In his ambitious program for the 2011 French presidency of the G8/G20, President Sarkosy has stressed the need to make significant progress in the governance of world markets and has pinpointed two specific objectives: on the one hand a better regulation of commodity markets, subject that will not be address herein, and, on the other, a new multilateral financial framework aimed at curtailing the domination of the US dollar (“Dollar”) that he considers excessive.
The subject is highly complex and requires full transparency of its aims prior to devising practical solutions, should they be required.
Until 1971, a fixed relationship between a benchmark (gold valued at USD 35 per oz.) and currencies prevailed, as organised by the Bretton Woods system, and the question of an implicit advantage accruing to the American currency did not arise in the same terms as today. Indeed, physical convertibility of the Dollar into gold imposed constraints on the United States from which it only became free after suspending convertibility. This unilateral decision created a choc by which the Dollar became, overnight, the only reference against which all other currencies were valued, and bestowed on it the status of unique “reserve currency” for all members of the system.
The undisputed dominance of the world economy by the United States meant that this situation was inescapable – if not acceptable – underpinned by the fact that the great majority of cross border transactions were carried out in Dollars or at least through the intermediation of the US currency.
At that time, a further characteristic of markets was that the settlement of trade in goods and services represented a significant part of global financial flows. Since then, globalisation has induced a tenfold growth of financial markets compared to the value of underlying commercial transactions.
Simultaneously, the capacity of intervention (reserves), needed to defend exchange parities, at the disposal of monetary authorities, did not keep up with these developments. This led to the progressive introduction of a regime of “floating” exchange rates. Initially it enhanced the flexibility of the authorities but, with the exponential growth of financial flows, they finally had to give up any thought of intervening decisively in the market.
The means available to private operators, on the other hand, were growing exponentially (sometimes created ex nihilo such as in the unregulated derivatives market) which increased significantly their power, weighing heavily in favour of further market deregulation. It would be wrong, however, to conclude that this was the result of some dark plot organised by a Machiavellian group of “financiers” or “speculators”; rather it was the clear manifestation of the inability of authorities to intervene efficiently: indeed, at the same time that globalisation was reinforcing the interdependence of financial markets, the powers of Regulators and Supervisors remained largely confined to their national territories. This allowed operators to ignore or circumvent regulations to the point of voiding them from any substance, creating a feeling of powerlessness on the one hand and impunity on the other.
In the aftermath of the collapse of communism, political authorities, obsessed with the neoliberal ideology of Milton Friedman, closed their eyes to these developments. Their quasi blind support of the “Washington consensus” contributed significantly to the worldwide progression of financial deregulation. This policy was abetted by very powerful lobbies representing the large multinational corporations and in particular the global financial institutions. Thus, in the name of unfettered competition (and sometimes of a very “unfair” level playing field), governments were led to give up entire areas of their sovereignty, depriving them of their powers of intervention and rendering them unable to discharge their duties.
It is within this context that structural imbalances grew rapidly affecting both private and public indebtedness as well as the balance of payments and the budgets of countries large and small. These were aggravated by major geopolitical phenomena such as the rapid integration of the former communist world and the new emerging economies into the global “free market economy”. The dismantling of barriers revolutionised labour markets exerting worldwide pressure on salaries, in particular at the bottom of the scale. In turn, this induced delocalisations increasing job uncertainty, mainly in the industrialised world. At the same time, relieving of poverty a growing number of people and transforming them into “consumers” (with no decrease in the overall number of poor due to the high birth rate in underdeveloped countries) put upward pressure on demand and prices for many commodities.
Initially, these two factors tended to neutralise each other, creating the illusion of a global equilibrium. There was a belief that one had discovered the recipe of uninterrupted inflation-proof growth introducing an era exempt of economic cycles. More importantly, this apparent stability induced a feeling of reduced and better controlled risks, a factor that weighed heavily on the excessive build up of indebtedness at all levels.
Aided and abetted by “financial innovation”, responsible for creating ever more complex and opaque products (some of which were fraudulent), the ever increasing use of leverage, itself amplified by pyramidal structures (as in 1929), undermined a system that had itself become highly interconnected. It is therefore not surprising that when one of its weakest links (in this case the U.S. subprime market) collapsed, the shockwave spread rapidly throughout the entire financial system and thereafter to the whole economy, threatening to create a planetary systemic crisis.
From one day to the next, governments were faced with a situation calling for determined and coordinated intervention for which they were neither prepared nor equipped, having themselves been largely accomplice to the “regulatory disarmament” resulting from the dogma of the superiority of self regulated markets.
Nevertheless, one should commend the rapidity and efficiency of the initial reaction by the authorities because it has proved successful in avoiding - to date - the collapse of the entire edifice. In this respect, Central Banks played an important part by providing unlimited liquidity, reducing interest rates and, when necessary, using additional “unconventional” tools (QE). Governments also provided support: they instituted “stimulus plans” limiting the socio-economic impact of the recession; furthermore, they initiated reforms of their financial systems aimed at preventing the recurrence of such crisis and at establishing a new equilibrium between governments and the private sector, in the aftermath of the rescue of the latter by the “taxpayer”.
In addition, globalisation encouraged authorities to devise new means of cooperation to deal with crisis and remedy the deficiencies of the existing framework. In the absence of a perfectly utopian “world government”, charged with the uniform and transparent enforcement of a single new regulatory framework, the aim of the G20 is to ensure at least the coherence between the various new regulatory regimes. It is, however, facing increasing difficulties as the immediate dangers associated with the crisis appear to recede.
It is within this particular context that the need for a new “World Reserve Currency” should be considered. It only makes sense to the extent it would contribute to the stabilisation of the financial system as a whole.
While it is clear that “re-regulating” large segments of the financial system is necessary, it is far from established that, in order to create a new “reserve currency”, it is either realistic or even desirable to reintroduce, at global level, a system of enforceable rules covering deficits, indebtedness or other chosen parameters One should not confuse the objective with the aims of the Euro which was designed to be used in everyday transactions in “substitution” for existing tributary currencies and which, correspondingly, required the discipline imposed by the EU Treaty and the SGP.
It is the particularly liquid, transparent and secure foreign exchange (FX) market that reveals the (dis)equilibriums resulting from the trade in goods and services and other financial flows between countries: it establishes the relative “value” of “national currencies”, emblematic symbols of “sovereignty”.
It is noteworthy that the FX market is the only global financial market whose operations were not disrupted by the crisis, which may explain why the whole financial system did not collapse. The settlement of daily transactions, representing astronomical amounts, was carried out smoothly, despite the difficulties faced by some of its major participants (Lehman, AIG, Fortis etc.).
It would therefore seem reasonable not to tamper of the FX market in order to preserve its valuable characteristics.
On the other hand, the creation of a new (reserve) currency must, by definition, meet the requirement that its value can be established and expressed in relation to other currencies. It is, of course, possible to create a currency by reference to a “material” benchmark (such as a quantity of gold) or by reference to a series of variables referred to as “baskets”, (such as the SDR or the former ECU). The advantage of the latter as a reserve is largely confined to ensure risk diversification for its holders, similar to index funds for investors.
A reversal to a monetary system based on the “gold standard” (or any other material benchmark) is out of the question, because no country would undertake to ensure permanent convertibility of its currency at a fixed rate, as was the case of the United States, prior to 1971 (see above).
Furthermore, introducing a basket does not impose any particular constraint on countries whose currencies are selected, its value being simply the “variable” sum of its component parts expressed in terms of a chosen “pivot”. As is demonstrated by the SDRs – a perfect example of a purely abstract construction – a basket cannot by itself ensure a discipline capable of improving the governance of the global financial system. To impose additional objective criteria contractually is out of reach, to the extent that participants do not benefit from any corresponding advantage. This was apparent in the failure of the G20 in Seoul to reach any agreement establishing “acceptable” fluctuation limits in financial imbalances and assigning responsibility for correcting them between creditor and debtor countries.
Another approach would be to introduce a two tiered market, as was used to accompany the progressive transition from the post WWII fully controlled to the current free FX market.
- The “official” market would be restricted to a series of “authorised” transactions, for instance trade in goods and services as well as settlements of “official payments” such as development aid, etc. In this market, fluctuations would be limited by strict rules; in exchange it would remain shielded from distortions resulting from purely financial and/or speculative flows.
- All other transactions would be executed on the “free” market.
This solution faces quasi insurmountable practical difficulties because the “financirisation” of the economy renders the clear and transparent categorisation of transactions particularly difficult. For instance, the purchase by China of iron ore from Australia, whose settlement would be authorised on the “official market”, is also the subject of a series of additional legitimate financial transactions aiming at managing associated risks: a bank loan to finance the purchase, forward FX cover to manage the currency exposure, forward commodity price cover to stabilise production costs, purchase of “insurance” to protect against counterparty default (CDS) etc. Should such transactions be carried out on the “official” or “free market” and who is to decide? Furthermore, the official character of a transaction could apply to only one of the counterparties because the risk taker on the other side may be a pure “speculator”; restricting each market to “acceptable” counterparties would severely impair the liquidity of both, increasing transaction costs as well as price volatility.
In addition, implementing such a system would create a bureaucratic nightmare, exorbitant costs and, unavoidably, the emergence of a new field in “financial engineering” aimed at circumventing the regulations and benefitting the most creative intermediaries (lawyers and bankers). It would also have a significant negative impact on the volume of world trade.
The irreversible dual development of economic globalisation and “financirisation” has profoundly and durably modified the environment which forbids any possible thought of returning to the past. On the other hand, significant efforts are needed in order to achieve greater harmonisation of the regulatory and supervisory regimes so as to better deter abuses and forestall the recurrence of crisis. In such a system, the FX market remains one of the cornerstones, which does not need any fundamental changes in its operation. It is difficult to envisage in what manner it would benefit from the introduction of an artificial “world reserve currency”.
To be guided by the desire to deprive the Dollar of its apparent “privileges” on a flimsy “moral” premise that, in a multilateral world, it is only fair to share the rights and obligations of the main actors of the International Community, is a trap!
To the contrary, it is up to the countries who aspire to “share” the advantages they impute to the Dollar, to take the necessary measures to ensure that their respective currencies are attractive at all levels, offering operators a real choice that remains at present largely elusive.
So, China should – at such time as it will determine that it is advantageous – open completely its FX and capital markets. As long as it chooses to “manage” its exchange rate and “control” capital flows, which as an emerging economy is both understandable and reasonable, it must also fully assume the consequences, including the need to invest a large proportion of its surpluses in Dollars, accepting the FX risk as the price for retaining access to its indispensable export markets. In the mean time, China must respect international rules to which it has adhered in the context of the WTO, the IMF and the UN.
As far as the Euro is concerned, while the FX market is perfectly free, the Eurozone suffers nevertheless – in comparison with the Unites States – from the absence of a deep and liquid euro denominated market of “reserve assets”, comparable to the US Treasury market. The current sovereign debt crises affecting EMU participants and its consequences on the perception of the long term survival of the Euro (see: “Proposals concerning the establishment of a permanent European Crisis Management Mechanism and the issuance of Euro Bonds” on www.paulngoldschmidt.eu), go a long way to explaining the perceived advantages ascribed to the Dollar. These would disappear progressively if the structural weaknesses of EMU were squarely addressed.
Be it for the United States, China, the Eurozone, the United Kingdom or Japan (or any other potential candidate), a harmonisation of the characteristics as well as the access conditions to their respective markets would lead automatically to a greater multilateralisation of the rights and obligations of participants as well as the establishment of a more competitive level playing field. It follows that it is also necessary to render comparable and efficient the liquidity and transparency of markets, the resilience of the delivery and settlement systems, the legal certainty of transactions, the availability of information etc., including their supervision enhanced by credible sanctions. Within such a framework, markets would be able to impose a discipline that would discourage countries to pursue irresponsible policies.
The option to become one of the leading actors within the global financial system must be open and underpinned by the conviction that the advantages outweigh the corresponding constraints. It can be compared to countries that choose to join the EU and accept the obligations of the “acquis”, including the obligations of the SGP, as the quid pro quo for the advantages of Union membership.
In conclusion, the G20 should focus its efforts on reinforcing the Supervisory and Regulatory Framework of the global financial market rather than waste time on the establishment of a new World Reserve Currency. Its creation is, indeed, likely to prove elusive as long as the barriers, both political and structural, mentioned here above survive, and would be largely unnecessary to the extent that these outstanding questions found a satisfactory solution.
Brussels, 23rd January 2011
Paul N. Goldschmidt
Director, European Commission (ret); Member of the Thomas More Institute.
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