To avoid a currency war, reform the global reserve system
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
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)
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
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.