All the same, the dollar-based global monetary system is defective. It would
be good to start building alternative arrangements.

We should start with what is not happening. In the recent panic, the children
ran to their mother even though her mistakes did so much to cause the
crisis. The dollar’s value rose. As confidence has returned, this has
reversed. The dollar jumped 20 per cent between July 2008 and March of this
year. Since then it has lost much of its gains. Thus, the dollar’s fall is a
symptom of success, not of failure.

Can we find deeper signs that the world is abandoning the US currency? One
beloved indicator is the price of gold, which has risen four-fold since the
early 2000s (see chart). But its price is a dubious indicator of inflation
risks: its previous peak was in January 1980, just before inflation was
crushed.

Gold
Higher prices of gold reflect fear, not fact. This fear is not widely shared.
The US government can borrow at 4.2 per cent over 30 years and 3.4 per cent
over 10 years. During the crisis, the inflation expectations implied by the
gap in yields between conventional and inflation-protected securities
collapsed. These have since recovered – yet another sign of policy success.
But they are still below where they were before the crisis. The immediate
danger, given excess capacity, in the US and the world, is deflation, not
inflation.

The dollar’s correction is not just natural; it is helpful. It will lower the
risk of deflation in the US and facilitate the correction of the global
“imbalances” that helped cause the crisis. I agree with a forthcoming
article by Fred Bergsten of the Peterson Institute for International
Economics that “huge inflows of foreign capital to the US facilitated the
over-leveraging and underpricing of risk”.* Even those who are sceptical of
this agree that the US needs export-led growth.

Finally, what can replace the dollar? Unless and until China removes exchange
controls and develops deep and liquid financial markets – probably a
generation away – the euro is the dollar’s only serious competitor. At
present, 65 per cent of the world’s reserves are in dollars and 25 per cent
in euros.

Yes, there could be some shift. But it is likely to be slow. The eurozone also
has high fiscal deficits and debts. The dollar will exist 30 years from now;
the euro’s fate is less certain.

This view may be too complacent. The danger of a collapse of the dollar is
small and of its replacement by another currency still smaller. But a global
monetary system that rests on the currency of a single country is
problematic, for both issuer and users. The risks are also growing,
particularly since the emergence of “Bretton Woods II” – the practice of
managing exchange rates against the dollar.

Triffin
In the 1960s, Robert Triffin, a Belgian-American economist, argued that a
global monetary system based on the dollar had a flaw: the increased
liquidity the world sought would require current account deficits in the US.
But, sooner or later, the overhang of monetary liabilities would undermine
confidence in the key currency. This view – known as the “Triffin dilemma” –
proved prescient: the Bretton Woods system fell in 1971.

Strictly speaking, reserves could be created if the key-currency country
merely borrowed short term and lent long term. But, in practice, the demand
for reserves has generated current account deficits in the issuing country.
In a floating exchange-rate regime reserve accumulations should also be
unnecessary. But, after the financial crises of the 1990s, emerging
countries decided they needed to pursue export-led growth and insure
themselves against crises. As a direct result, three quarters of the world’s
currency reserves have been accumulated just in this decade.

Yet this very search for stability risks creating long-run instability.
Indeed, Chinese policymakers are worried about the risk to the value of
their vast dollar holdings that, on Triffin’s logic, their own policy
exacerbates.

US policymakers may repeat the “strong dollar” mantra. But this is an
aspiration without an instrument. Relevant policy is made by the Federal
Reserve, which has no mandate to preserve the dollar’s external value. The
only way China’s policymakers can preserve the domestic value of external
holdings is to support the dollar without limit, which compromises China’s
domestic monetary stability and will prove self-defeating in the end.

Solvency
At this point, the widespread concerns about US monetary stability and the
dollar’s external role converge. A standard recommendation on the former is
to preserve both the independence of the Federal Reserve and ensure long-run
fiscal solvency. If the fear grows that either – or, worse, both – is in
danger, a self-fulfilling crisis might ensue. The dollar could tumble and
long-term interest rates soar.

In such a crisis, it might well be feared, a less-than-independent Federal
Reserve would be compelled to buy public debt. That would accelerate flight
from the dollar.

The two key preconditions for long-run stability, then, are a credibly
independent central bank and federal solvency, both of which seem to be
within US control.

Yet this is too simple. Most analysts assume that the US fiscal position can
be determined independently of decisions taken elsewhere. But if the US
private sector were to deleverage over a long period (and so spend
substantially less than its income), while the rest of the world wanted to
accumulate dollar-denominated assets as reserves, the US government would
naturally emerge as the borrower of last resort.

A corollary of the Triffin dilemma is that the international role of the
dollar could make it hard for the US to manage its fiscal affairs
successfully, even if it wanted to do so.

I arrive, by a somewhat different route, at the same conclusion as Mr
Bergsten: the global role of the dollar is not in the interests of the US.
The case for moving to a different system is very strong. This is not
because the dollar’s role is now endangered. It is rather because it impairs
domestic and global stability. The time for alternatives is now.

* The Dollar and the Deficits, Foreign Affairs, November/December 2009

Copyright Financial Times, 2009

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