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.