It is hardly a surprise that the question of dollar supremacy re-emerges within the context of the debate surrounding the financial crisis. Indeed, numbers of authorities – mainly political – find in the designation of the United States as responsible for the crisis, a convenient scapegoat absolving them from their own shortcomings.
The arguments put forward are many: the trigger of the crisis was the collapse of the “subprime” market; the United States continued to tolerate structural balance of payments deficits that were unsustainable over the long term; domestic household savings had turned negative and indebtedness reached new highs; the American economy being largely dependent on consumer spending was particularly vulnerable to an economic downturn which, in the face of the bursting of a “bubble” (the subprime market) lead to a vicious circle: fall in asset values – credit restrictions – deleveraging – bankruptcies – unemployment – lower consumer spending – renewed fall in asset values and so on; finally, the spectacular increase in budgetary deficits made the United States ever more dependent on foreign investors to fund their domestic requirements.
This accumulation of weaknesses, both structural and cyclical could not fail to raise concerns among the foreign holders of ever increasing dollar balances. Thus, the famous quip of Secretary Connolly back in 1972 “the dollar is our currency and your problem” took on its full significance.
It is indisputable that the privileged position of the dollar, in particular as the world’s main “reserve currency”, allowed the United States to postpone repeatedly the decision to undertake the reforms needed to return to a sustainable internal equilibrium and which ultimately caused the crisis. However, on this score, responsibility should be also shared by all those who accepted to accumulate ever increasing dollar balances, often to forestall the appreciation of their own currency (China) in order to underpin their own domestic economic growth.
The call, issued recently by authorities of some major countries, to include in discussions on the reform of the global financial architecture a chapter concerning currencies appears therefore fully justified. However, on closer examination, it would appear that the underpinnings of such demands are largely “political” aiming primarily at forcing the United States to fall back into line in the new emerging multi-polar world. The financial implications of reform remain, however, extremely limited, as we shall endeavour to demonstrate.
Though, to date, no detailed concrete proposals have been put forward, those who promote such reforms appear to envisage a system based on the concept of the Special Drawing Rights (“SDR”) issued over time by the IMF. It would be essentially an “accounting” currency, the value of which would be set by reference to a fixed basket of selected existing currencies.
If the value of such a currency was based exclusively on a basket of “floating” currencies, its stability or volatility would rest only on market forces, without any possibility for authorities to intervene and thus assume any responsibility for its management. For such a system to be able to impose the necessary discipline on its participants – which is its main justification – it would we indispensable to introduce further constraints, similar to those that prevailed in the “European Monetary System”. This means, as a minimum, fixed parities between “basket currencies” (within reasonable fluctuation margins) accompanied by a “realignment” mechanism to give the system the necessary flexibility and ensure its ability to survive. Short of an agreement of this sort, the political feasibility of which is highly unlikely, the creation of a purely “accounting” currency would not be of great value.
Indeed, such a mechanism would not allow a significant diversification of dollar reserves – which is its other objective – because to achieve this goal it would be necessary to create from scratch a market for assets denominated in this “new currency”. For such a market to develop, it would be necessary to ensure its credibility with potential investors and issuers alike; this could take years, as was the case for the ECU, despite being underpinned latterly by the perspective of the Single Currency to which both a Central Bank and a territory was appended. If the usage of the new currency was deliberately limited to the settlement of official bilateral transactions, its impact would be negligible in relation to the colossal private flows transiting through foreign exchange markets, the liquidity of which remains firmly anchored on the availability of the dollar. Indeed, in this situation, one can fear that the introduction of a purely artificial currency will lead, a contrario, to the reinforcement of the dollar’s dominating role, underpinning its unchallengeable status as the world’s reference “transaction currency”.
If no significant advantages are to be expected from the “new currency”, dollar holders should achieve appropriate diversification of their currency risk by spreading their investments across assets denominated in existing currencies where they can assess both liquidity and stability characteristics or, alternatively, by covering excessive dollar exposures in the forward foreign exchange market.
A multi-polar financial system should definitively be encouraged, but it should emerge from the individual efforts of the main economic actors rather than be imposed artificially by a “political agreement” the finality of which would be “negative” insofar as it would aim at restraining rather than fostering the sovereignty of participants to the detriment of transparency and sound governance.
That is why it is crucial for the Euro – instead of diluting its intrinsic strength (which constitutes one of the few real powerful tools at the disposal of the EU on the international scene) – to continue to assert its relevance as a credible alternative to the dollar. This should in no way prevent other currencies from achieving over time a similar “reserve currency” status by pursuing policies conducive to attracting capital in search of stable investment opportunities.
In conclusion, one can note that the foreign exchange market has proven to be one of the most resilient in the face of the financial crisis and exempt – so far – of any notorious scandals. The impressive liquidity of this market (based on the availability of large dollar flows) as well as secure clearing mechanisms have allowed operators to conduct their business in close to optimal conditions. The reform of this particular segment of the financial markets does not, therefore, appear to be a priority.
On the other hand, it is necessary that both official and private actors assume their responsibilities and work towards the progressive reestablishment of sound and sustainable economic equilibriums which should eliminate the threat of reciprocal “blackmail”.
A parallel can be drawn with nuclear disarmament, initiated in the 1970’s, when the realisation that the destruction of the opponent would entail one’s own demise lead the parties to conclude a series of agreements that, over time, substantially reduced the risks of mutual destruction. Similarly, in the present environment, an abrupt fall of the dollar – whether initiated by irresponsible policies pursued by the United States or its creditors – would have cataclysmic consequences for the world economy. It is therefore urgent to negotiate agreements that shield the world from such risks in which the collective future of mankind totally overshadows any particular national interest.
Those are the real stakes defining the rightful place of the US dollar in the international financial system. It would be unfortunate if attention was sidetracked from this important objective by focussing on the “false good idea” of a new currency, the virtues of which are largely illusory.
Brussels, July 9th 2009
Paul N. Goldschmidt
Director, European Commission (ret); Member of the Advisory Board of the Thomas More Institute.
Tel: +32 (02) 6475310 +33 (04) 94732015 Mob: +32 (0497) 549259