Nobel laureate economist Joseph Stiglitz’s suggestion last month that the US dollar could be easily phased out as the de facto universal currency has some merit, but ultimately overlooks the political and strategic hurdles in the way of global monetary reform.
Writing in the Financial Times, Stiglitz argued that the G20 nations could wean the globe off the greenback by broadening the use of special drawing rights (SDRs) – a synthetic monetary unit issued by the International Monetary Fund (IMF).
By widening the SDRs system, he wrote, the IMF would be able to rebalance the global economic recovery and decouple global liquidity from US domestic monetary policy.
There’s nothing seriously wrong with this proposal, but there is little mention of the political constraints – particularly the inability of the IMF to enforce policy and change the behaviour of its member countries.
There is a recognition of the need for change around the world, but there is little political will to coordinate policies to bring about this change.
Consequently, a gradual shift towards a set of several reserve currencies seems more likely than a sudden purge of the US dollar.
Special drawing rights are unique monetary units. They’re not a currency, and they’re not a claim on the IMF either.
Created in 1969, SDRs were designed to ultimately replace the use of gold and silver in large international transactions and provide a low-cost means for countries to build reserves.
They are a potential claim on the currencies of IMF members. This means that holders of SDRs can exchange their drawing rights for the currencies of fund’s constituent members.
This is done voluntarily. In principle, the IMF can, through central designation measures, compel members with strong external positions to purchase special drawing rights from members with weaker external positions.
But this rarely happens in practice.
Nonetheless, Stiglitz’s hope is that an expanded SDR system will help overcome imbalances between the US and other deficit countries and the surplus countries, such as China and the major oil-exporting countries.
The question here is: what mechanisms does the IMF have to enforce such transactions?
It doesn’t really have any.
If the two countries don’t agree, and especially if one of the parties is a powerful country like the US, it is hard to see what the IMF can do.
How is it going to sanction one of those countries? Is the IMF going impose a fine on the US, for example?
Considering that the US only got a slap on the wrist when it did not meet its quota obligations IMF for many years, this does not seem likely.
The key problem is that Stiglitz’s argument does not really take into account the political and economic constraints inherent in the global monetary system.
The proposal assumes the IMF has teeth and that it can enforce rebalancing through its designation mechanisms. But this hasn’t been tested properly yet.
Stiglitz’s proposal might, however, offer a starting point.
It might refocus countries to think in terms of other currencies.
And it may force the world’s financial leaders, particularly the US, to re-evaluate the merits of the US dollar as the sole reserve currency.
The problem with having the US dollar as the de facto global reserve currency is that it results in a predicament known as Triffin’s Dilemma.
This theory, developed by the Belgian-American economist Robert Triffin in 1960, observes a tension that emerges between domestic and international monetary policy when a country’s currency is used as the global reserve currency.
Using the US dollar as the global currency means that the US must constantly run a current account deficit (as it is continuously exporting its currency) while maintaining a flow of dollars into its own economy.
This situation is unsustainable – observers have even identified it as one of the root causes of the global financial crisis – because a country cannot run current account deficits forever.
With persistent deficits confidence in the US dollar will be eroded and demand for the dollar will eventually fall.
The US dollar will lose its reserve currency status as the rest of the world shifts into other, stabler currencies.
Currently, the US Federal Reserve’s expansionary monetary stance, aimed at reviving the flagging US economy, is risking just that.
Last week’s decision by the rating agency Standard & Poor’s to downgrade its outlook on the US from “stable” to “negative” shows this risk is becoming quite serious.
The Fed could take steps to preserve the value of the US dollar but that means raising interest rates and choking off demand at home
With neither option being palatable, the US indeed faces a dilemma – preserve the value of the currency and force the economy into recession or boost aggregate demand and let the value of the US dollar wither.
Stiglitz’s proposal to rely less on the dollar means there is less pressure on the US to adopt policies that preserve the value of the dollar.
In practice, rebalancing the world economy can be done in different ways and expanding the SDR system could be one piece of the puzzle.
But developing a global monetary system with several concurrent reserve currencies seems like a more natural way.
They would need to be currencies of big, economically important and reliable countries – of which there aren’t that many.
The euro is an obvious candidate, while the yen offers some prospects.
The most intriguing question, however, is whether China, now the world’s second-largest economy, can steer the renminbi towards global reserve status.
China would like to see the renminbi gain importance in international transactions. It is taking successive steps to allow for invoicing of trade in renminbi, such as issuing offshore renminbi denominated bonds.
The key concern for most countries is that China still maintains capital controls, even if they by no means work perfectly.
China still has pretty strict capital controls that by no means work perfectly. There are a number of holes in that system.
Without free convertibility of its currency, China will find it difficult for the renminbi to become a serious contender as an international reserve currency.
This is one of many political difficulties that need to be overcome in order to resolve the imbalances that characterise the global economy.
Currently, there is no political appetite for a concerted, coordinated effort between debtor and creditor nations to address these imbalances. Any adjustments are likely to be unilateral and piecemeal.
The problem of persistently large current account imbalances is that they lead to a drastic costly global misallocation of resources. Sooner or later, the world’s biggest economies will have to act. Sooner would be better.