To avoid a currency war, reform the global reserve system

Economic opinion

The US dollar has been the world’s main reserve asset since the implementation of the Bretton Woods System 75 years ago. Though much has changed since 1944 (including the dissolution of Bretton Woods), the US dollar remains at the centre of the international monetary system today. It is widely used for invoicing global trade and held in mass by emerging and developing economies as a precautionary measure against economic or financial volatility. There have long been calls to reform the system and implement a global financial safety net that is more efficient, more equitable, and less prone to creating global imbalances. The US has had a strong interest in maintaining the status quo and the influence it provides. Now, however, US President Trump has made no secret his animus towards a strong dollar and is egging the world towards a global currency war. Given the circumstances, it’s time for international policymakers, including those in Europe, to give serious consideration to a major reform of the international monetary system. An international network of swap lines is one viable alternative to the current system.

A flawed system

The major critiques of the current international monetary system can be summarized into two main points.1 First, a system in which poorer countries are highly incentivized to hold US dollar assets (i.e. lend money to the US) to avoid a crisis does little to make the world a more equitable place. Second, the current system is less than ideal because it contributes to global imbalances and weighs down aggregate global demand. In order to supply the world’s reserve currency, the US must run a current account deficit and borrow from the rest of the world. Related to this, the stockpiles of reserve assets held by other countries effectively act as a drain on global demand, thereby weighing on global growth. The US is left to make up for that lost purchasing power as the consumer of last resort - a role that becomes increasingly complicated to fill as the US debt burden widens. A reform of the system, therefore, would seek to address these issues.
 

Swap lines to the rescue

Some argue that greater diversification of reserves, i.e. countries holding more euros, yen, and even the Chinese renminbi in addition to US dollars, will solve many of these problems. However, such a system could actually lead to a more volatile global economy than a single-currency system if central banks around the world were to become active and massive traders of these currencies. Furthermore, emerging markets being compelled to buy negative yielding euro and yen assets or risk a crisis does not at all address the inequity of the current system. Finally, the fact that the euro’s role as a reserve currency has declined since the crisis shows that there is, at present, no real alternative to the dollar.
 

Global holdings of international reserves (by currency, in % of world GDP)

Source: KBC Economics based on IMF

Other potential solutions include various ways to expand the IMF Special Drawing Rights (SDRs)2 to take on the role of reserve asset (e.g. through expanding the frequency and size of its issuance). Perhaps most effective, though likely controversial, would be expanding the role of the IMF’s SDR pool so that it is effectively a standing swap line between the central banks of all IMF member countries. This would mean that instead of receiving SDRs through allocations, countries could exchange their own currencies to hold SDRs and would then be able to trade these SDRs for the currencies of other members, with the IMF essentially acting as an intermediary between global central banks. In other words, an SDR would be backed by the agreement of all members to provide liquidity to other members in times of economic and financial need (with some conditionality agreed to at the outset). For the euro area specifically, this would mean the ECB would control the monetary union’s SDR account rather than individual countries, giving more legitimacy to the single currency. While difficult to envision politically, there is precedent for such swap lines between advanced and emerging economies, particularly during the 2008 crisis.

A pressing opportunity

The US has, so far, appeared unwilling to support a change to the global reserve system that would give the US dollar a less prominent place. Both seigniorage3 and the ability to borrow at a cheaper rate thanks to some degree of ‘fabricated’ demand for US assets are two (relatively small) benefits accrued to the US under the current system. The main factor likely driving US resistance to such a change, however, is the fact that the dollar’s role at the centre of the international monetary system, and its widespread use for invoicing global trade, gives the US an enormous amount of global influence (both in terms of economic and political policies).

US President Trump, however, sees the world as unfairly stacked against the dollar. He often takes to Twitter to call out other countries for trying to weaken their own currency and had the US Treasury Secretary, somewhat paradoxically, label China a currency manipulator for no longer intervening to keep the renminbi above a certain level. He has even thrown out the window the orthodox belief that central banks should be independent of government, and constantly rails on the Federal Reserve for not easing monetary policy enough to weaken the currency. His incessant tirades have even raised speculation that he might direct the Treasury and Fed to intervene directly in FX markets. Why? Because for Trump, a strong US dollar is the lifeblood of his great nemesis—the US trade deficit.

There are a lot of problems with Trump’s view on global trade and foreign exchange rates, but it is true that the current international reserve system makes it incredibly difficult, if not impossible, for the US economy to close its many imbalances. For example, a decline in the value of the US dollar can have a negative wealth effect for the countries that hold significant US assets and a positive wealth effect for the US, theoretically muting any trade effect one might expect from the dollar’s depreciation.

If the Trump administration has decided that the drawbacks of the current monetary system outweigh the benefits, the international policymaking community should take this opportunity to implement serious reforms. A global network of swap lines, perhaps coordinated through the IMF’s SDR, seems politically complicated, but is not out of left field. It would address many of the imbalances that contribute to global instability and that irk the current US administration. While there are other factors that might contribute to a currency war (competitive devaluations to gain a leg up in trade would still be possible), such a reform would ease many of the global tensions arising from these imbalances. Furthermore, it would not by itself change the use of the US dollar for invoicing trade, as SDRs would still only be held by central banks. This of course, makes such a system more palatable for US authorities. Thus, the time seems ripe for such a change. Afterall, the alternative of sticking with the status quo is leading us closer and closer to a currency war.
 

1. For a more complete discussion, see Stiglitz, Joseph E. and Greenwald, Bruce (2010) “Towards A New Global Reserve System,” Journal of Globalization and Development: Vol. 1: Iss. 2, Article 10.
2. An SDR is a potential claim on the currencies of other IMF members. It is valued in terms of a basket of currencies and allocated to members according to quotas.
3. Seigniorage is the profit a central bank or government makes by issuing currency, determined by the difference between the face value of the currency and the cost of producing that currency.

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