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The Reform of the International Monetary System

What’s at stake France, which has taken over the chair of the G20 group of leading economies in mid-November and that of the G8 on January 1, has placed reform of the international monetary system at the top of its agenda for its year-long presidency. France wants a reformed international monetary system which is "more […]

By: Date: January 10, 2011 Topic: Banking and capital markets

What’s at stake

France, which has taken over the chair of the G20 group of leading economies in mid-November and that of the G8 on January 1, has placed reform of the international monetary system at the top of its agenda for its year-long presidency. France wants a reformed international monetary system which is "more balanced", "more stable" and "more transparent" in order to "better protect" emerging and developing countries, to "better diversify" reserve currencies and "better coordinate" exchange rates. The task, however, is anything but simple. The subject is abstruse and barely anybody outside academia has taken an interest in it for the last twenty years. Accordingly, there are hardly any worked-out proposals on the table.

Increasing consensus about the shortcomings of the current system for some…

Ousmène Mandeng argues that there seems to be increasing consensus about the shortcomings of the present system. The management of international liquidity is based on a fundamental asymmetry, namely the fact that while the U.S. represents about 25 percent of world GDP the dollar represents 65-75 percent of central bank international reserves. This implies that there is an undue reliance on national currencies to manage international liquidity; that is the U.S. Federal Reserve is unlikely to subordinate its domestic policy objectives to the needs of the international economy.

In what may be considered his most important speech since the helicopter money talk nine years ago, Ben Bernanke recognised the flaw of the current international monetary system. As currently constituted, the international monetary system has a structural flaw: It lacks a mechanism, market based or otherwise, to induce needed adjustments by surplus countries, which can result in persistent imbalances. According to author and economist Richard Duncan this is the first time the Federal Reserve chairman has publicly pointed out that the international monetary system may have a structural flaw.
Fred Bergsten urged the United States to not only accept a more varied currency regime as an inevitable reality, but actively encourage such a development as part of its effort to recalibrate its own international economic position. Huge inflows of foreign capital into the U.S. facilitated, if not overtly induced, the overleveraging and underpricing of risk. Moreover, the international role of the dollar has led to overvaluation of the U.S. dollar, reducing the competitiveness of U.S. exports.

But not for others

Dominique Strauss-Kahn
’s view is that the current international monetary system, despite its problems, is still working reasonably well. It proved resilient during the recent crisis, and near-term concerns about the dollar can be eased with appropriate policy actions from the U.S. authorities.

Kenneth Rogoffpoints that Robert Mundell – the intellectual father of the euro – once famously opined that the optimal number of currencies in the world is an odd number, preferably less than three. But it is hard to see why right now as the financial crisis was hardly an advertisement for expanding the scope of fixed exchange rates. The modern system of floating exchange rates has, on the whole, acquitted itself remarkably well. Even if exchange rates work sometimes in mysterious ways, their cushioning effect is undeniable. The sharp depreciation of the euro after the crisis helped sustain German exports, thereby keeping the eurozone afloat. By contrast, the eurozone’s peripheral countries, including Greece, Portugal, Ireland, and Spain, found themselves pinned to the mast of the common currency, unable to gain competitiveness through exchange-rate depreciation.

Edwin Truman points that a malfunctioning international financial system contributed to the crisis, and may have been a major cause, but a malfunctioning international monetary system was not a major or a minor cause of the crisis. To deny that the evolution of the international monetary system has been constructive, or to argue that it was anti-Darwinian in nature resulting in a dysfunctional nonsystem, is like arguing for dismantling the internet because it is used to recruit terrorists. Reversion to some prior international monetary system, or a new, more automatic and more rigid system, is not going to happen primarily because the supporting conditions are not present today.

Seeking Alpha argues that every monetary system suffers tradeoffs. There is no ideal strategy for a) insuring price stability; b) minimizing economic volatility;and c) maximizing employment. At times there’s a virtuous circle of positive reinforcement in the business cycle that promotes that trio. But this circle eventually ends. Expecting that a monetary system will somehow dispense all three is expecting the impossible in the long run.

A multi-currency regime

Barry Eichengreen
argues that the premise that the network-based nature of the IMS leaves room for only one true international unit is wrong. The sheer size of today’s global economy means that there is now room for deep and liquid markets in more than one currency. And the view that there can be just one international and reserve currency at any point in time is inconsistent with history. Before 1914, there were three international currencies: the British pound, the French franc, and the German mark. The dollar and the pound then shared international primacy in the 1920’s and 1930’s. Today, currencies other than the dollar account for 40% of identified international reserves. The implication is that the dollar, the euro, and the renminbi will share the roles of invoicing currency, settlement currency, and reserve currency in coming years. The very fact that there are questions about all three means that none of them will obviously dominate. Some worry about the stability of this world of multiple international currencies. They shouldn’t: a more decentralised international monetary system is precisely what is needed to prevent a replay of the financial crisis. Countries seeking additional reserves will not be forced to accumulate only – or even mainly – dollars. No one country will be able to run current-account deficits and use foreign finance to indulge in financial excesses as freely as the United States did in recent years. This will make the world a safer place financially.

Ousmène Mandeng argues that the adoption of a broad multi-currency regime rests on two fundamental assumptions: 1) that use of several currencies provides greater stability and more liquidity for the international monetary system, as official asset holdings will be more balanced across currencies; and 2) that positive externality effects of using few currencies can be overcome amid technological change and low transaction costs. While the possibility of substituting the dollar is very limited in the short to medium term, the objective should be to identify complementary regimes that can be adopted today to allow for an orderly transition over the long term. Central banks can today play a key role in establishing greater symmetry in the international economy by assuming a more diversified international reserve portfolio. It would represent the clearest sign yet that policy makers are willing to support their stated policy intentions

Reza Moghadam argues that the increased scope for arbitrage among the major reserve currencies could potentially make such a system unstable, unless tight policy coordination among reserve issuers could be achieved.

Special Drawing Rights redo

In March 2009, China triggered a debate by recommending reforming the international monetary system with a new super reserve currency –  pointing especially to the IMF’s special drawing right (SDR).

Reza Moghadam argues that to combine the advantages of multiple and single currency systems, a basket-based reserve system, perhaps built on the IMF’s Special Drawing Rights (SDRs), could be envisaged. The SDR is not a currency; it takes its value from its constituent currencies (currently, the US dollar, euro, pound sterling, and yen, but the basket is periodically reviewed), and this makes it more stable: if one of its constituent currencies depreciates, the share of the others in the basket rises proportionately, dampening the volatility of the basket. However, for the SDR to take on such a significant role, its liquidity would need to increase massively. While an increase in demand (from BRIC central banks) and supply of SDR assets (from the Fund) have recently materialized, the scale remains limited–about 4 percent of global reserves. Generating a liquid SDR market of the size needed to create a new reserve currency would be a major undertaking. 

Patrick Artus argues that an "artificial" currency, which would not be the currency of a given country, would have the enormous advantage that its supply could be controlled (by the IMF, or by the central banks as a whole). That is why the proposal of returning to SDRs (which are defined as a basket of currencies) was made recently, and why the G20 Summit in London decided to make an SDR allocation. But although public investors may agree to hold reserves in SDRs, created ex nihilo, private investors won’t as they will want to examine an issuer’s creditworthiness and plans. DBS Group Research notes that jst as the US had to convince the post-war world that the USD would be “as good as gold” at Bretton Woods in 1944, China must first convince the world that the SDR will be “as good as dollars”.

Barry Eichengreen argues that if China is serious about elevating the SDR to reserve-currency status, it should take steps to create a liquid market in SDR claims. It could issue its own SDR-denominated bonds. Better still, it could encourage other G-20 countries to do likewise. They would pay a price, since investors in these bonds would initially demand a novelty premium. But nothing is free. That price would be an investment in a more stable international system. Of course, an earlier attempt was made to create a commercial market in SDR-denominated claims. Back in the 1970’s, there was some limited issuance of SDR-denominated liabilities by commercial banks and SDR-denominated bonds by corporations. But these efforts ultimately went nowhere. The dollar being more liquid, its first-mover advantage proved impossible to surmount. Overcoming that advantage now would require someone to act as market-maker for private as well as official transactions and subsidize the market in its start-up phase. The obvious someone is the IMF.

Panellists at a recent conference organised by Marc Uzan commented on the fact that the objectives of adopting and promoting the SDR had always differed among its proponents; it could be viewed for example as a world currency, or as an official reserve asset, or as a vehicle to transfer aid and that this ambiguity may have been the main reason why the role of SDR has not grown as hoped for. Panellists pointed out that agreement had not been reached despite several earlier attempts on setting up a SDR substitution account amid unresolved difference on meeting possible valuation shortfalls.

Ecstasy of gold

World Bank President Robert Zoellick suggested that the new system include gold as an international reference point of market expectations about inflation, deflation and future currency values.
RGE weigths the pros and cons of a gold standard. Advocates of a gold standard (GS) cite its ability to provide stability: It limits government profligacy by capping the central bank’s ability to issue money and promises price stability by tying the supply of money to holdings of gold while the resulting constraints on the banking system avoid credit bubbles. However, a gold standard is no panacea. In the presence of unsustainable policies, a GS can prompt brutal economic adjustments and exacerbate inflationary/deflationary forces via accelerated capital flows. In addition, a GS is incompatible with the demands of modern economies, most critically a fractional reserve banking system and open capital accounts.

Brad DeLong nominates Zoellick for stupidest man alive and says that the last thing that the world economy needs right now is another source of deflation in a financial crisis. And attaching the world economy’s price level to an anchor that central banks cannot augment at need is another source of deflation – we learned that in the fifteen years after World War I.

Global Currency wishful thinking

Reza Moghadamargues that an even more ambitious solution would be to move to a truly global currency, along the lines of Keynes’s “bancor”, that would circulate alongside countries’ own currencies and would offer a store of value truly disconnected from economic conditions and policies in any country. To achieve this, one would need to set up a global monetary institution that would issue the global currency depending on global economic conditions, and that could act as a global lender of last resort. It would need to have an impeccable (“AAAA”) balance sheet, and governance arrangements that engender widespread credibility and acceptability. Given the practical and political challenges it raises, this option is probably one for the very long time horizon. But perhaps the experience with another international monetary authority, the European Central Bank, suggests that it is not altogether impossible.

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