Page 2 of 2 China's sleepless nights By Hossein Askari
The gold exchange standard was re-enacted under the Bretton-Woods agreements in
1944 with fixed parities, a narrow band (a total of 2%) of permissible
exchange-rate fluctuations around parity and International Monetary Fund
monitoring to prevent the competitive devaluations of the inter-war period.
Each currency, including the dollar, was defined in relation to gold. The US
dollar was redeemable in gold. Convertible currencies were redeemable in
dollars or in other currencies. No country could devalue except for fundamental
disequilibrium with the approval of the executive board of the International
Monetary Fund.
Following large external deficits by the US, mainly as a result of the Vietnam
War, and considerable gold outflows, the US had
insufficient gold relative to the global holding of dollars and president
Richard Nixon decided to disband the Bretton-Woods system on August 15, 1971.
The present payments non-system, dominated by a few reserve currencies, has
experienced wide exchange-rate cycles and overshooting of equilibrium exchange
rates. As in previous periods, war-related fiscal deficits and cheap monetary
policy have led to large current account swings and deficits; to unparalleled
instability in asset prices; to volatile exchange rates; and to inflation in
commodity prices. Monetary authorities in reserve currency centers have largely
ignored exchange-rate depreciations and energy and food crises.
The recent simultaneous money and fiscal expansion in major countries, as
called for by the G-20 London summit, combined with zero-interest rates and
competitive devaluations, pose a significant risk over the next two years for
oil and food prices to overshoot their 2008 record levels. Inflation seems to
be the greatest threat in not distant future.
The world economy could face two scenarios: one in which inflation will burn
itself as it did in 2008 and precipitate a world recession. Another possible
scenario is where major countries contract their expansionary policies in
anticipation of inflationary pressures, again leading to a recession. Most
likely, the world economy will be kept in a vicious circle of credit expansion
followed by bankruptcies and credit contraction, in turn counteracted by even
more powerful inflationary policies and renewed fiscal and money expansion.
A reform of the international payments system, while becoming increasingly
pressing, cannot be conceived without a diagnosis of the past systems as well
as the causes of financial instability.
The gold standard worked smoothly until about 1908 or so. The Bretton Wood's
gold exchange standard had at least worked well during 1945-1965. These systems
were fixed exchange-rate systems. The main requirement for stability under a
fixed exchange-rate system is the need to coordinate policies. Namely, if
macroeconomic policies diverge, then there is a need to adjust exchange rates.
The two main causes of divergence have been: excessive fiscal deficits financed
with printing money and unchecked credit expansion in reserve currency centers
(in the earlier period Britain and in the latter period the United States).
These two causes have faulted previous payments systems. Any reform of the
international reserve system should aim therefore at eliminating these two
causes of instability.
Here is where a new reserve currency comes in. More specifically, a world
currency would neither finance fiscal deficits nor become a countercyclical
source of money for inducing economic booms and preventing the working of price
mechanisms. While under a floating system, the need for policy coordination is
theoretically not needed, in practice, reserve-currency centers have neglected
the international role of their currencies and have caused disruptive
expansionary and contractionary cycles, affecting exchange rates, trade and
external balances.
A reform of the world currency reserve system does not aim at diminishing the
role of other currencies such the US dollar, the Japanese yen, the euro, the
British pound, or the Swiss franc as reserve currencies and medium of
international payments. It aims mainly at establishing a world central bank and
a reserve currency that belong to no government and would never be called to
finance fiscal deficits or engage into countercyclical policies.
Such a proposal would be closely in line with Keynes's 1943 plan that called
for a world emitting entity and a reserve currency, which he named "bancor". A
new world currency would operate alongside all other currencies. However, it
would obey strictly different rules and would enjoy considerable stability in
terms of its purchasing power value.
The emission of this new currency would be in a one-to-one mapping with real
flows and would not be multiplied or diminished through credit multiplication
and contraction. The proposed world central bank would not engage in lending
operations or in setting interest rates. It would operate as a 100% reserve
bank, providing a reserve asset and settling payment operations. Its initial
capital could be subscribed in gold. Countries could acquire the reserve
currency through export and other credit operations. They use it for imports
and debit operations.
The value of a world currency has to be defined in relation to a standard, be
it gold or a commodity basket as in Keynes's original plan. Thus, the reserve
currency would have constant purchasing power in terms of internationally trade
commodities. Unlike the IMF's Special Drawing Rights (SDR), which is a purely
credit money with limited usage among designated users (member countries) and
necessitating interest payments by users, a world currency would be a
full-fledged currency, materialized by a banknote, and could be used
unrestrictedly as any medium of exchange.
The world is yearning for financial stability. A world reserve currency may
even turn out to be more beneficial for countries that today jealously guard
their reserve currency status. The presence of a world currency would enable
reserve centers to tackle their domestic priorities without necessarily causing
instability in the rest of the world. Speculation would be reduced, commodity
prices would be stabilized, and trade could grow without going through major
cycles.
Hossein Askari is professor of international business and international
affairs at George Washington University.
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