Illusions bred by a reserve currency

Since the Bretton Woods system broke down in August 1971, economist Robert Mundell has convened periodic round-table meetings of economists, bankers, and officials to deliberate on the future of the international monetary system. The Santa Colomba Conference is named after the venue, a magnificent Renaissance villa situated on a crest in the rolling hills outside the city of Siena in Tuscany, which Mundell has called home since the late 1960s. I had the privilege of participating in this year’s recently concluded meetings and would like to share with the reader some of the insights that came out of the gathering.

This summer’s most noteworthy panels were on the “International Monetary Fund (IMF) at 70” and “Where to for the intentional monetary system?” In the wake of the global financial crisis and the still unfolding euro-area crisis, the topics are more timely than ever.

The Achilles heel of the failed Bretton Woods system was its reliance on a “dollar-gold standard”, in which every country fixed its currency to the US dollar, with the dollar, in turn, fixing the price of gold at $35 an ounce. That meant, in effect, that the US had to maintain a “gold window”, always open, in which foreign central banks could swap their holdings of dollars for gold. President Richard Nixon’s unilateral decision to close the gold window, in response to the growing macroeconomic crisis in the US, essentially killed Bretton Woods in one fell swoop—breaking the dollar’s link to gold and the system of fixed exchange rates almost simultaneously.

With the demise of the dollar-gold standard, it was widely—and incorrectly—predicted that the dollar would decline in importance as an international reserve currency. In fact, the opposite has happened, with the global monetary system operating on a de facto, if not de jure, dollar standard—other possible contenders, such as the pound sterling, euro, or yen simply lacked (and continue to lack) the heft and credibility to displace the dollar.

The reliance of global finance on a single reserve currency creates a unique dilemma, noted as long ago as the 1960s by economist Robert Triffin: that the short-term, domestic policy needs of the reserve country may diverge from the long-term, structural needs of the global economy itself, as the reserve country is forced to supply liquidity to the global system and thereby run perpetual balance of payments deficits.

Eventually, and inevitably, the hegemonic power privileges itself at the expense of providing the global public good to which it had initially committed—exactly as Nixon did in 1971.

In fact, the “Triffin paradox” is alive and well today.

As noted by economist Ronald McKinnon at this year’s Santa Colomba meetings, the history of US monetary policy since the time of the “Nixon shock” is a story of the US subordinating the need for a stable and credible global nominal anchor—the dollar—to the short-term exigencies of what is seen to be demanded by the state of the US business cycle.

Thus, with the onset of the global financial crisis and a corresponding macroeconomic crisis in the US, the Federal Reserve’s policy of “quantitative easing”—mimicked by other rich country central banks—drove short-term interest rates down virtually to zero, where they still reside.

Quite apart from whether zero interest rates have really had the restorative effect on the US economy that proponents argue—rather than driving the US financial system into a liquidity trap in which the supply of credit is not forthcoming from banks, who prefer to hoard it—McKinnon points to the damaging effects on the global economy, and emerging economies in particular, of the near zero-interest rate policy.

For with few profitable opportunities in the US and other mature economies, investors seeking returns have poured their resources into emerging economies. These flows of “hot money” can potentially destabilize emerging economies—their central banks, such as the Reserve Bank of India, have the unappetizing choice of either allowing their currencies to appreciate or, instead, to intervene in the foreign exchange markets to soak up the excess dollars, thereby losing monetary control.

What’s more—a point raised by several participants, including me —a hot money-induced economic boom in emerging economies such as India creates the illusion that all is well, allowing governments to postpone unpopular structural economic reforms while they ride the wave of the foreign-financed surge.

Eventually, of course, such bubbles burst, when a change in monetary policy in the US spooks investors and hot money flows back to the centre—much as occurred in May 2013 when then Fed chairman Ben Bernanke touched off a global stock market crash after announcing a “tapering” of Fed purchases of government securities—a plan which he was forced to tone down a month later, given the backlash.

The world will continue to live for some time with the “exorbitant privilege” enjoyed by the US in the global economy—whether to our benefit or our detriment. We shall see, in the fullness of time, if the creation of the Brics bank will help tilt the balance away from the Bretton Woods “twins” and the dollar standard.

Vivek Dehejia is a professor of economics at Carleton University, Ottawa, Canada.

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