Global imbalances and the Triffin dilemma

January 13, 2009

John Kemp Great Debate– John Kemp is a Reuters columnist. The opinions expressed are his own –

For the world monetary system, the financial crisis which erupted in the summer of 2007 is a cataclysmic shift that will prove every bit as significant as the outbreak of the First World War (which heralded sterling’s demise as a reserve currency) and the suspension of gold convertibility in 1971 (which marked the end of bullion’s monetary role).

The crisis marks the passing of an era in which the U.S. dollar has been the world’s undisputed reserve currency for making international payments and storing wealth.

The dollar is not about to lose its reserve status completely. But it is set to become less “special”. In future, it will increasingly have to share its reserve status with the euro, the yen and perhaps the currencies of the other advanced economies. In time, it may even have to share its status with China’s yuan.

In fact, the whole concept of a single reserve currency (the dollar) and a principal reserve asset (U.S. Treasury bonds) is set to undergo a profound shift. Policymakers, businesses and households will in future think about and hold a whole portfolio of competing reserve currencies and assets. Multipolarity in the world of security and economic relations is set to be matched by a world with multiple reserve currencies.

One positive consequence may be greater stability in a more diversified financial system, once the current crisis is passed. But the price for the United States may be a loss of policy autonomy for Treasury and Federal Reserve officials used to being able to ignore the international dimension when deciding interest rates and budget deficits.

EXTERNAL IMBALANCES

Leading economists agree that global imbalances lie at the root of the current crisis. But opinions are more sharply divided on their origins, which countries are to blame, and what should be done to resolve them.

The Fed’s critics argue that cheap money policies in the late 1990s and early 2000s are mainly responsible for fueling a debt-driven consumer boom, and sucking in record volumes of imports, many from the newly industrializing economies of Asia. Funding all this required issuing huge volumes of debt, much of it securitized against dubious mortgages and consumer debts, and sold to foreigners when domestic savings proved inadequate.

In contrast, Fed Chairman Ben Bernanke and some leading commentators blame China. In their view, China’s reliance on export-led growth, refusal to allow the yuan to appreciate, accumulation of foreign reserves, and recycling of surplus foreign exchange back into the market for U.S. government bonds and mortgage-backed securities created a “global savings glut”. This glut artificially reduced global interest rates and created the perverse incentives for an unsustainable build up of debt in the United States.

Differing interpretations about the origin of the imbalances lead to the two sides to proffer different solutions. Fed critics argue the solution lies in a long-term tightening of U.S. credit conditions and higher domestic savings. Bernanke and his supporters argue the solution is for China to stimulate domestic demand, appreciate the yuan and reduce reserve accumulation.

In reality, it takes both a lender and a borrower to create a debt crisis; the solution to the crisis lies in balanced adjustments on both sides.

AMERICA CONTRA MUNDUM

While it is tempting to blame China’s “mercantilist” trade policies for the crisis, China is only the latest in a long line of countries the United States has blamed for its own trade and financial problems (Germany and France in the 1960s, Japan in the 1970s and 1980s, the Asian Tigers in 1990s).

It is possible the rest of the world has been consistently wrong, and the United States has been consistently right. But it seems more likely there is something that makes the United States uniquely prone to excess domestic spending and running large trade deficits that in put pressure on the country’s external position.

There are several candidates for the source of American exceptionalism. But perhaps the most obvious cause is the role of the dollar. The United States has run larger budget and current account deficits than most other countries simply because as the issuer of the principal reserve currency it can.

The positive side has been the ability to borrow more cheaply and in larger amounts than other countries. The dark side has been a steady accumulation of internal and more importantly external debt that is now a source of enormous financial instability.

THE TRIFFIN DILEMMA

This paradox linked to the provision of the world’s reserve currency was first noted by Yale economist Robert Triffin. In a famous warning to Congress in 1960, Triffin explained that as the marginal supplier of the world’s reserve currency the United States had no choice but to run persistent current account deficits.

As the global economy expanded, demand for reserve assets increased. These could only be supplied to foreigners by America running a current account deficit and issuing dollar-denominated obligations to fund it. If the United States stopped running balance of payments deficits and supplying reserves, the resulting shortage of liquidity would pull the global economy into a contractionary spiral.

But Triffin warned that if the deficits continued, excess global liquidity risked fueling inflation. Worse still the build up in dollar-denominated liabilities might cause foreigners to doubt whether the United States could maintain gold convertibility or might be forced to devalue.

Triffin was writing in a world of fixed exchange rates, but his work provides a useful way of thinking about the current crisis. In the 1950s, the fear was convertibility of greenbacks into gold. Today, the fear is dollar devaluation, inflationary default on Treasury bonds, or capital losses on securitized products linked to widespread insolvencies.

Triffin’s work suggests that the Fed did have a choice in the late 1990s and early 2000s, albeit an unpalatable one. Officials could have refused to supply the incipient demand for liquidity. Higher interest rates could have prevented the (worldwide) borrowing boom and widespread deterioration of financial standards seen in recent years. But they would also have meant lower growth in the United States and the rest of the world.

Instead, senior officials chose to accommodate overseas demand and reserve accumulation. Low interest rates and the resulting current account deficit provided record liquidity to the rest of the world but at the price of deteriorating credit standards and increasing fragility. The result was plentiful international liquidity and rapid growth, but with the build up of huge indebtedness concentrated in the United States as the issuer of the world’s main reserve currency.

The United States is not the first country to discover the perils as well as the benefits of issuing the world’s main reserve currency. The United Kingdom experienced chronic instability during in the 1918-1939 period in part because the large outstanding “sterling balances” overseas threatened to overwhelm the country’s limited gold reserves and financial system if reserve holders tried to convert them into gold or other currencies.

Maintaining sterling’s convertibility into gold and the integrity of the sterling area required a recognition that attempted conversion would involve “mutually assured destruction” (the United Kingdom would be forced off gold and the Dominions would find the value of their sterling holdings cut). The United States and China are now locked in a similar embrace over China’s massive holdings of U.S. Treasury bonds.

But perhaps the clearest warning about the problems of being the dominant supplier of reserves to the rest of the world was issued by Henry Fowler, secretary of the U.S. Treasury in the mid-1960s: “Providing reserves and exchanges for the whole world is too much for one country and one currency to bear”.

Triffin’s own solution to the dilemma – the creation of new sources of liquidity based on issuing more IMF special drawing rights that would not be liability for any one country – is politically unrealistic. But reducing reliance on the dollar and U.S. Treasuries and supplementing them with other reserve assets is a necessary step to reduce system fragility. The shift is probably already underway as faith in the once-invincible dollar and U.S. financial system declines.

21 comments

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Although the article does highlight many key issues concerning the global economic market it follows a continual theme that fails to recognize the lack of a Federal Sales tax. The US economy originally was built on manufacturing, domestic expansion, and foreign export providing an extensive robust base to stabalize the dollar. As the economy shifted to a global footprint the US has failed to recognize the weight of the income tax on US corporations. This has resulted in lower cost imports, a shift of manufacturing off-shore, and then inevitable devaluation of the US dollar. To compete globally the US must overhaul the antiquated tax code and convert to a sales tax.

Posted by James Middleton | Report as abusive

Good article, well balanced, and objective. Objectivity difficult to find in the USA.

Posted by Remy del Coro | Report as abusive

I read in a Financial Times article about 2 weeks ago that because of this financial crises the world reserves have already changed – instead of above 70% in US dollars, now we hold about 60% in US dollars.

If I recall correctly the Euro gained a larger portion than the Yen or the Pound of the 10% the US dollar lost.

Posted by monica | Report as abusive

The yuan is unlikely to become a reserve currency any time soon. The massive repatriation of investment capital from China is putting a powerful depreciation pressure on the Chinese currency. The Chinese will have to stem the capital flight by selling its dollar reserves but who knows if that will be enough. I think we will see a much weaker yuan in the not too distant future, maybe even a collapse.

Posted by ian | Report as abusive

I believe the USD will continue to strengthen as long as deleveraging and debt-deflation is raging. This is not a vote of confidence for the dollar but an effect of the “money multiplier” going in reverse. I.e. the distress selling is causing asset deflation and a flight to cash. In contrast to inflation, deflation causes the purchasing power of cash to increase. As a consequence, as long as the deleveraging continues the USD will gain.

As for the Chinese renmimbi, the distress selling by major institutional investors has reached a point where assets held in emerging markets are sold at fire sale prices. Right now the big banks and other investors are in the process of divesting massive holdings in places like China. This is reinforced by the expectation that the dollar will rise and that China’s foreign currency reserves will not be boosted by imports to the same extent as in the past. The resulting repatriation of money from China to the U.S. creates an excess supply of yuan and a deficit in China’s capital account. Since exports have weakened, this translates into a balance of payments deficit since the current account surplus is insufficient to offset the outflow of money.

Posted by Jens | Report as abusive

The Chinese government has not permitted the Yuan to trade freely or for people (in or out) to buy and sell the Yuan. There is no capital account convertibility. Therefore by definition the Yuan cannot be a reserve currency and the author should know that.

China is a paper tiger that appears to be a power by sponsoring terrorist states, coddling brutal regimes (North Korea, Zimbabwe, PolPot-Cambodia). It lacks the physical and moral authority to sponsor a reserve currency.

Posted by Tom Petty | Report as abusive

As long as there is economic instability in this crisis, the dollar with only strengthen. Period. Fx flows out of China are increasing, along with the Chinese quietly inflating the value their currency even more. Look at the lending spread and auction rates for US debt, plenty of buyers there. The author makes many important observations for the next cycle, but people vote with their assets and currently those assets don’t seem shy of US debt. Of course it won’t last forever and once inflationary pressure becomes a reality, we may see shift to a more international balanced asset class. But to say anything else in the near term, is to be willfully blind.

Posted by Whatever | Report as abusive

This is a very clear article, one that really gets at the roots of the current disorder in international monetary affairs.

Dealing at the national level, the article does not, however, attempt to address the other head of the two-headed monster, which is to say, the way in which the world’s leading financial institutions’ massive speculations in CDS’s has drastically corrupted the world’s commercial banking system, resulting in the credit crisis which is now bringing economic activity throughout the developed world to its knees.

Posted by Hugh Willis | Report as abusive

The problem is not the USD as a world currency per se; the USD is just an innocent piece of paper to which the world [currently] attaches great value [as it should because it is money]. The global economy needs a reserve currency and a growing global economy needs a reserve currency supply to grow with it.

In Triffin’s day, the Bretton Woods arrangement presented the USD as ‘good as gold’ [since it was convertible to gold]. We are no longer on any kind of gold standard but in many ways the post Bretton Woods dollar regime has been like a gold standard, only better [for the US] and worse [for the rest of the world]. Oil is priced in Dollars [commodity backing], world central banks hold USD to defend their own currencies. The FED has also supported foreign with central banks in this crisis. The flight to quality is to the dollar. All this is similar to gold during a gold standard.

The problem is that if the USD is now “Gold” in this scenario, then only the FED has the ability to make gold whenever it wants and it has the appearance that it will ‘bail-out’ the US ‘losers’ first. Under a gold standard the ability to make and distribute gold would similarly debase the value of gold for others. If the ‘creditor’ world is holding US dollars that have yet to be redeemed for USD assets, then it is in their interest for the USD to be as strong as possible. Conversely, The US debtor desires a weak dollar since that will relieve their debt burden.

The world is waiting to see if the US has the guts to deliver the fair liberal world economy or unfairly change the rules to eke out a few more decades of world ‘dominance’ which as far as I can tell means we get cheap TVs.

The world has never been so productively linked. The international institutions that exist, including the Dollar regime must be made to work FAIRLY for the good of the global market. Scrapping them and staring over would be much more difficult and painful. If the Dollar regime was fair [ie not exclusively under America"s control], the world financial system would be stabilized.

The French said it best: “Nous sommes tous Américains”.

Posted by scootie | Report as abusive

Interesting, however the author does not take into account the insane fluctuations in dollar traded oil, nor the exchange pressures put on the currency by Eurozone banking practices. Since the euros introduction the pressure has been to undervalue the dollar in favor of an artificially propped up euro. Selling dollar assets was also made fashionable by the international opposition to the Iraq war. These pressures combined led to an undervalued greenback and an overextended credit market. When it became obvious that the dollar per barrel price became unsustainable and therefore crashed, liquidity got squeezed by the likes of Russia, Saudi Arabia, UAE et al. These oil exporters had been betting on a weak dollar and strong oil to finance THEIR debt. When this dried up, they had to start paying their IOUs. The price of oil is in a free fall and will reach $10 or $5 in short order. By that time the dollar will be worth 1.50 euros if not 2. China does stand to gain from its hoard of Treasuries but only if it is prepared to wait another 20 years before cashing in. In the meantime the US will have to mop up the mess left in the international financial system by oversupplying greenbacks and therefore creating inflation. In the short term we are looking at deflation re imports and oil and then inflation re an oversupply of greenbacks.

Posted by Beau Tardy | Report as abusive

The China-hating here is truly hilarious– especially sad too, since the current mess is squarely the result of budget overextension and overspeculation in the USA (and UK, to a lesser extent). I’ve worked there for 3 years in China and they are no “paper tiger.”

The China-bashers here seem to forget that China bases its economy on REAL GOODS rather than commercial paper, and in sharp contrast to the capital flight many of you seem to be pathetically fantasizing about, I actually see more and more capital inflows every time I make a trip to Chengdu, Urumqi or anywhere in Heilongjiang (which are actually peripheral to the industrial centers FWIW). China has more than sufficient reserve currency to guard against wild swings in the yuan (really the only purpose as it is), and the reduction in China’s exports isn’t something for China-bashing Americans to be cheering about– that’s the only thing that’s prevented a dollar rout as it is, and as China refocuses its economy more on domestic goods, there’s even less reason for them to store their savings in USD-denominated assets.

This isn’t rocket science– China wants the USD to rise enough so that it can sell off its USD for Euros, commodities and other tangible goods without too much of a loss on the reserve value. It’s a gradual deleveraging away from US debt instruments rather than sudden dump (which would be costly for them). It then uses the proceeds and increased savings to re-focus on domestic infrastructure, something that the China-bashers here seem too clueless to understand. In fact, while exports have slumped, the reduction in commodity prices is providing a net benefit for China in terms of raw materials acquisition, in particular. So to those hating on China for a problem that the US and UK are chiefly responsible for– pull your heads out of your a**es and wake up to the new world. The rest of the world (and especially Asia) isn’t as dumb as you think they are.

Posted by Cadassus | Report as abusive

The Euro wipped out the D-Mark, French Franc, Lire and many other currency’s that were all excellent investment platforms. Triffin did not live to see the effect of the Euro, which is now unfolding. For the entire period after WW2 the world has seen the USA is the prime buyer for Euro and Asia’s products.

The Euro was an attempt to replace the USD as the currency of reserve for the world. While not having the actual base to create a viable alternative to accomplish the goal that Europe’s banks dream about. The Euro’s creation was an attempt to trade around the US Dollar and not for the benefit of consumers in Europe or the USA

The current greater crisis is who will have the cheapest currency so that it’s products are advantaged for sale world wide. Dropping all, death taxes, capital gains, corp and personal income taxes for a Federal Sales tax. Is a great idea and would stimulate the US economy more than any Federal bailout will ever accomplish.

The credit crisis is wiping out investment funds world wide and shrinking the money supply as we speak.

Money flows in the direction of the best rate of return and the assurance of repayment. The US still holds that role. Can we shoot ourselves in the foot…possible. The credit crisis is putting the vast majority world back on a cash accounting or cash in hand basis.

The IMF has just inked the creation of a new all Arab based currency like the Euro, just last week. To show up on the world stage in 2010-2012. The World has many times had multiple currency situations, but liquidity is so limited outside the US Dollar and Japanese Yen…trading in other currency’s is difficult at best. Lack of stability and liquidity… Try swinging 750 million or a few billion US Tres. Bonds in current conditions inside the US. In the mid 1980′s..that was not a problem…lots of liquidity back then. Liquidity has been drying up for years.

Triffin would most likely have a different view today as conditions are outside his historical perspective.

Posted by Laurance Marvin | Report as abusive

It is almost inconceivable that anyone can argue that the US needs a national sales tax to pay our bills. Only the most simplistic analysis could possibly lead one to believe that this so called “solution” would benefit the American citizens.

What it would do is complete the task of shifting all expenses for our nations operation from corporations to individuals as companies export more and more jobs overseas and purchase less and less material goods to be taxed on.

This is exactly the opposite of what we need to have happen, which is to shift all expenses for operating our nation to the corporations that do business here, realizing that this will require a lowering of individuals gross incomes to the current level of net incomes, thus providing to the corporations a one-time adjustment that allows them to continue to afford to operate.

The benefits of this process are too numerous to mention but a few jump right out at anyone who starts to really think about it.

No more individual income tax forms being filed means a massive reduction in the number of IRS agents required to be employed by the government with a corresponding decrease in the massive number of people cheating on their taxes and the concurrent lobbying pressure of assorted groups to avoid paying their fair share of taxes.

Additionally our weak, weak, oh so weak elected officials would now have to choose between which of their lobbyists they would work for instead of taking all their money and punishing the people with ever increasing taxes and debt (you know, the way it was supposed to work to start with).

The list goes on for as long as anyone wants to think about of all the good things that happen when the voters do the voting and the companies do the paying instead of vice-versa, which is how it has been for at least the last 30 years, maybe the last 50.

RIGHT ON JOHN, WHERE DO I SIGNUP AT?

Posted by Jonnyrox | Report as abusive

Massive global imbalances are a product of the fundamental mechanisms within capitalism. The fact that both Britain , and now the U.S. (100 years later), have found themselves in this position should be an indication of that. We need a better understanding and discussion of the nature of capitalism itself, rather than arbitrary cultural attacks, or picayune details. Otherwise we are rushing blindly in a dark alley.

I disagree with the fundamental thesis of Triffin’s assertion. There’s no “obligation” for the reserve currency sovereign to provide liquidity. US cuts back on treasury issuance, yield drops and then stabilizes somewhere close to zero. To make the debt issuance sound like a moral obligation and service to the world is intellectually dishonest at best.

Instead, the reserve currency status makes it politically convenient — almost irresistible — to issue ever-more debt. It’s our greed and lack of discipline or political will.

there is no need for global reserve currency. such policy only supports imperialism. there is need for a multi currency regime where the paper of the most competitive appreciates relative to all others and things balance out and are in relative equilibrium. no one wins when there is a glut for the currency of a poorly run country just because it is designated reserve currency: the economy in trouble cannot regain advantage due to the appreciation of its paper, sound countries like germany become even more competitive due to the euro depreciation.

Posted by baychev | Report as abusive

There are a lot of paper dollars throughout the world in bazaara, mattresses, used to pay taxis from Russia to Israel toKenya. These may start to find there way home also.

Posted by s veit | Report as abusive

In response to James Middleton, I’d like to say that a tax system that places the burden on the consumer while the beneficiaries of capital abscond with the mass of the wealth of the society is unjust.

Posted by David Ellsworth | Report as abusive

The solution should not be focused on what can the US do to maintain both political and economic dominance of the world, but rather how can the US concede what is necessary towards the creation of new global institutions and instruments to ensure a workable and healthy world economy in which to prosper.

Posted by David Ellsworth | Report as abusive

My Reasoning for Eventual Dollar Decline (with one paragraph about sales taxes):

China is not presently experiencing capital flight. I don’t see it on any significant scale at all. If the Chinese government cracked down on individual Chinese banks or other companies the same way the Western governments are doing to their own companies, you might get some capital flight out of China. But the China-based writer above (Cadassus) is correct about China having more than enough reserve currency to manage the yuan just fine, thank you. Cadassus’s examples of individual cities are pretty convincing. Besides, you don’t hear about anyone making a run on the yuan either way, do you? The quadrillion-dollar question is, does the United States have the “currency” (by that I mean the real capital, and the capital-creating power) to manage the U.S. dollar? In my view, no.

It is critical that we Americans understand that the debt the Treasury (and possibly the Federal Reserve) issues needs to be bought by people outside of the United States in addition to people here. Not enough people here can afford to buy all the debt. Once the foreign incentive to buy American debt lessens (as a consequence of deteriorating fundamentals in the American economy relative to less-leveraged, less-indebted potential places to invest), long term rates will rise. No entity in America, not even the government itself by printing money out of thin air, will be able buy enough long-term Treasury debt to offset the inevitable rise in interest rates. I suppose the Federal Reserve could buy quite a bit of the long-term Treasury debt (print money to buy debt), but at a hit to the value of the dollar–a weird snake trying to eat its own tail. Now those foreigners who already hold a lot of Treasuries might try to bolster the value of their own holdings by defending prior purchases with additional purchases, but all it takes is a persistent marginal seller(s) to drive up interest rates (Japan? The UAE?) who simply believes there is a better risk/reward elsewhere.

I do not understand the euro bashing or the yuan bashing in the above comments. The reasoning makes no sense to me. I would appreciate it if some of you would reply and explain yourselves more thoroughly, particularly in terms of the sovereign debt associated with each currency. Here is my reasoning about why I think the dollar will decline: the amount of debt the United States is issuing and about to issue will be more per capita than the amount of debt issued by any other country or group of countries in any other currency. Granted the United States has more capital-creating power per capita than many other countries, which offsets the debt somewhat (sort of like how you look at debt-to-equity ratios when evaluating corporate debt or equity investability). But let’s be honest and bring onto the U.S. balance sheet all the off-balance-sheet stuff like Social Security, Iraq, Medicare, etc. for the purposes of this paragraph–because the foreign investors surely do so, or will do so, when deciding where to invest their money–and all this excess debt will eventually overwhelm the capital-creating power the U.S. possesses. I understand that the United States has, as Kevin Phillips likes to point out, the luxury of issuing debt denominated in its own currency, and that declines in the dollar will effectively lower the amount America owes, but after some point, sooner rather than later, the tectonic plates must shift, i.e., the dollar’s dominant relationship will scoot about the earth suddenly, differently, not favorably to those of us living here. The foreign investors will not enjoy getting back, when their holdings of U.S. debt mature, less purchasing power as a result of dollar decline. Jim Rogers didn’t just move to Singapore because he likes the food there–I suspect he moved there at least partially because Singapore has a true AAA-rated currency that is less likely to dent him and his family.

Sales taxes instead of income taxes? No. Sales tax is the most regressive tax possible. You take away money from the individuals who spend nearly all, or all, or more than all of their income (the poor and the lower middle class) and who thereby stimulate the essential economy–and you give money to the individuals who hoard it and who, far too often, make lousy discretionary leveraged investments (the upper middle class and the rich). Absolutely not. Sales tax is anti-capitalism, anti-stimulus, and socialism to benefit the rich, period.

I wonder how those of you reading will respond to my assertion about the dollar. I am not the first to be dubious about the dollar. Please, if you disagree, explain yourself clearly to me–please pretend I am very, very young–because I am not an economist, just a fairly skeptical investor who has been prescient enough the last few years to sidestep the crashes in real estate (sold my house in 2004, been renting since) and other equities and who has placed himself higher in the capital structure, buying high-quality bonds so far, buying yen and Swiss francs so far, and very nervous now as to when to 180 the bulk of my deflationary-linked investments into inflationary-linked ones. I have been correct so far, so please grant me that tiny bit of credibility. I don’t doubt there are many holes in my arguments, but I want to learn. Thank you.

Posted by violpoet | Report as abusive