Toronto, the ghost of Keynes and the future of the international monetary system
By Michael Prowse
If Lord Keynes were alive today how would he have reacted to last weekend’s G20 meeting in Toronto?
Like President Obama, he would probably have accepted the consensus view that fiscal deficits should be halved by 2013, while worrying that too much fiscal consolidation too soon could derail the global recovery. He would also have accepted the logic of delaying the implementation of more stringent rules on bank capital until the recovery is better established.
But Keynes would have criticised the assembled leaders for failing seriously to address the longer-term needs of the world economy. He would have argued that the measures agreed in Toronto were unlikely to solve two of the most pressing problems: large and persistent current account imbalances; and the inadequate flow of capital to the developing and emerging economies. He would have been frankly astonished that the global financial infrastructure he helped construct at Bretton Woods in 1944 was still largely unreformed, even though the global economy now faces entirely different challenges.
As Joseph Stiglitz, among other economists, has argued, there are strong grounds for believing the US’s large and persistent trade deficit primarily reflects design flaws in the global infrastructure rather than the unfair trade practices of other nations. That said the perverse policies of the US’s trading partners, such as China’s deliberate undervaluation of its exchange rate and Germany’s implicit protection of its home market, certainly do not help.
The basic structural problem is that the US supplies the world’s primary reserve asset. Following the Asian crisis in the late 1990s, emerging and developing countries’ demand for reserve assets (i.e. dollars) exploded because these nations wanted to protect themselves from global financial instability so as to avoid ever becoming wards of the IMF again. China today has $2.3 trillion of reserves which makes it immune from any kind of speculative attack in financial markets. Most other Asian nations have impressive dollar war-chests.
But if poor countries are to accumulate dollar assets, such as US Treasury bills, the US must be induced to supply them. If US imports persistently exceed US exports, it will run a large current account deficit. Since the balance of payments in aggregate must always balance, this implies a large capital account surplus.
In other words the US must be a net borrower from other nations, i.e. a supplier of dollar assets. If in addition it runs a large budget deficit, there will be a ready supply of US Treasury bills, a particularly safe dollar asset.
If the global demand for reserve assets, which is really a demand for national economic security, accounts for all or part of the US’s persistent current account imbalance, then efforts by particular trading partners to reduce their surpluses with the US are unlikely to resolve the problem. If the structure of the reserve asset system is the primary factor driving the US trade deficit, surpluses will just pop up somewhere else.
As Keynes argued 70 odd years ago, an international monetary system needs an international reserve asset. Regrettably delegates at the original Bretton Woods conference rejected his proposal for just such a synthetic asset – the bancor. Keynes would have tackled the problem of imbalances directly: deficit countries needing to acquire additional bancors would pay interest on them, but so would surplus countries that held unnecessarily large stocks of the reserve asset.
Under Keynes’s rules, Germany would have to compensate the rest of the world for sucking demand out of the global economy and depressing world growth.
But if the case against relying on the dollar as a global reserve asset was strong in 1944, it is infinitely stronger today. According to IMF figures, developing and emerging economies now account for 46 per cent of global production against 54 per cent for advanced economies. Since Asia is expected to grow much faster than the US or EU, these shares will soon approach parity.
The US now accounts for only 20.5 per cent of global output, while China and India combined are not far behind with a share of 17.5 per cent. The eurozone’s share is just 15.5 per cent.
Yet at present, the dollar accounts for about 67 per cent of global reserves and the euro for perhaps 30 per cent. Given the US’s dwindling share of global output, dollar assets are not going to remain the overwhelmingly dominant component of global reserves for the indefinite future.
History suggests that suppliers of sovereign reserve assets can lose their market share surprisingly quickly. In 1914 the principal reserve asset was the pound sterling. The US dollar was a purely domestic currency: US exporters sought trade credit from London in sterling. Yet a mere decade later, the dollar was indisputably the world’s leading reserve asset.
Partly because of the historical record, economists differ on what to do about the dollar today. Barry Eichengreen of the University of California at Berkeley argues that policymakers should sit back and allow market forces to determine the distribution of global reserves. He argues that a tripolar global economy (the US, the EU and China being the three poles) will naturally produce a tripolar distribution of global reserve.
As China’s financial system matures and as it lifts restrictions on the use of its currency, the renminbi will take its place alongside the dollar and euro as a reserve asset. The renminbi will eventually be strongly in demand as a reserve asset among the Asian nations that trade heavily with China.
Yet although the renminbi’s use as a reserve asset looks probable, it is not likely in the near term. Other economists – such as Mr Stiglitz - have followed Keynes and argued for the deliberate creation of a synthetic global reserve asset. Perhaps surprisingly, Governor Zhou of the People’s Bank of China has enthusiastically endorsed this position. In a much discussed paper published ahead of the London G20 summit last year, Mr Zhou argued that the US would be unable to set the dollar’s value appropriately or reduce its trade deficit significantly until a “super sovereign reserve asset” replaced the dollar in the portfolios of central banks around the world.
Perhaps tongue in cheek he advocated the issue of a global reserve asset by a trusted international institution subject to clear rules and with the objective of sustaining global economic and financial stability. It was imperative, he argued, that the supply of the global reserve asset be disconnected form the needs and policy agenda of any one nation.
In purely theoretical terms, Mr Zhou’s arguments, which echo those of Mr Stiglitz, make a great deal of sense. There is an international institution capable of managing the issue of a global reserve asset – the IMF – although whether it is universally “trusted” is a moot point. And the IMF has already invented a synthetic quasi currency – the Special Drawing Right (SDR) – which it uses as a unit of account in its dealings with member states. Central banks already hold some SDRs as reserves and there are informal arrangements whereby SDR’s can be exchanged for “hard” currencies such as dollars or euros – either by the mutual agreement of countries or through the IMF formally asking a member state in surplus to buy SDRs from a member state wishing to sell.
Mr Stiglitz has argued that future incremental demand for dollar reserves be satisfied by the issue of SDRs. This would remove upward pressure on the dollar, thus helping the US to achieve external balance, and adding to global demand. With a costless supply of reserves, emerging nations could adopt more expansionary policies without fearing loss of autonomy as a result of financial crises not of their making. At the London summit, the G20 agreed a new SDR issue worth $250bn. This was big by historical standards yet still brought the share of SDRs in total global reserves to only 4 per cent, hardly sufficient to make any discernible difference.
There remains a strong case for further issues of SDRs both to boost global growth and to reduce the strain on the US. Other possible reforms, such as changing the SDR’s composition to better reflect the distribution of global output and allowing its use as “private” money rather than only in dealings between central banks, also ought to be discussed. In general, the G20 needs to show that it can think imaginatively about longer-term challenges as well as respond to short-term crises. Otherwise Lord Keynes is going to continue turning in his grave.