as you probably guessed, this was not the case for Lebanon.
Its government is well known for spending a lot of money to keep its key supporters happy and not so much on basic government services such as garbage removal. or… I don’t know making sure the city doesn’t explode…
So, how can a currency crisis this severe ever be solved?
Well, the first step is to ‘stop the bleeding.’ In other words, to stabilize an economy that is spiralling out of control. There are several ways to do that, but in my opinion they should definitely include:
- Some debt-restructuring in which the bad banks are separated from good banks and the good banks are supported so that they can re-start the economy.
- Also, resisting the urge to cut spending on basic necessities, while cutting corrupt political government spending.
And then, when the economy is stabilized, Lebanon can work to further tackle its two underlying problems: its massive trade and government deficits.
A good step to tackle the first problem is to let the currency rate be determined by the market. As it is now, there are three exchange rates. The first is the central bank official rate which still means that you need 1507 pounds to get one dollar… This is how the central bank supports importers of critical goods. Then there is the Ministry of Economy & Trade exchange rate, which is lower, you need 3,900 pounds to get one dollar. This also used to support critical imports. And then finally, there is the black market rate which is… fluctuating wildly but at the time of writing closer to needing 10,000 pounds to get that same 1 single dollar bill.
Now, while it does make sense to support critical imports, there are two major problems with having multiple exchange rates and that is that (1) its confusing, and (2) its bureaucratic, arbitrary, and in a country with sky-high corruption this means that it mainly benefits the rich well connected elite.
So, these three separate exchange rates need to go. One exchange rate provides clarity and less opportunity for corruption as it is the same for everyone. Sure, this exchange rate will be much lower, but that is also what is need to make the Lebanese industry more competitive and might help the well educated people of Lebanon to start productive businesses. That brings us to the government problem of spending money on political bribes rather than on the basic services necessary to grow the economy. Here some steps have already been made when parliament got rid of the banking secrecy law that facilitated a lot of that corruption. But, more transparency is needed for the government to get back on its feet and start supporting the economy rather than holding it back….
And, there we go! Another easy win for economics, we isolated the core underlying problems that led to the crash of the Pound and came up with clear economic strategies that will get Lebanon back on its feet…
Nah, in all seriousness, I really do believe it is important to clarify what Lebanon’s core economic problems were. But, economics does not operate in a vacuum, and I believe that economists have to recognize political realities. And this is where this story takes a darker turn.
You see, a lot of the solutions I discussed in this blog were actually part of the government proposal last year…. However that plan, was rejected by Lebanon’s political elite…
You see, there is a deeper underlying structural reason why the Lebanese Pound has fallen so far, and why its government is so dysfunctional and that is sectarian politics. Lebanon has a very particular political system in which the highest political posts are reserved for representatives of the different religious factions in the country. After the civil war it was agreed that seats in parliament are always 50% Christian and 50% Muslim. To complicate things even further, it was agreed that the president always has to be a Marionite Christian; the Speaker of the Parliament has to be a Shi’a Muslim; and the Prime Minister always has to be a Sunni Muslim. Furthermore, each of the different religious groups have their own political apparatus and geographical areas in which they rule.
And, this makes sense from a political perspective, after all it prevents domination by any of the sectarian groups, and therefore it can help prevent a new war.
However, this system has also promoted political patronage as people vote for their religious faction rather than on the party that has their economic interests at heart. So, while giving the political elites of each faction indirect access to government money makes sense to keep the peace, it set Lebanon on the path to economic ruin. Furthermore, with the various elites at risk of losing their lavish income streams, it makes sense that they block attempts to clean up corruption and the economy.
So yeah, I think that the protesters are right to be in the streets. To truly save the Lebanese pound, political change is needed and Lebanon’s elites need to be brought in a position such that it no longer makes sense for them to block the necessary economic change.
Now, to get to that point, I see two possibilities. The first is that their economic pain gets so bad that they will no longer block reforms. However, this is a risky path since elites are often far more resilient then the people. If you want examples of that you just have to look at Venezuela or Zimbabwe. The second option is that the protesters get the elites on board with reforms by making some concessions, such as promising not to prosecute for previous corruption while still ruling out new corruption.
And look I know, this is not fair at all…. But, the reality is that working with evil elites to a certain extend does have track record of preventing a complete social and economic collapse. For examples, look no further than at South Africa after Apartheid, Chile after Pinochet, and Japan after the Second World War….
Not great … but perhaps better than a total collapse?
So, that leaves us with a pretty bitter conclusion about Lebanon’s currency crisis. While it is pretty clear what needs to be done to fix the Lebanese Pound:
- A single floating exchange rate
- And Government reform
, these choices are currently not aligned with the economic interests of the ruling elites… and so not very likely to happen. So, how to fix the pound has become how to fix Lebanese politics and that would be to align the interest of the elites with those of the people, be it the easy way or the hard way…
So yeah, that was my take on this tragic crisis. Do you agree? Have I missed something? I probably did, so let me know in the comments, I’ll be happy to continue the discussion there with you.
And, if you were intrigued by this blog have a look at my other blogs or YouTube channel, where you will find similar blogs and videos on other countries as well as explanations of some of the basic economic concepts that underpin this video such as exchange rates and the balance of payments.
Here are some of the sources I used which I couldn’t directly attribute to a certain part of the blog:
- Lebanon Economic Monitor, Fall 2020 : The Deliberate Depression, by the World bank
- Lebanon’s Debt-Resolution Challenges Continue, One Year On From Default, by Forbes
- Statement by IMF Managing Director Kristalina Georgieva on the International Conference on Support to Beirut and the Lebanese People
- Overview of the Lebanese Banking Sector in 2018, by Blom Bank
- Lebanon’s Currency Crisis Paves The Way To A New Future, by Forbes
- Lebanon’s monetary meltdown tests the limits of central banking, by the Peterson Institute for International Economics
- Awdeh, Ali. “Monetary policy and economic growth in Lebanon.” Journal of Central Banking Theory and Practice 8.2 (2019): 147-171.
- IMF Executive Board Concludes 2019 Article IV Consultation with Lebanon, by the IMF
- Kubursi, A. A. (1999). Reconstructing the economy of Lebanon. Arab studies quarterly, 69-95.