President Johnson stated in 1968: “To the average citizen, the balance of payments, the strength of the US dollar, and the international monetary system are meaningless phrases. They seem to have little relevance to our daily lives. Yet, their consequences touch us all consumer and captain of industry, worker, farmer and financier.”
This is true when international financial arrangements are working well; and becomes even more evident when they are not. While not all would argue there is no life left in the international monetary system (IMS), almost all would agree the present system contains inherent contradictions which lead to frequent breakdowns.
Basic principles
Four basic principles underlie the IMS: (i) a country's sovereign right to regulate internal demand to maintain stable conditions at home in terms of employment and domestic prices; (ii) free international movement of goods and capital and here, substantial progress has been made in meeting this goal; (iii) a system of mixed exchange rate regimes - from fixed exchange rate (eg China) to flexible exchange rate (eg US dollar, British pound and euro) to degrees of managed floats (eg yen and the ringgit); and (iv) a nation's right to hold international reserves in the form of gold, US dollar and other major currencies. In addition, lines of credit are available from the IMF. The reserves available and potentially obtainable set a limit on the cumulative size of a country's balance of payments (BOP) deficit, thus acting as a BOP constraint in domestic policy making. But there is no such corresponding limit for surplus nations. The system is asymmetrical; it “punishes” those in deficit and lets the surplus nations alone.
Most countries experience some trade-off between unemployment and price stability. As unemployment is lowered by policies to expand demand (as with the US stimulative packages), the higher is the price that has to be paid in rising inflation. The trade-off varies over time, and from country to country. The rationale behind this relationship centres on the tendency for money-wage increases to outstrip rises in productivity even under conditions of high unemployment. The current state of a jobless growth in the US with low inflation in the face of continuing high unutilised capacity shows no trade-off at this time. But as demand picks up and as growth picks up and unemployment trends down, inflation is bound to creep up.
G-20 finance ministers and central bank governors gather for a group photo during the IMF and World Bank spring meetings in Washington on April 15. — ReutersWhat's wrong?
First, there is the adjustment problem. The present IMS has no reliable mechanism to eliminate BOP dis-equilibrium (ie payments imbalances). This is fundamental. There are three possible ways of correcting a payments deficit: use of trade and capital controls; adjustment of exchange rate; and government policies working through internal changes in income and prices. All three go against the the principles underlying the system. So, when a country experiences a deficit, there is no assurance the deficit will be eliminated before its reserves are used up; or depending on the extent to which market forces are allowed to sufficiently depreciate the currency; or whether domestic policies are tightened enough to reduce demand.
Second, there is the problem of the exchange rate, which usually doesn't react fast enough to correct imbalances. Destabilising capital flows exacerbate the problem. The IMS is also subject to massive (especially speculative) flows of funds which could complicate BOP adjustment. The flooding of cheap US dollar funds into emerging markets following QE2 (2nd phase of Fed's quantitative easing) have led to capital controls and managed exchange rates limiting their appreciation. Of late, the size of speculative flows has become too large for even the larger emerging markets to cope. This is not the end. In the event QE2 exits, the impact of large capital withdrawals on the exchange rate can be just as destabilising.
Third, there is the problem of liquidity. The system has no arrangement to generate in an orderly and predictable way, increases in foreign reserves that are needed to meet demands of growing world trade. The creation of SDRs (Special Drawing Rights) in the IMF, as and when needed, is supposed to do the job; but in practice, increases in SDRs have been few and far between. By chance, the Fed's recent expansionary program, including QE2, is now over-doing the job; indeed, these capital flows have become too large for orderly adjustments to take place.
Finally, there is the confidence problem. The system allows persistently large surplus nations to do virtually whatever they please in postponing real adjustment. Today, about two-thirds of global reserves is held in US dollar-denominated assets (especially Treasuries). China's international reserves today amounted to about US$3.1 trillion, of which US$1.15 trillion is invested in US dollars. It has been estimated that Italy's entire sovereign debt (principal plus interest until 2062) totalled US$3 trillion. In terms of oil, China's reserves can buy 25 billion barrels of Brent crude, equivalent to 13 years of its net oil imports. Indeed, it could pay for the entire Nikkei 225 list of companies, with US$30bil in change. That's how big China's reserves are.
True, the Bretton Woods system had served the world economy reasonably well. In a sense, the system operated well in the 50s and 60s but was on borrowed time. The “tearless deficits” during this period left a legacy of a large and growing “overhang” of foreign dollar holdings, which frequently threatens a confidence crisis. Persistent US deficits had since led to a diminution in the quality of the US dollar in the eyes of most foreign holders.
Global payments imbalances require a co-ordinated global action to resolve. This is hard to come by. Of the four problem areas, I think the matter of speculative and exchange rate instability is serious. This involves two aspects: (a) threat imposed by the “overhang” of convertible claims against the reserve currencies (especially US dollar) where such claims are today touching 15% of global GDP (6% 10 years ago); and (b) the danger of private speculative runs against currencies under pressure, especially the greenback. They are inter-related. To top it all, the IMF practice of allowing nations to choose their own exchange rate regimes didn't help the adjustment process. Fixed exchange rates operated uneasily alongside flexible exchange rates, including managed floats and permutations of these two major regimes, in the hope that somehow policies would be co-ordinated to converge and foster imbalances adjustment. Nothing like it will ever happen as each regime did its own thing to protect its national interest.
And so, until today, the four problems of adjustment, exchange rate, liquidity and confidence underlying the IMS persisted. One thing is clear: there is no political will to reform. The US, for which reform means the diminution of the dollar's global role, is lukewarm. And Europe is distracted more than ever with protecting the status of the euro and the EU's sovereign debt crisis. France, as chair of G-20, wants to find an IMS that more accurately reflects the new structure of the world economy. But the major emerging nations, especially the BRICS (Brazil, Russia, India, China & South Africa) want to move away from a virtual one-reserve regime to one based on multiple reserve currencies.
Are payments deficits good or bad?
For most, payments deficits are instinctively bad. But think about it. After all, the purpose of international trade is to obtain goods and services from abroad at less than can be produced (or not available) at home. Imports are the benefits of trade. A trade deficit means more goods and services are being received from abroad than are being given up. Surely that's good from the deficit nation's point of view. But this deficit has to be financed. So, the nation either loses reserves (uses savings) or borrows (living on credit), and this may prove uncomfortable as the deficit persists. In the end, the deficit country has to take corrective action, such as deflationary domestic policies (austerity measures), exchange controls, or devalue its currency. All of them conflict with one or more of its domestic economic goals. There is a cost to adjust.
The soft solution is to use reserves (“its function is to render exchange rate stability compatible with freedom for individual nations to pursue national economic goals”). While drawing down reserves or borrowing may reduce the conflict of objectives, it nevertheless increases the potential for future conflict.
That's exactly what's happening in the US. It has run persistent deficits for so long that its debt is now too high (close to 100% of GDP) and its liabilities to nations accumulating US dollar reserves (especially China and Japan) have grown so large that it can trigger off a confidence run on the greenback.
This has proved inconvenient at a time when the US continues to need expansionary policies to bring down its high unemployment. Surplus nations have the opposite problem since these surpluses are inflationary and reflect an inefficient utilisation of reserves in the form of involuntary foreign lending. It can be viewed as the mere hoarding of resources that might have enhanced future output and welfare if added on to domestic investments instead. To sum up, today's mixed exchange rate regimes provide no mechanism for systematic and effective BOP adjustment that does not conflict with major goals of public policy.
IMS reform
Reform of the IMS is clearly needed. V. Lenin once said that “the surest way to destroy the capitalist system (is) to debauch its currency.” The IMS is at the heart of the world economy. When rules of the global monetary game are unclear, inadequate, some even obsolete, nations find it difficult to play; indeed, some may exploit them to their advantage.
This undermines the very fabric of the IMS. Some history. In 1944, Bretton Woods gave birth to the IMF and today's US dollar-centred IMS. The Bretton Woods conference was dominated by two strong-willed economists, H.D.White (US) and J.M.Keynes (UK). The UK wanted a system in which global liquidity is regulated by a multilateral agency (IMF), while the US (for self-interest) preferred a US dollar-based system.
Because of its enormous political power, the US got its way. Keynes, for all his intellect and persuasiveness, failed to: (i) endow the IMF with the power to create a new global reserve unit as an alternative to the US dollar; and (ii) secure a global regime which forces surplus as well as deficit nations, and the issuer of the reserve currency as well as its users, to adjust. It's a pity as Keynes' failures haunt us to this day. Nations with chronic surpluses (Germany, China and Japan) and the US as dominant supplier of US dollar reserves, do not face the same pressures to adjust their imbalances as do deficit countries that are often bullied to do so.
In my view, what is needed is a tripolar IMS organised around the US dolar, euro and RMB (China's yuan or renmimbi). Let's face it, neither the euro nor the RMB are in any position today to challenge the US dollar. The world will be better off with a viable alternative to the US dollar. Their interplay forces on the reserve currencies a market discipline earlier and more consistently. This way, central banks seeking to accumulate reserves will have a choice, so that the US no longer has “so much rope with which to hang itself” (so says my friend Barry Eichengreen). Another view is to transform the IMF's SDRs into an international reserve currency (IRC). The trouble is, the SDR is not market tradable. To be an effective IRC, the IMF will have to be accorded the role of a world central bank. This is unlikely; indeed, a non-starter, as it was in the Bretton Woods days.
At the recent G-20 finance ministers meeting in Paris, all central bankers acknowledged that global imbalances remain a critical problem, and that a solution will involve policy co-ordination. Yet, each played down its own role. Until a solution is found, the “accumulation of foreign exchange reserves is a powerful instrument of self-insurance.” There is no political will to reform only the will to congregate and obfuscate. In the Bretton Woods days, the might of the US called the day. Today, it's nobody's call. What a pity.
