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The global economy needs a new currency anchor

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  • The US dollar has been the anchor currency of the international monetary system since 1944
  • This gives the United States certain advantages, but has negative consequences for international financial stability
  • EU President Juncker wants to see the euro take over the dollar’s role; this is not a good idea
  • The global economy does indeed need a new anchor, but one that is not tied to an individual country
  • The dollar will not be replaced by an anchor any time soon

Introduction

Since the inception of the Bretton Woods system in 1944, the US dollar has been the world’s leading currency. Under Bretton Woods, the dollar was linked to gold at a fixed price for gold and could, at least in theory, be exchanged for gold at this fixed price. The dollar was the successor to the British pound, which fulfilled this role for the best part of the 19th century, under the gold standard. With the adoption of these standards, the importance of these ‘anchor currencies’ reflected the financial-economic, political and military position of Great Britain (in the 19th century) and the United States (US) since 1945.

Figure 1: The largest economies
Figure 1: The largest economiesNote: Proportions are calculated on the basis of nominal exchange rates in 2015.
Source: IMF

The choice of the dollar as the central currency of the global monetary system was therefore entirely logical. After the Second World War, the US was by far the world’s largest and richest economy, it was an important net creditor country and was by some distance the strongest Western power in political and military terms. The situation today has changed radically. The US’s share of global GDP has contracted significantly, mainly due to the rise of other countries. The eurozone and China are now challenging the US economy’s leading position (figure 1). Note that the proportions of the global economy in the figure are shown on the basis of nominal dollars. After adjustment for domestic prices, known as purchasing power parity, China’s economy is also of comparable size to that of the US.

Since 1980, the US has had a permanent savings deficit, meaning that in absolute terms it is now by far the world's largest debtor country. But because the dollar, which for a long time has not been linked to gold, is still the core of the global financial system, the US has the fortunate side-effect that almost all this debt is priced in US dollars. This means that if the dollar weakens, US citizens experience virtually no ill effects (Boonstra, 2017). Things are of course different for the rest of the world, which sees the value of its dollar assets decline as a result of the depreciation. The currency markets thus in fact play little or no role in disciplining the US.

Figure 2: The major currencies
Figure 2: The major currenciesSource: ECB, June 2018

Although the relative importance of the US has declined substantially due to the rise of other blocks, the dollar’s central role is still unaffected. This is shown in figure 2. The dollar is still the dominant currency for the issuance of bonds, bank loans in foreign currency and the holding of official reserves. The euro is only challenging the dollar’s position when it comes to settlement of international transactions. Put briefly, the dollar’s dominance in the financial markets today is much greater than the dominance of the US economy itself. The dollar continues to be unsurpassed when it comes to liquidity in the market.

The anchor country enjoys an “exorbitant privilege”

The country with the anchor currency enjoys huge benefits. As stated above, it can finance virtually all its debts to other countries in its own currency. The same applies to imports and exports, which also can largely be paid for in its own currency, as can its investments in other countries. In the 1960s, the French President De Gaulle referred to this as "America's exorbitant privilege". As Barry Eichengreen put it (in 2011): “It costs only a few cents for the Bureau of Engraving and Printing to produce a $100 bill, but other countries had to pony up $100 of actual goods in order to obtain one.” This led the French to exchange their dollars for gold, whereupon other countries threatened to follow their example. The US accordingly decided to end the link between the dollar and gold in 1971. This effectively marked the end of the Bretton Woods system (Boonstra, 2018).

The dollar’s central role also gives the Americans political power, as shown by the current situation with respect to Iran. Although the EU takes a different political position with respect to Iran than the US, the US can get its way, partly because the US can monitor every dollar transaction. This is because world trade, especially in commodities, is mainly settled in dollars.

But this status also has disadvantages

The status of anchor country however also has disadvantages. Since the anchor currency has such a central role, demand for it is much higher than would otherwise be the case. This leads to a permanent overvaluation of the currency, which harms the competitive position of the anchor country. The effect of this is a permanent trade deficit. This is no problem in purely financial terms, since these deficits can, as noted above, be financed in the country’s own currency. But because a strong currency undermines the competitive position of the export industry in the US in this case, it also has consequences for domestic business activity and employment. If the dollar was a ‘normal’ currency, its exchange rate against the euro would probably be significantly lower, the US economy would have been in better shape and there would possibly have been less domestic dissatisfaction.

The dollar’s central role is also a problem for the rest of the world, since the US is a major source of disturbances from time to time. This was evident when the Bretton Woods system came to an end in 1971 and more recently, during the great financial crisis in 2008, which originated from the sub-prime crisis in the US. The essence of the problem is that policymakers in the anchor currency country have two simultaneous responsibilities. On the one hand they have to protect their national interest, on the other they are largely responsible for global financial stability. These interests conflict at certain times, and when they do, the Americans unwaveringly choose to protect their own interests. And from the point of view of US domestic politics, this is a perfectly defensible position to take.

A different anchor currency will not solve the dollar problem

All of this leads regularly to calls that it is time for another currency to take over the dollar’s role. The most obvious candidates would according to many be the euro or the renminbi, with the observation that the renminbi is compared with the dollar, the euro and even the Japanese yen still a financial dwarf (see figure 2). Very recently, EU President Juncker called for the euro to gradually take over the dollar’s position (2018). The Eurozone is now just as large an economy as the US, while international trade by the Eurozone today exceeds that of the US. Nonetheless, Juncker’s proposal is a bad idea, for several reasons. First of all, today’s financial-economic position of the EU, and also of China, is nowhere near the absolute dominance enjoyed by the US in 1944. China was then a very poor country, while almost all other industrial countries were all ruined by the war. Nowadays, the large economic blocks are much closer together in terms of size. No one economy is now really dominant. So it is by no means obvious that the currencies of the EMU or China could have such a dominant role as the dollar. The euro is still subject to the continuing political uncertainty around European integration. Secondly, and much more importantly, there is absolutely no guarantee that the EU or China would be better guardians of global stability than the US, since the fundamental problem that lies in the potential for conflict between domestic and international interests will not be solved. The problem would simply be shifted from the US to another country. Thirdly, the country with the anchor currency would sooner or later be faced with an overvalued exchange rate, which would increasingly be determined on the basis of factors other than domestic developments. Although it might seem attractive to have such a dominant currency, over time the other side of this would lead to destruction of industry and loss of jobs. In the Eurozone, for example, this destruction would begin in the weaker Member States, further increasing the already existing tensions within the eurozone. If Juncker gets his way and the euro becomes as important or more important than the dollar, paradoxically this could lead to the end of the euro in the longer term.

Nostalgia for the gold standard?

The gold standard, which had its heyday roughly between 1873 and 1914, marks an era that has gone down in history as the first period of globalisation. There are still people today who hanker for a return to this. The important advantage of the gold standard was that there was an objective measure of value (gold) that was recognised by all the participating countries. This was a great benefit, especially for cross-border trade. It is entirely logical that the gold standard marks the first wave of globalisation, which ushered in a flowering of international trade and direct investment. For domestic payments however, gold played only a modest role. These were settled mostly in low value currency. A second benefit of the gold standard was the wide acceptance of general policy rules. If a country had a foreign trade deficit, this was settled in gold. The gold stocks of the deficit countries declined, while those of the surplus countries increased. If the central banks eased or tightened their domestic money supply in line with the increase or decline in their gold stocks, this ultimately was reflected in domestic purchasing power and therefore their competitive position. This at least was the principle. This system did actually function reasonably well, albeit with the associated disadvantages (Boonstra, 2018). One important disadvantage was that the growth of the gold stocks was not sufficient to keep pace with economic growth. This was compensated for in practice because the money supply in the form of demand deposits increased rapidly during the 19th century. This prevented the economy stalling in deflation due to money supply being too tight, but it also meant that the amount of gold covering the effective money supply (demand deposits plus notes and coin) had substantially declined over time. The gold standard thus became a so-called gold core standard, meaning that the money supply was only partly covered by gold.

In the end, the gold standard also turned out to be a product of its time. But nostalgia for this ‘golden age’ lived on. The gold standard effectively came to an end with the outbreak of the First World War in August 1914 (although it continued to operate for some decades after 1918 and its ultimate removal in 1936). After this, there were attempts to form a new objective anchor. There were proposals to move to what is known as a commodity standard (Hayek, 1943). These were unsuccessful, mainly because they were very impractical and highly expensive. Ultimately we stuck with gold, albeit in a reduced role. The Bretton Woods system was in theory also based on gold, as what is known as a gold exchange standard, but in practice it was mainly a dollar standard. In this system, the dollar was even more dominant than the British pound had been under the gold standard. The current dollar standard has no underlying cover any longer, with all the disadvantages of this situation described above.

An objective standard would be better, but a global currency is an illusion

Since the weights of the world’s largest economies are nowadays more or less the same, it would not be illogical to move to a multi-polar system consisting of the currencies of the major countries. This would mean that over time, the dollar, the euro, the renminbi and in the longer term possibly the Indian rupee would be of more or less equal importance internationally. Nonetheless, supplementing such a multi-polar system with a neutral currency basket as an anchor would seem advisable. This anchor would have to be actually usable as international (base) money, or it would have to be possible to use it as a unit of account, a unit of value and an asset. At the same time, it is important that countries and regions retain their own currencies. The anchor could not therefore become a global currency that could be widely used everywhere. As the world is indeed not an optimal currency area, the whole idea of having one global currency is basically flawed. An area qualifies as an optimal currency area if it has a high level of internal cohesion, meaning that it is logical for it to have one single currency. In practice, most countries are not naturally optimal currency areas, but they qualify in practice because they are also political entities. This means that political agreements, for example on financial transfers within national borders, can ensure that countries can function as an optimal currency area. The chance of this happening at global level is nil, so any attempt to install a single global currency will be a non-starter. The currencies of the major economies will fluctuate with respect to the central anchor (the role that gold used to have), functioning as global base money, while the currencies of most of the smaller countries will be linked to currency of a large country in one way or another. The major currencies will thus fulfil the function of a local anchor.

We already have a proper candidate for the role of currency anchor

In principle, such a global currency anchor is already available, in the form of SDRs, or Special Drawing Rights. This is a basket of currencies that is issued by the International Monetary Fund (IMF). The major currencies are already included in this basket, so the outlines of a potential central anchor are available, subject to the necessary adjustments to enable SDRs to fulfil this role effectively. This concerns both the adjustments to the SDRs and the necessary reforms of the IMF.

There is much work to be done here. The first step, an important precondition, has to be the reform of the IMF. The IMF was set up in 1944 and the composition of its board for a long time reflected the political relationships at that time. There have been changes in recent decades, but generally it can be said that emerging markets have relatively little influence in the IMF. In addition, the US has a de facto veto in some key areas. The European countries are also relatively strongly represented, although their votes are fragmented across various electoral units.

Partly as a result of this, the EU and the EMU do not necessarily speak with one voice. If the Eurozone countries were to get together and vote collectively, the European vote could outweigh the vote of the Americans. Such a step would also force changes within the IMF, since as stated above, the European countries are divided between various electoral units.

Managing a currency basket is however primarily an executive task that, as with most modern central banks, has to be exercised outside the influence of day-to-day politics. One could therefore question whether it would not be more logical to set up a separate management body within the IMF to manage the currency anchor on a daily basis. This body could then for instance consist exclusively of representatives of the countries whose currencies are included in the SDR. This would significantly simplify the management of the currency anchor. The task could also possibly be delegated to a less political body such as the Bank for International Settlements (BIS), which is already frequently referred to as the central bank for the central banks. Obviously, the manager of the SDR must be given a clear mandate, including a rule for money growth for the increase in the amount of the official SDR. The manager would also have to give account to the full IMF meeting on its policy at least once a year.

Figure 3: Composition of the SDR
Figure 3: Composition of the SDRSource: IMF

If the SDR is to fulfil the role of a global currency anchor, it will also need to be adjusted. The composition of the SDR is reviewed once every five years. Since 2015, the SDR consists of five currencies: the dollar, the euro, the Japanese yen, the British pound and the Chinese renminbi, as shown in figure 3 with the various percentages. Note that these percentages date from 2015. At that time, the SDR basket was constructed on the basis of these weights, but the SDR is defined in fixed amounts of the constituent currencies. The actual exchange rate of the SDR in comparison to the constituent currencies is thus determined by their mutual exchange rate developments. This means that the weights are subject to change on a daily basis. In fact, the value of the SDR is a weighted average of the values of the constituent currencies.

Since the introduction of the euro, which replaced the German mark and the French franc, the SDR consisted of four currencies until 2015, when the renminbi was added to reflect the increased economic and political influence of China. One can however question whether the renminbi should have been included, since the Chinese currency is still not freely negotiable. Secondly, the renminbi still has a very limited role as a reserve currency in the financial markets. Not only the yen, but also the British pound and even the Swiss franc are in general more important than the renminbi. Thirdly, the renminbi is in practice closely pegged to the US dollar and the currency is closely managed by the central bank. Inclusion of the renminbi in the SDR basket would thus seem to be premature. It was above all a political decision, but nonetheless also a decision that could stand in the way of further development of the SDR. This will be explained further below.

If we want the SDR to develop into a fully-fledged alternative to other currencies, a private SDR market would definitely also have to be developed. The fact that this is perfectly possible was demonstrated in the 1980s and 1990s, when a lively private market developed for the ECU, the currency basket that served as pivot for the European Monetary System at that time. This was strongly encouraged because private parties could accumulate ECUs themselves on the basis of the underlying currencies. There is no reason why a similar process could not occur for the SDR. But this will only work if all the currencies in the basket are fully convertible, are freely negotiable in the financial markets - which in turn would need to be highly liquid for each of these currencies - and can move freely against each other.[1] This last point is essential if the SDR is actually going to reflect the weighted value of the constituent currencies. From this point of view, the inclusion of the renminbi is a step backwards, since this currency is the only one in the SDR basket that does not meet any of these requirements at this time.

Once an SDR market develops, it will be increasingly attractive for borrowers to issue bonds in SDR and/or draw down credit in SDR. A mature market for government bonds in SDR would be essential. The central banks could provide a strong boost to the market by converting a substantial part of their currency reserves at the IMF and executing their open market operations and other market interventions mainly in SDR. The markets would have to gradually quote and trade commodities in SDR, rather than in dollars.

Global financial stability would be significantly improved if the IMF (or the BIS) were to allow the official SDR reserves to increase on the basis of a fixed rule for money growth, under which all countries would automatically be allocated a modest increase in their SDR reserves each year, and investors seeking certainty could put their money into a large and highly liquid market denominated in SDR. Major currencies like the dollar, the euro and in due course the renminbi could still play their part as regional anchor currencies. But their policymakers could no longer avoid the discipline of the market if investors have recourse to a safe and highly liquid haven denominated in SDR. This would also mean that no single country would enjoy an exorbitant privilege, and the global economy would become significantly more stable as a result.

Conclusion

All this will be a very long haul (IMF, 2011). All the major countries will have to work together, and this is politically inconceivable at this time. It will only become possible if the US realises that over the longer term its status as anchor country is a very mixed blessing and that it could also benefit from a transition to a system based on the SDR. It is also very important that the renminbi develops into a fully-fledged and freely fluctuating currency. The same applies to the Indian rupee, which will most likely develop into a very important currency over time, but which currently is still subject to capital controls.

Today, all of this is well out of reach. For the time being, we will be stuck with the current dollar standard with all the consequences that this entails. In any case, it is important that policymakers realise that striving to introduce a euro or a renminbi standard will not solve the underlying problem. This does not change the fact that Europe can indeed encourage use of the euro. Like the renminbi, the euro could in theory develop into a more equivalent alternative to the dollar without the world adopting a different currency standard.

In anticipation of a different standard, governments could actively encourage use of the SDR by market parties. Countries could issue government and other loans in SDR, private parties could maintain liquidity in this market and central banks could make a start on converting their currency reserves into SDR. This would gradually create the preconditions under which the SDR could possibly develop into a currency anchor over time. It is however important that governments do not frustrate this process by forcing the IMF to include other non-convertible currencies in the SDR basket for political reasons. If this happens, the private SDR market will never get off the ground and a global currency system based on the SDR will remain a mirage. Apparently feasible and close at hand, in reality distant and unachievable.

Footnote

[1] There is of course the important question of why the arrival of the official ECU was quickly followed by the rise of a sizeable market in private ECU, while this has never happened for the SDR. Allen (1986) has researched this question and offers the following observations. The ECU was a ‘fixed basket’, while according to Allen the SDR was a ‘fixed-weight basket’. Due to its constant composition, a fixed basket is suitable for private contracts, since private parties could create their own ECUs from the constituent parts. Due to its composition, this was not so easily possible for SDRs. The ECU also enjoyed wider use since the EU settled its financial transactions in ECU: this did not apply to SDRs. Governments strongly encouraged private usage of the ECU, which was definitely not the case for the SDR. In addition, the dollar had a large weight in the SDR, while the ECU was more broadly diversified. Lastly, there was greater volatility between the constituent currencies in the SDR than in the ECU. This last point can be seen as a sensible compromise between the strong and weak constituents. This applied much less to the SDR (Allen, 1986, chapter IV). Aglietta (2000) also notes the paralysis that occurred as a result of the disagreement between the US and France over the role of the SDR.

References

Aglietta, M. (2000), The International Monetary Fund And the International Financial Architecture, CEP II, Document de travail no. 2000-08, May.

Allen, P.R. (1986), The ECU: Birth of a New Currency, Occasional Paper No. 20, Group of Thirty, New York.

Boonstra, W.W. (2017), The US external debt is no cause for concern, yet, VoxEU, August 17 2017

Boonstra, W.W. (2018), Geld. Wat is het, wat doet het, waar komt het vandaan? (Money. What it is, what it does, and where does it come from? (in Dutch))Amsterdam, VU University Press.

Eichengreen, B (2011), Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System, Oxford University Press.

Juncker, J-C (2018), State of the Union Address 2018, Brussels, 12 September.

Mundell, R.A. (1961), A Theory of Optimum Currency Areas, American Economic Review, Vol. 51 (4), Sep. 1961, pp. 657 – 665.

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Author(s)
Wim Boonstra
RaboResearch Global Economics & Markets Rabobank KEO
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