Saturday August 8, 2009
The international monetary system is in need of real reform
WHAT ARE WE TO DO
BY TAN SRI LIN SEE YAN
ONCE in a while, we have good reason to feel unhappy with the US dollar. Not only did the United States bring down the global economy, whatever wealth there was left in the dollar was subject to significant diminution.
After peaking in 2002, the trade-weighted US dollar had depreciated ever since. Sure, the dollar has since been given a temporary lift on its safe haven status.
As things stand today, it’s just a matter of time before the dollar, as it begins to further weaken, to once again take its toll.
So, we are all caught in a strange quagmire. Strange because ever since I was little, the dollar – known in Cantonese as mei-kum or American gold – is now anything but a quagmire, on account of feeling caught in a trap: in good times, you feel safe holding-on to mei-kum. When things turn sour, you can’t (as a group) get out of the dollar’s assets fast enough, without “cutting your nose to spite your face.” How did we get here? Some history will be helpful.
US dollar as an anchor and reserve
After World War II (WWII), the US financial system was the only one kept intact.
There was even runaway inflation, widespread currency restrictions, rationing and price control, etc. in Europe, Japan and most other countries.
The American economy was the strongest then and the dollar was very much in demand. For the US, winning the war didn’t hurt.
And so, under the Bretton Woods agreement of 1945, every nation pegged to the dollar. But the dollar was not required to have a formal exchange rate peg – except for the residual tie to gold. Hence, mei-kum.
Soon, one thing led to another and the dollar became a natural monopoly mainly because of economies of scale. The more nations that dealt in the US dollar, the cheaper and more convenient it was to trade in that currency.
Before you know it, the dollar became the text-book anchor and reserve currency (along side the pound sterling, which even before WWII was already a reserve currency, but was devastated by war). To do this well, the US price level has to be kept stable and remain so.
To complement this role, the dollar met what has come to be known as Kenen’s rule of international money: a reserve currency must have the ability to facilitate as a medium of exchange, a store of value, a unit of account, and a standard of deferred payment for international transactions (for example, bonds). The US dollar and the dollar exchange standard have been so from 1945 into the new millennium.
The Bretton Woods system
The dollar standard is supposed to work within the Bretton Woods-designed international monetary system (IMS), which is based on four main principles: right of each nation to manage internal demand to meet the objective of growth with price stability; exchange rate convertibility in the face of free movement of goods, services and capital as a means to achieve efficient use of resources; international trade to be conducted on an adjustable-peg exchange rate regime with provision for material changes in the event of structural imbalances; and countries hold own-reserves but given a line-of-credit by the International Monetary Fund (IMF).
However, the system began to unravel in the late 1960s. The special drawing right (SDR) was created by the IMF in 1969 as a new international reserve asset to supplement existing reserves. Nixon closed the “gold window” in 1971. By 1973, the US dollar parities were abandoned and currencies moved to non-par floating.
High and variable inflation in the 1970s-1980s eroded the dollar’s usefulness as anchor. The euros only came into its own in late 1990s.
Despite the changes and more flexibility in exchange rate regimes, the overall basic structure of the IMS had remained essentially the same.
It still faced three underlying difficulties: no reliable mechanism to correct international payments imbalances; it is subject to destabilising speculative bouts; and no orderly arrangement to generate in a predictable way, new reserves to meet demands of a growing world economy.
Hence, you now see the mess we are in today. Clearly, the IMS is in need of real reform.
Payments surpluses good or bad?
A nation with a payments deficit means it is importing (spending) more than it exports (earns). It settles this by losing reserves or borrows to cover it (for example, living off its savings or on credit). Often, it has to deflate, slow-down, or devalue (or some combination), which brings about a dilemma in the form of conflict of policy objectives.
In other words, any adjustment comes at a cost. But one thing is certain, continuing deficits are not sustainable (for example, the United States). Similarly, a payments surplus nation exports too much (saves). To adjust, it has to inflate, push-growth or revalue – each of which (or a combination thereof) also comes at a cost.
Like persistent deficits, continuing surpluses are also not sustainable (for example, Japan and China). For the world system to get back into balance, both surplus and deficit countries have to adjust – that is, the surplus nation has to expand and the deficit nation, contract.
But, in practice – unlike the gold standard – the Bretton Woods system has no reliable mechanism to make both of them adjust. And, both parties find adjustment just too costly. Hence, this often precipitates in a crisis which forces adjustment, at a time that is usually sub-optimal.
To most, deficits are bad. Why? After all, the idea of trade is to obtain goods and services from abroad that costs less than they can be produced at home.
Imports are the fruits of foreign trade. So, an excess of imports has to be good – for the deficit nation most certainly. But that’s just part of the story because the excess of imports over exports has to be paid for, resulting in having less reserves or using up borrowing power – either may not be the most comfortable.
And adjustments can be costly in economic terms, whether in slowing down the economy or having to devalue currency. Similarly, surpluses may sound good but are actually not. It can be inflationary and represent an inefficient use of resources. For the surplus country, the saving reflects the mere hoarding of resources, which otherwise could be invested to enhance future output and welfare.
Adjustments back to equilibrium here can be just as costly in terms of having to revalue currency or stimulate spending.
The international monetary system is in need of real reform
WHAT ARE WE TO DO
BY TAN SRI LIN SEE YAN
ONCE in a while, we have good reason to feel unhappy with the US dollar. Not only did the United States bring down the global economy, whatever wealth there was left in the dollar was subject to significant diminution.
After peaking in 2002, the trade-weighted US dollar had depreciated ever since. Sure, the dollar has since been given a temporary lift on its safe haven status.
As things stand today, it’s just a matter of time before the dollar, as it begins to further weaken, to once again take its toll.
So, we are all caught in a strange quagmire. Strange because ever since I was little, the dollar – known in Cantonese as mei-kum or American gold – is now anything but a quagmire, on account of feeling caught in a trap: in good times, you feel safe holding-on to mei-kum. When things turn sour, you can’t (as a group) get out of the dollar’s assets fast enough, without “cutting your nose to spite your face.” How did we get here? Some history will be helpful.
US dollar as an anchor and reserve
After World War II (WWII), the US financial system was the only one kept intact.
There was even runaway inflation, widespread currency restrictions, rationing and price control, etc. in Europe, Japan and most other countries.
The American economy was the strongest then and the dollar was very much in demand. For the US, winning the war didn’t hurt.
And so, under the Bretton Woods agreement of 1945, every nation pegged to the dollar. But the dollar was not required to have a formal exchange rate peg – except for the residual tie to gold. Hence, mei-kum.
Soon, one thing led to another and the dollar became a natural monopoly mainly because of economies of scale. The more nations that dealt in the US dollar, the cheaper and more convenient it was to trade in that currency.
Before you know it, the dollar became the text-book anchor and reserve currency (along side the pound sterling, which even before WWII was already a reserve currency, but was devastated by war). To do this well, the US price level has to be kept stable and remain so.
To complement this role, the dollar met what has come to be known as Kenen’s rule of international money: a reserve currency must have the ability to facilitate as a medium of exchange, a store of value, a unit of account, and a standard of deferred payment for international transactions (for example, bonds). The US dollar and the dollar exchange standard have been so from 1945 into the new millennium.
The Bretton Woods system
The dollar standard is supposed to work within the Bretton Woods-designed international monetary system (IMS), which is based on four main principles: right of each nation to manage internal demand to meet the objective of growth with price stability; exchange rate convertibility in the face of free movement of goods, services and capital as a means to achieve efficient use of resources; international trade to be conducted on an adjustable-peg exchange rate regime with provision for material changes in the event of structural imbalances; and countries hold own-reserves but given a line-of-credit by the International Monetary Fund (IMF).
However, the system began to unravel in the late 1960s. The special drawing right (SDR) was created by the IMF in 1969 as a new international reserve asset to supplement existing reserves. Nixon closed the “gold window” in 1971. By 1973, the US dollar parities were abandoned and currencies moved to non-par floating.
High and variable inflation in the 1970s-1980s eroded the dollar’s usefulness as anchor. The euros only came into its own in late 1990s.
Despite the changes and more flexibility in exchange rate regimes, the overall basic structure of the IMS had remained essentially the same.
It still faced three underlying difficulties: no reliable mechanism to correct international payments imbalances; it is subject to destabilising speculative bouts; and no orderly arrangement to generate in a predictable way, new reserves to meet demands of a growing world economy.
Hence, you now see the mess we are in today. Clearly, the IMS is in need of real reform.
Payments surpluses good or bad?
A nation with a payments deficit means it is importing (spending) more than it exports (earns). It settles this by losing reserves or borrows to cover it (for example, living off its savings or on credit). Often, it has to deflate, slow-down, or devalue (or some combination), which brings about a dilemma in the form of conflict of policy objectives.
In other words, any adjustment comes at a cost. But one thing is certain, continuing deficits are not sustainable (for example, the United States). Similarly, a payments surplus nation exports too much (saves). To adjust, it has to inflate, push-growth or revalue – each of which (or a combination thereof) also comes at a cost.
Like persistent deficits, continuing surpluses are also not sustainable (for example, Japan and China). For the world system to get back into balance, both surplus and deficit countries have to adjust – that is, the surplus nation has to expand and the deficit nation, contract.
But, in practice – unlike the gold standard – the Bretton Woods system has no reliable mechanism to make both of them adjust. And, both parties find adjustment just too costly. Hence, this often precipitates in a crisis which forces adjustment, at a time that is usually sub-optimal.
To most, deficits are bad. Why? After all, the idea of trade is to obtain goods and services from abroad that costs less than they can be produced at home.
Imports are the fruits of foreign trade. So, an excess of imports has to be good – for the deficit nation most certainly. But that’s just part of the story because the excess of imports over exports has to be paid for, resulting in having less reserves or using up borrowing power – either may not be the most comfortable.
And adjustments can be costly in economic terms, whether in slowing down the economy or having to devalue currency. Similarly, surpluses may sound good but are actually not. It can be inflationary and represent an inefficient use of resources. For the surplus country, the saving reflects the mere hoarding of resources, which otherwise could be invested to enhance future output and welfare.
Adjustments back to equilibrium here can be just as costly in terms of having to revalue currency or stimulate spending.