Global imbalances and the Triffin dilemma
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.
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.