Page 2 of 2 IMF lost on the high seas
By Hossein Askari
provided by the exit of the UK from the gold standard in 1931, followed by the
US in 1971.
Gold imposed a financial discipline that governments had always to circumvent
and therefore pave the way for financial instability. Economic history for the
19th century showed that episodes of financial instability erupted in some
industrial countries, mainly following period of wars; however, financial
crises never became contagious as each country's financial system was sheltered
through the gold standard from financial shocks affecting another country.
The current financial crisis would not have surged under a gold standard,
simply because liquidity cannot be expanded arbitrarily
and without limit by central banks. Abundant liquidity causes unsafe credit
expansion and is propitious for speculation. Gold outflows from a deficit
country force an increase in interest rates and contraction in credit in that
country and triggers an adjustment mechanism known as monetary approach to the
balance of payments. While a gold standard system is no longer practical, a
system that embodies monetary discipline, a feature of the historic gold
standards, is imperative today.
Under the present regime of floating exchange rates, the US has run large
fiscal and external deficits and pushed real interest rates to a negative
range. These deficits double the increase in liquidity. They allow liquidity to
increase in countries that receive dollars in payments. Next, central banks
place their dollar holdings in the US, providing thus a further basis for
credit expansion in the US. Moreover, in a world with flexible rates and high
capital mobility, these same policies are, or will be, felt the world over.
Financial institutions in the US have extremely limited capacity to place this
liquidity in a productive way; in view of the short-term character of foreign
holdings, US banks find themselves compelled to push this liquidity onto US
consumers and subprime markets. In the 1970s, abundant liquidity was pushed on
to middle-income countries leading to a severe debt crisis in these countries.
Could Bernanke set interest rates at zero and engage in non-orthodox money
instruments under a gold standard, or any system with discipline? The Fed lost
tons of its gold reserves when it attempted expansionary policy in 1950s and
1960s. Because of these losses, the US was compelled to renege on the gold
standard in 1971. Hence, under a gold regime, the Fed would loose all its gold
reserves if it set interest rates below an equilibrium level dictated by the
real economy.
The same truth would apply to Japan. The Japanese central bank would have never
been able to set interest rates near zero under a gold standard. It would
immediately loose all its gold reserves to private speculators. Under the
present system, Bernanke can set interest rates freely at zero and inject
trillions of dollars as he wishes with a stroke of pen. His actions will have
long-run disruptive effects on financial stability and employment. His actions
have already triggered massive unemployment and are spreading despair and
misery among millions of US families. Zero interest rates cause huge
distortions and will dissipate real savings and growth.
Amidst this financial chaos, China has called for the creation of a new
currency to eventually replace the dollar as the world's standard, proposing a
sweeping overhaul of global finance that reflects the developing countries'
growing unhappiness with the US role in the world economy. The unusual
proposal, made by central bank governor Zhou Xiaochuan, is part of China's
increasingly assertive approach to shaping the global response to the financial
crisis.
China Premier Wen Jiabao recently voiced concern about the financial and
economic outlook for the US and for the safety of its US Treasury bills and
bonds. The Chinese concern is shared by all central banks that hold vast US
dollar reserves and US securities.
The Chinese proposal could be considered a distress call, seeing the
unavoidable happening, namely huge losses in the real value of its
dollar-denominated assets. A world reserve currency was proposed in 1943 by
John Maynard Keynes, along with the creation of a world central bank. Keynes's
proposal was defeated in favor of the 1944 Bretton-Woods agreement of fixed
exchange rates. A world currency has been repeatedly revived by prominent
economists such as Robert Triffin, Jacques Rueff, Robert Mundell, Paul Volcker,
and Stiglitz. While a domestic currency imposes a financial constraint on
economic entities such as households and firms, a world reserve currency would
impose discipline on national central banks, in the same way as gold did prior
to 1914.
It is high time that the world community saved itself from unruly reserve
currency central banks and financial chaos. There will be forces that will
fight the creation of a world currency. Yet, the benefits for world economy at
large could be far reaching in terms of financial stability, curtailment of
exchange rates instability, and growth of trade and employment.
The US could ironically be the biggest beneficiary of this proposal, dwarfing
US seinorage benefits. The US economy over the past four decades has become a
market for the rest of the world and in so doing has lost its manufacturing
base and its competitiveness. Such was indeed the case of mercantilist
countries that enjoyed large discoveries of gold and became pure importers when
other countries were pushing on with their industrial revolution.
More than any decision that could be adopted, the adoption of a world currency
would be symbol of the most far-reaching and responsible international
cooperation. Rueff, the French economist, noted that the Genoa conference in
1922 abolished the gold standard. He called for an international conference to
re-establish a common currency; his preference was gold.
Just as the world community convened in Bretton-Woods to establish a fixed
exchange regime, there is now an urgent need for a conference to establish a
world central bank, a world currency and a new international payments system.
Such a central bank would be under no fiscal pressure or any mandate to insure
full-employment or temper with interest rates. It's goal would be to provide a
safe and stable currency that would grow at rate to accommodate steady and
sustained economic growth and prosperity.
Absent this fundamental reform of the world payments system, and in view of the
scary financial disorder in reserve currency countries, the world economy may
have no choice except to seek refuge in gold. Bernanke, European Central Bank
president Jean-Claude Trichet, or Bank of England governor Mervyn King can
instantaneously create trillions of dollars in fake money; but they cannot
create even one gram of gold.
They will rob millions of workers and pensioners of their real and hard won
gains and spread misery around the world. Their monetary injection is a pure
tax on holders of money and amounts to a redistribution of wealth in favor of
debtors. The more they inflate the economy, the more they will deflate real
activity and spread unemployment and despair.
Finally, I must rekindle a debate on the the payments system and the reserve
currency that the late Nobel Laureate, Franco Modigliani, and I proposed in
1971. We initially made our proposal before the collapse of the Bretton Woods
system and elaborated on its soundness in 1973, especially in limiting the
international propagation of economic shocks. I still believe that it is the
best system for global financial stability and sustained economic growth.
Hossein Askari is professor of international business and international
affairs at George Washington University.
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