The dollar reserve system may not be the only source of global financial instability, but it contributes to it. The question is, will the global economy lurch from the current system to another – such as the two currencies reserve system toward which the world now seems to be moving – equally beset with problems? Or will something be done about the underlying problem?
There is a remarkably simple solution, one that was recognised long ago by [John Maynard] Keynes: the international community can provide a new form of fiat money to act as reserves (Keynes called his new money “bancor”). The countries of the world agree to exchange the fiat money – let’s call it “global greenbacks” – for their own currency, for instance in a time of crisis.
Not only is this a theoretical possibility, but at the regional level, in Asia, there is already an initiative under way that employs some of the same concepts. The origins of the initiative go back to the east Asian crisis. At the peak of the crisis, Japan proposed establishing an Asian Monetary Fund, a co-operative movement among the countries of Asia, and generously offered to put in $100bn to help finance it – funds badly needed to help restore the economies in the region.
Chiang Mai Initiative
The US and the IMF did everything they could to stop this; both were worried that an Asian Monetary Fund would undermine their influence in the region, and both were willing to put their own selfish concerns above the well-being of those countries. They succeeded in scuppering the proposal. But only a few years later, in May 2000, the members of the Association of Southeast Asian Nations (ASEAN), plus China, Japan and South Korea, meeting in Thailand, signed the Chiang Mai Initiative, agreeing in effect to exchange reserves, to set up the beginnings of a new co-operative arrangement that would enhance their ability to meet financial crises.
The IMF’s management of the 1997 crisis laid bare the divergence of interests between it – and, by extension, the US – and the countries of the [Asian] region. These countries naturally asked: why should we put the money in our sizable reserves in western countries that treated us so badly, when we could keep reserves in the region, with each holding the currencies of the others? We need more investment, and if we are going to lend to enhance someone’s consumption, why not lend to support the low level of consumption of our people, rather than the profligate consumption of the US?
There were both economic and political dimensions to the initiative. The fact that, in the dollar reserve system, [Asian countries] received lower interest rates on what they lent than on what they borrowed was particularly galling, given that they were saving more and pursuing far more prudent fiscal policies than the US and other advanced nations. They have, moreover, repeatedly been on the losing side of exchange rate instability. As debtors, their falling exchange rate in the 1990s meant that, in terms of their own currency, they had to repay far more than they borrowed; in 2000, with the falling dollar, as creditors they would be repaid in real terms far less than they had lent.
Mutual insurance
As of November 2005, about $60bn in currencies had been made available for exchange between various Asian nations, with agreements in place to expand that amount even further. As this initiative illustrates, reserves can be viewed like a co-operative mutual insurance system. The holding of one another’s currencies in reserves has the same effect as a line of credit, a commitment on the part of other countries to allow the country access to resources in times of need.
The international community has already recognised that it can provide the kind of liquidity that Keynes envisioned, in the form of special drawing rights (SDRs). SDRs are simply a kind of international money that the IMF is allowed to create.
The global greenbacks proposal extends the concept. I refer to the new money as global greenbacks to emphasise what is being created in a new global reserve currency, and to avoid confusion with the existing SDR system, which has two problems: SDRs are only created episodically, while global greenbacks would be created every year; and SDRs are given largely to the wealthiest countries of the world, while global greenbacks would be used not only to solve the world’s financial problems, but also to combat some of the deeper problems facing the world today, such as global poverty and environmental degradation.
Greenbacks system
Here is a simplified description of how the system might work. Every year, each member of the club – countries that signed up to the new global reserve system – would contribute a specified amount to a global reserve fund and, at the same time, the global reserve fund would issue global greenbacks of equivalent value to the country, which they would hold in their reserves. There is no change in the net worth of any country; it has acquired an asset (a claim on others) and issued a claim on itself. Something real, however, has happened: the country has obtained an asset that it can use in times of an emergency. In a time of crisis, the country can take these global greenbacks and exchange them for euros or dollars or yen. If the crisis is precipitated by a banking failure, the money can be used to recapitalise the banks. If the crisis is precipitated by an economic recession, the money can be used to stimulate the economy.
The size of the emissions each year would be related to the additions in reserves. This will undo the downward bias of the global reserve system. Assuming that, going forward, the ratio of reserves to GDP [gross domestic product] remains roughly constant, and that global income grows at 5% a year, with a global GDP of approximately $40,000bn, annual emissions would be approximately $200bn. On the other hand, if the ratio of reserves to imports stays constant, with imports growing at roughly twice the rate of GDP, annual emissions would be as much as $400bn.
Normally, these exchanges of pieces of paper make no difference. Each country goes about its business in the same way as it did before. It conducts monetary and fiscal policy much as it did before. Even in time of emergency, life looks much as it did before. Consider, for instance, an attack on the currency. Before, the country would have sold dollars as it bought up its own currency to support its value. It can continue to do that so long as it has dollars in its reserves (or it can obtain dollars from the IMF). Under this new regime, it would exchange the global greenbacks for conventional hard currencies and sell them to support its currency.
(There is an important detail: the exchange rate between global greenbacks and various currencies. In a world of fixed exchange rates [the kind of world for which the SDR proposal was first devised], this would not be a problem; in a world of variable exchange rates, matters are more problematic. One could use current market rates; alternatively, the official exchange rate could be set as the average of the exchange rates over, say, the preceding three years. In such a case, to avoid central banks taking advantage of discrepancies between current market rates and the official exchange rate, restrictions could be imposed on conversions [for instance, conversions could only occur in the event of a crisis, defined as a major change in the country’s exchange rate, output or unemployment rate]. I envision global greenbacks being held only by central banks, but a more ambitious version of this proposal would allow global greenbacks to be held by individuals, in which case there would be a market price for them and they could be treated like any other hard currency.)
Because each country is holding global greenbacks in its reserves, each no longer has to hold (as many) dollars or euros as reserves. For the global economy, this has enormous consequences, both for the former (current) reserve currency countries and for the global economy.
We noted earlier the self-destructive logic of the current system, where the reserve currency country becomes increasingly in debt, to the point at which its money no longer serves as a good reserve currency. This is the process that is currently in play with the dollar. Because the global reserve system would no longer rely on the growing debt of a single country – the basic contradiction of the current system, which makes instability almost inevitable – global stability would be enhanced.
Trade deficits
There is a second reason why the system of global greenbacks would bring greater global stability. A major factor in the repeated crises of recent decades has been trade deficits: when countries import more than they export, they have to borrow the difference. So long as trade deficits continue, foreign borrowing continues, but at some point lenders worry that the country is too much in debt, that it may not be safe to continue to lend. When these questions start to be asked, there is a good chance that there will be crisis around the corner.
Obviously, if one country exports more than it imports, then other countries must import more than they export. Apart from statistical discrepancies, the sum of the world’s trade deficits and surpluses must equal zero. Put another way, trade deficits must collectively match trade surpluses. This is the iron law of global trade deficits. Accordingly, in order for a country like Japan, which insists on running a surplus, to achieve that surplus, some other country or countries must have a corresponding deficit. Similarly, if some countries get rid of their deficits, either the deficits of others countries must increase or the surpluses of other countries must decrease, or a combination of the two.
Winners and losers
In this sense, deficits are like hot potatoes. As South Korea, Thailand and Indonesia eliminated their trade deficits after the east Asian crisis and turned them into surpluses, it was almost inevitable that some other country or countries would wind up with a very sizable deficit to offset their gains. In this case, the country was Brazil. But just as South Korea and Thailand could not sustain a trade deficit, neither could Brazil. As investors saw Brazil’s deficit rise, they acted as they had so often done before: debts were recalled, precipitating a crisis. As Brazil’s economy plunged into recession, imports contracted, and Brazil’s deficit was converted into a surplus. Again, that surplus means a same sized deficit was created somewhere else in the global system.
While the IMF – and the financial community generally – has focused on countries with trade deficits as the problem giving rise to global instability, this analysis suggest that trade surpluses are just as much the problem. In fact, Keynes, thinking about the problems of the financial system 60 years ago, went so far as to suggest that there should be a tax levied on countries running a trade surplus, to discourage them from letting it grow too large.
Extracted from Making Globalization Work by Joseph Stiglitz, published by Allen Lane on September 7, price £20. Copyright © Joseph Stiglitz 2006. www.penguin.co.uk
