Among the Most Important Recommendations of the UN Commission on the Reform of the Global

THE CASE FOR A GLOBAL RESERVE CURRENCY

By José Antonio Ocampo and Joseph E. Stiglitz

Columbia University

Among the most important recommendations of the UN Commission on the Reform of the Global Financial and Monetary System in response to the global economic crisis was a major reform of the current dollar-based global reserve system. At the UN Summit of June, 2009, the proposal to begin discussion of such a proposal was endorsed. Both before and after, the idea has received support from many quarters around the world.

The idea is, of course, not a new one. Deficiencies in a single currency reserve system were noted by Keynes and Triffin, and Keynes proposed a new system, which he referred to International Clearing Union, with a global currency, the Bancor, at the center. He had hoped that the meeting at Bretton Woods would lead to the creation of such a system, but that was not to be the case. But the world did come together in the late 1960s in support of a more modest scheme, the creation of Special Drawing Rights, which have episodically been expanded, most notably recently as a result of decisions taken at the G20 meeting in London in March 2009.[1]

Critics of the current system have pointed to its deflationary (or recessionary) bias, particularly during crises; its instability and possible lack of sustainability; the conflicts it imposes between global interests and the national interests of especially monetary policy authorities in the reserve currency country, that can lead to global volatility, as a result of “surpluses” or “deficiencies in supply” of the global reserve currency, and its inequity.

Some opposition to the creation of a global reserve currency comes from the current reserve currency country (countries) and those who aspire to that status. They see the advantage that arises from the ability to create money that is used internationally (“seignorage”) and the ability to borrow at low interest rates from countries that invest their reserves in the country issuing the global currency. But there is a compelling case that even for the reserve currency country the current system is disadvantageous; the disadvantages more than outweigh these small advantages.

Indeed, no one benefits from the high level of instability associated with the current system, not even the reserve currency: though it may temporarily gain advantage in access to funds at low interest rates in a time of crisis, such as in late 2008 and early 2009 in the immediate aftermath of the current crisis, that advantage was offset by the higher exchange rate, which made exports more difficult and decreased aggregate demand. Those effects, so evidenced then, are, however, always present: the increased demand for the currency to serve as reserves results in a higher exchange rate. In effect, the reserve currency country exports its T-bills (which do not generate jobs) rather than goods (which do). This forces the country, if it wishes to maintain full employment, either to run larger fiscal deficits or looser monetary policies; the crisis has demonstrated the risks of each of these responses.

Opponents cite the political difficulties in reaching an agreement for the creation of a new system, the complexities of working out the details. They argue that the problems that have been identified can be (and are being) addressed through the evolution of the global financial system, in particular from a single reserve currency system to a multiple reserve currency system. As we explain below, these evolutions of the global reserve system are not likely to resolve the problems that have been raised, and may make them worse.

This paper addresses a number of the economic questions raised concerning the creation of a global reserve currency. We do not address the politics, except to note that the world has come together to create numerous institutions and initiatives, including the IMF, the global currency it already issues (the SDRs), and regional reserve arrangements. Though they may not have worked perfectly, to everyone’s satisfaction, such institutions and arrangements will have to play an increasing role as globalization proceeds. The fact that the politics is difficult does not absolve us from the responsibility of trying to create a better global monetary system. The politics of each of these achievements was difficult. In each of the cases complex decisions have had to be taken about institutional details. Again, many of the details have been a subject of dispute; many have had to be reformed and changed over time. That will inevitably be the case for a new global reserve system. But a reasonably designed but imperfect system is better than no system at all, and we have enough understandings of what is at issue that a reasonably designed system is within our grasp.

1. Will a multi-currency system towards which the world is evolving resolve the problems of a single currency system?

The answer, unfortunately, is no. Four problems have been identified. (a) The deflationary bias to global aggregate demand as countries set aside reserves as a form of precautionary savings, a major problem of the current system, will remain. The fact that countries are putting their money into three or four different reserve currencies in no way addresses this fundamental problem. Indeed, if, as many think, a multi-reserve currency system is even more unstable (see below), then countries will want to have more reserves to protect themselves against the greater volatility, exacerbating the problem. (b) The externality generated by monetary policies adopted by reserve currency countries on the rest of the global financial and monetary system, and the problems posed as they pursue their own interests, which may conflict with global needs. This problem too will not be addressed, and could be worsened. When there is a single reserve currency, it cannot (or at least should not) ignore the global ramifications of its policies, and it has incentives not to do so (though, in practice, it has often done so.) In, say, a three reserve currency stem, each country feels absolved of full responsibility, and may be even more tempted to ignore the global consequences of its policies. When the shocks the different countries face are different, a diversified reserve system may perform better than the current dollar system; but in critical cases when they face correlated shocks, the system may perform worse. (c) The instability of the system. There is broad consensus (but not universal agreement) that a multiple reserve system could be more unstable. The reason is obvious. If the authorities managing reserves believe one currency will weaken, they will shift out of that currency, fulfilling their expectation. Of course, monetary authorities are less likely to speculate than private speculators, and so the global reserve system may be more stable than it would be if each country turned over its reserves to the private sector to manage. But increasingly, countries are transferring portions of their reserves to sovereign wealth funds for management. Variants of the Triffindilemma will still be evident, though perhaps in more muted forms. As the debts in each of the reserve currency countries increases, credibility of its currency may erode; and fiscal discipline in each of the reserve currency countries will be undermined by the ease of borrowing. But more important is the fact that the lack of aggregate demand in each of the reserve currency countries resulting from the trade deficit that accompanies reserve accumulation will induce countries to have offsetting fiscal deficits, which in the long run may prove unsustainable. (d) The reserve currency system is inequitable, with poor countries lending to rich countries at low interest rates. The fact that the seignorage is shared between, say, the United States and Europe in no way improves the matter.

1. Will the system be inflationary?

No, not under any of the proposals which limit the growth of emissions to a number less (normally substantially less) than the amount put aside in reserves; the global reserve system simply offsets the deflationary bias associated with the current system. Variants of the proposal provide incentives for countries not to have excess surpluses, which, in times of weak global aggregate demand, contribute to slow global economic growth.

1. Will the global reserve system ensure global financial and monetary stability?

There are many sources of global instability. The current reserve system is one—but an important one. Market economies are prone to instability, but the current system exacerbates it. A new global reserve system can reduce this specific problem.

1. Can’t the desire for countries to have insurance be satisfied in a simpler way than the creation of a global reserve system?

One of the reasons for the accumulation of reserves is “precautionary”—so that countries can weather economic storms (such as the one the world has been passing through) better. Private markets typically have not done a good job in ensuring against macroeconomic risk; indeed pro-cyclical capital flows have often exacerbated fluctuations. Unfortunately, there are sound theoretical reasons why, going forward, we should not expect them to be able to absorb macroeconomic shocks, particularly of any significant size. Indeed, in the recent crisis, private markets that were supposed to be managing (insuring) risks not only did a particularly bad job in doing so, they had to turn to government for their very survival. Though the IMF has at times suggested that it could serve that function, most developing countries would prefer to continue holding reserves over relying on the IMF; they worry that were they to turn to the IMF, conditions would be imposed that would in effect amount to a loss of economic sovereignty. Though the IMF might say it would not do so in the future, it is hard to make binding commitments, and it is, in any case, difficult to distinguish circumstances in which the crisis is partially brought on by flawed economic management by the country from those in which country economic management has played an insignificant role.[2]

1. How can we be sure that countries will in fact hold on to the global reserve currency?

There are two approaches (that can be mixed): the “articles of agreement” creating the global reserve system can require that countries that join the system to hold a certain fraction of their reserves in the global reserve currency (and penalize them if they don’t, by not being eligible to get new allocations); alternatively (or complementarily), interest can be paid on the global reserve currency to induce holdings. In versions of the proposal in which the currency is backed by holdings of a market basket of T-bills from the constituent currencies, the T-bills themselves will generate the income required to pay the requisite interest. Currently, most countries continue to hold large dollar reserves, even though those reserves pay almost no interest, and relative to the local currency, are expected to yield a capital loss.

1. Even if a global reserve system were “ideal,” won’t the transition to the new system

be traumatic for the global economy? Given the fragile recovery, isn’t this a particularly bad time to be discussing this issue?

There are several ways by which the transition can be brought about, and all of them can be managed in ways that will not impose trauma on the global economy, and some of them can play an important role in facilitating a strong global recovery. At the center of the current weakness is lack of global aggregate demand. Reserve emissions will reduce the need for precautionary savings on the part of countries trying to augment their reserves, and thus add to global aggregate demand. That is why creating a global reserve system is an imperative today. Moreover, the instability to which the crisis has contributed has meant that the euro is currently not viewed as a good reserve currency, and the kind of convertibility that would be required to make the RMB a reserve currency may look particularly unattractive—it would confront China with the challenge of managing unstable short term capital flows, an onslaught of capital that would put enormous pressure on China for currency appreciation that could destabilize its economy—so that the diversified multiple reserve currency system that has been proposed as an alternative to the global reserve system is not likely to emerge now, precisely a time when it is most needed.

1. Will it ever be possible to get the United States to go along, so isn’t the idea just a pipe dream? Will it ever be possible to get global unanimity around the system?

As pointed out, the current system also has some disadvantages for the United States, in particular the tendency of the system to keep the dollar exchange rate high during times of crises. So, it might be inclined to accept the system. The US was actually strongly favorable to the creation of the SDRs in the 1960s, as it saw that global currency as a way of creating global liquidity, which would in turn reduce the pressures that were leading at the time to the need to generate balance of payments deficits to provide international liquidity, which were in turn leading to the destabilization of the dollar-gold parity. The US also proposed the creation of the substitution account in the late 1970s, again to face particular problems it was facing at the time. And it proposed the large issuance of SDRs in 2009.[3] Moreover, as the UN Commission emphasized, it is possible to proceed with the creation of a global reserve currency even if the United States were not to go along with the proposal. Indeed, the Chang Mai initiative can be thought of as an attempt to create a regional reserve arrangement. Integrating this effort with comparable efforts in Latin America and expanding the reach globally could go a long way towards creating a global reserve system. There are reasons to believe that the U.S. would eventually join in the arrangement. [4]

1. How is it possible to manage a global system given the changes in exchange rates and the relative sizes of different economies?

The new system will have to agree on the management of exchange rate rules among major currencies, including possibly some target zones for them, and perhaps even allow the issuer of the global currency to intervene through a special account (similar to the substitution account proposed by the US in the late 1970s and supported by many analysts today), with an agreement also on how to cover eventual losses in that account (though backward estimates indicate that losses would have been minimal if a substitution account for the dollar had been in the late 1970s). There should also be agreement about the composition of the global reserve basket. Small countries may continue to choose whatever regime they find more appropriate for their countries.

1. Is it necessary that the reserve currency be used for transactions? If so, is it likely that an artificially created reserve currency will ever replace the dollar or other “hard” currencies?

A reserve currency only needs agreements among governments—to hold the currency and to make the reserve currency convertible. Asserting to the contrary notwithstanding, the reserve currency does not need to be used for ordinary transactions. Indeed, there are advantages of not allowing it to be used by private parties, for that could lead to speculation on its value. (Of course, in a world in which speculation is rife, and individuals and firms gamble on almost everything, it will be difficult to prevent some speculation on the value of the global reserve currency.)

1. If the SDRs are used as the new global reserve currency, how can it be made more effective?

One of the peculiarities of the SDRs is the division in the IMF accounts between the “general resources” and the “SDR” accounts. This results in a limited use of SDRs: in particular, they are reserve assets that can be sold to other countries, but cannot be used to finance IMF programs. For this reason, all supporters of an SDR-based IMF, starting with the late Jacques Polak, have argued that the division between the two accounts should be eliminated and that IMF lending should be fully extended in SDRs. One simple way would be to treat the SDRs that countries hold as “deposits” in the IMF, which the Fund can then use to finance its programs. The excess between SDRs issued and those lent to countries could then be used to buy Treasury bills of those member countries that make part of the SDR basket or commit to pay in fully convertible currencies if the IMF needs to sell the bills to finance its lending to countries. Either way, by directing lending to countries or purchasing T-bills, the IMF would raise funds to pay interest on SDR holdings, making it more attractive to countries to hold their reserves in SDRs. This would also make the creation of SDRs similar to how central banks create money at the national level.

1. Should the RMB be included in the SDR basket?

Yes, it should, but this has to be reciprocated by the commitment of the People’s Bank of China to make reserve holdings in RMB fully convertible for other currencies, even if the RMB is not fully convertible for private agents.