Wait for the next crisis for reform of the monetary system

There has been a lot of chatter of late about countries ditching the US dollar as the primary reserve currency and moving on to something else. Robert Zoellick mentioned gold as the alternative. Nicolas Sarkozy has been talking up special drawing rights and the Russians and the Chinese recently decided to open an exchange to trade rubles for yuan so as to avoid the dollar in bilateral transactions.

From all of this action it seems as if the US dollar is headed downhill. Yet, when there is panic in global market, everyone wants in to the US dollar. Of all the currencies, only the Swiss Franc is seen as such a safe haven in times of uncertainty. And there are not enough francs to go around. So I certainly anticipate the US dollar will retain its reserve currency and safe haven status for some time to come.

On the other hand, it is clear that the US dollar’s role as a reserve currency is part of the problem that has led to massive and destabilising global macro imbalances. The problem: national currencies don’t work as global reserve currencies. For the US dollar to be an effective reserve currency, the US must run a large current account deficit in order for foreigners to build up US dollar reserves via their corresponding capital account deficit. So, the US dollar’s role as a reserve currency requires the US to run trade deficits ad infinitum.

While this could be sustainable over the short run, invariably these deficits build, leading to recrimination and instability or worse when recession hits. For example, after the Asian Crisis in the late 1990s, Asian countries were quite keen on building up a buffer of US dollar reserves to prevent a similar episode in future. The result has been a mercantilist trade policy designed to promote current account surpluses and capital account deficits in Asia in order to build reserves. Much the same dynamic has been occurring all around the emerging markets, in Russia and Brazil in particular. EM countries have built a massive amount of reserves that reflect external imbalances with the US. We now see the protectionist rhetoric that this kind of unevenness creates. And eventually, rhetoric turns into action unless a buoyant economy dampens the calls for protectionism.

So there is a natural tension for the US between its role as global reserve currency creator and its domestic agenda to reduce current account deficits and increase the domestic private sector savings rate. I am speaking of the Triffin dilemma of course. Belgian-American economist Robert Triffin first brought these tensions to light in the 1960s during the Bretton Woods days. But they have not gone away even after the breakup of Bretton Woods in the early 1970s. Commenting on this in January I wrote:

“During the Bretton-Woods era, this problem was manifest in the continual loss of gold reserves in the U.S. since the tether to gold had not been completely broken. But, eventually the U.S. had to drop its peg to gold in 1971 as the pressure became too much to bear.

“In the post-1971 period, as emerging economies have grown and developed economies expanded credit, the U.S. has been forced to satisfy global claims for U.S. dollars. This has induced an even larger deficit because there has been no check on balance of payment imbalances without the gold anchor. These imbalances are unsustainable as it puts the U.S. in a situation in which U.S. dollar denominated public and private credit claims cannot be settled with the current dollars outstanding. Either more and more U.S. dollar net financial assets have to be manufactured or the dynamics of debt deflation will kick in.

“In plain English: the reason credit has surged dramatically over the last generation has much to do with the monetary system; unless we successfully reflate asset prices, the claims on dollar-based assets cannot be met under this jury-rigged monetary system with the U.S. dollar at the core. I see this as a Ponzi scheme which is now in its final chapter.

“There are two exit strategies from this.

  • Manufacturing more U.S. denominated financial assets. Implicitly, this is the strategy we are now following. The goal is to limit the currency depreciation through the additions from the real economy value which ostensibly underpins these new net financial assets. Obviously, if you think spending more money is likely to misallocate resources, as I do, you aren’t going to like this approach.
  • Maintain existing money stock despite the credit claims. Debt that cannot be repaid, won’t be repaid. It’s as simple as that. The problem here, of course, is that this is deflationary. Yes, it rewards savers by not diluting their assets, but there is the real threat of a deflationary spiral and geopolitical tension as a result.

“Both of these solutions have major problems. The first solution is a form of Ponzi finance in my view. It’s kicking the can down the road as it leads to debt deflation eventually anyway – unless you want to go the Weimar or Zimbabwe route. The second is deflationary and puts acute stress on economies with high levels of indebtedness due to debt deflation and resulting social unrest that accompanies it.

“Ultimately, I hope this highlights the untenable nature of current currency system, because that is what is at the heart of the problem. From a U.S. perspective, a diminished reserve currency role will actually help alleviate much of the problem.”

On this topic, see Credit crises, market equilibrium, economic policy and fiat currencies, The Age of the Fiat Currency: A 38-year experiment in inflation and A New World Order.

When the crisis was hot and heavy in early 2009, I saw a real need to address this issue. But, policy makers really do not want to upset the apple cart. Unless and until we see a complete economic breakdown, we are going to continue with the same rickety global financial system we had before the credit crisis – the same too-big-to-fail banks, the same unworkable framework in the euro zone and the same unsustainable currency system with the US dollar at its centre. I really do not see this changing in any abrupt way without the mother of systemic crises akin to what we saw in the 1930s and 1940s. That’s pretty much how politicians respond to events – dithering until things blow apart and then trying to put humpty dumpty back together.

But, the talk of Bancors and SDRs and of gold and multiple reserve currencies is a good thing. It means that there are market forces inching us toward a more multi-lateral reserve system. And that should alleviate pressure on the US. My hope is that these forces, pushed by the BRICs, move us far enough toward this new world order so that if and when humpty dumpty falls and cannot be put back together again, we have the outlines of something there to take his place. When the next recession hits, I suspect that’s when this issue will be pushed into the spotlight.

1 Comment
  1. Edward Harrison says

    I will probably be creating a new post to extrapolate on these ideas but the basic gist is that we have been in a long-term leveraging cycle – a secular leveraging in the developed world. At each new downturn in the economy, there is the potential for more concerted deleveraging. However, the pain associated with this deleveraging is too much for people to bear and so policy makers work to prevent it.

    At this stage in the secular leveraging, we have reached a termination point where interest rate cuts can no longer be used to support the leverage and so now the monetary base will be expanded as the next step in the cycle. When the next recession hits the flaws in the dollar standard will become the bone of contention and lead to a shift away from the current monetary system.

  2. Industry Accountant says

    Hi Ed –

    I am right there hoping with you. An opportunity to get fresh, sustainable ideas with regards to the new global currency arrangment is a good thing, at least in theory. The cynical part of me though can’t help but wonder if hard austerity pushes, ala Ireland and now the UK, broadly become the MO of the political leaders. Because if that happens, what will have been a good theoretical opening will quickly morph into a practical nightmare.

    These politicos would do well to get acquainted with your ‘glide path’ solution, which I have read about some time ago. I humbly ask that you use your platform to advertise these packages more often, otherwise the ‘bailouts for the banks, austerity for the little guy’ pattern we have seen in the early going will only end very badly for everyone…

    1. Edward Harrison says

      The credit crisis proves that, politically, it is hard to make dramatic changes to core institutional arrangements during a crisis. Certainly you can make changes to institutional arrangements that are superficially beneficial – hence the bailouts and talk of an EMF. But invariably it takes economic collapse to really win people over to a new paradigm.

      In Europe, the Euro was implemented with a faulty institutional structure that ensures friction during crisis. We are now seeing that. The problem is that the Euro acts as a gold standard without any failsafe mechanism to prevent external imbalances or to automatically aid with fiscal transfers in crisis This means restricting devaluation as well as monetary and fiscal policy, making government’s actions extremely pro-cyclical, increasing the friction.

      No one wants to address this problem because most people in Europe do not want a more integrated fiscal union across the euro zone. But at the same time, they also want to rear guard their previous political posturing in setting up the euro zone’s mechanisms. Hence Germany’s fixation on budget deficits – despite Ireland and Spain’s having better fiscal record than Germany, pre-crisis and despite Germany’s meeting neither of the two Maastricht criteria. None of this makes real sense except politically – again, I see it as a cover for previous policy mistakes.

      I am not optimistic about Europe. The best we can hope for is default or quantitative easing. But only a realization of the sovereign debt crisis fears will move Europe to a sustainable solution.

      1. Marshall Auerback says

        Actually, I would argue that it is precisely during crises that such large
        institutional changes are more likely to take place. If anything, I would
        say that the credit crisis has highlighted the institutional flaws that
        many of us have been warning about since the euro’s inception. This has given
        a huge push toward things such as a euro-wide bond market and increasingly
        federalisation of the fiscal responsibilities, which I think will have to
        continue if the euro is to survive. And my guess is that ultimately the
        political will is there to ensure that the euro does survive, even though I
        personally think individual currencies are a better proposition from the
        perspective of an ideal economic situation.

        In a message dated 12/16/2010 8:23:20 A.M. Mountain Standard Time,
        writes:

        Edward Harrison wrote, in response to Industry Accountant (unregistered):

        The credit crisis proves that, politically, it is hard to make dramatic
        changes to core institutional arrangements during a crisis. Certainly you can
        make changes to institutional arrangements that are superficially
        beneficial – hence the bailouts and talk of an EMF. But invariably it takes
        economic collapse to really win people over to a new paradigm.

        In Europe, the Euro was implemented with a faulty institutional structure
        that ensures friction during crisis. We are now seeing that. The problem is
        that the Euro acts as a gold standard without any failsafe mechanism to
        prevent external imbalances or to automatically aid with fiscal transfers in
        crisis This means restricting devaluation as well as monetary and fiscal
        policy, making government’s actions extremely pro-cyclical, increasing the
        friction.

        No one wants to address this problem because most people in Europe do not
        want a more integrated fiscal union across the euro zone. But at the same
        time, they also want to rear guard their previous political posturing in
        setting up the euro zone’s mechanisms. Hence Germany’s fixation on budget
        deficits – despite Ireland and Spain’s having better fiscal record than
        Germany, pre-crisis and despite Germany’s meeting neither of the two Maastricht
        criteria. None of this makes real sense except politically – again, I see it
        as a cover for previous policy mistakes.

        I am not optimistic about Europe. The best we can hope for is default or
        quantitative easing. But only a realization of the sovereign debt crisis
        fears will move Europe to a sustainable solution.

        Link to comment: http://disq.us/v068r

  3. Danstrodl says

    You mentioned two exit strategies for the US, neither of which is workable.

    I have a third which no one has mentioned … Go back on the gold standard.

    The US could raise the price of gold to $1,000,000,000 and as the world’s largest holder of gold reserves could easily repay their debts.

    Problem solved.

  4. Danstrodl says

    You mentioned two exit strategies for the US, neither of which is workable.

    I have a third which no one has mentioned … Go back on the gold standard.

    The US could raise the price of gold to $1,000,000,000 and as the world’s largest holder of gold reserves could easily repay their debts.

    Problem solved.

  5. Danstrodl says

    You mentioned two exit strategies for the US, neither of which is workable.

    I have a third which no one has mentioned … Go back on the gold standard.

    The US could raise the price of gold to $1,000,000,000 and as the world’s largest holder of gold reserves could easily repay their debts.

    Problem solved.

Comments are closed.

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