When the U.S. dollar ultimately loses its status as the world’s premier reserve currency it will be painful for all involved, almost certainly disorganized, and very possibly a very good thing.

World Bank President Robert Zoellick outlined the risks to the dollar’s status in a speech in Washington on Monday.

“The United States would be mistaken to take for granted the dollar’s place as the world’s predominant reserve currency. Looking forward, there will increasingly be other options to the dollar,” he said.

Zoellick went on to emphasize how choices in the United States on inflation, fiscal policy and financial system reform would help to influence the dollar’s fate.

Quite true. The U.S. cannot simply devalue its way to competitiveness, nor can it appear to be inflating away its debts without risking a run on the currency. The Chinese and others would sell dollars or fail to buy up new debt if they felt the U.S. was behaving both cynically and irresponsibly.

China has good reasons not to force a crisis and devalue its holdings of dollars, but not immutable ones. The two nations are like two men trying to swim to shore while dragging a heavy box of gold, the difference being that the U.S. is tethered to the box while China is only holding on. If China decides the water is too rough it can let go, sacrifice its dollar holdings and swim for it. The United States is not so lucky.

“Exorbitant privilege” is a term coined by an understandably embittered French Finance Minister Valery Giscard d’Estaing to describe the fact that under the old Bretton Woods currency system the United States, unlike everyone else, could simply print dollars to cover current account deficits.

Bretton Woods is gone, but the arrangements which replaced it also tended to underwrite U.S. overconsumption, as purchases of U.S. dollars as reserves by other nations kept funding rates lower despite household or government profligacy.

“The United States is incredibly fortunate that the dollar enjoys this special status,” Zoellick said. “When I work with countries struggling to pay for budgets or finance trade deficits, I reflect on how Americans do not spend a moment considering the unique advantages of being able to issue bonds and print money freely.”

My best guess is that Americans will spend quite a few moments in coming years considering that unique advantage, and that while they will miss it, they should also be sorry they ever enjoyed the right to borrow freely and seemingly without consequence.

THERE’S NO “G20″ IN “TEAM”

Of course the U.S. current account deficit has contracted massively, standing at about 3 percent of gross domestic product in the first quarter as compared to 6.5 percent of GDP in 2006. That’s the result of plunging global trade and steep falls in investment in the United States. And while the personal savings rate has jumped in the United States, which after all it had to since credit was no longer easy, the government has stepped up massively as a borrower, overwhelming households’ efforts to save.

Barclays Capital calculates that the United States now needs to attract 46 percent of the world’s net savings, i.e. the sum of all current account surpluses, as opposed to 54 percent before the crisis broke.

That 46 percent figure is an improvement, but it too is ultimately unsustainable. It’s also arguably starving lots of other places of investment that could ultimately produce higher returns.

The newly empowered G20 group of nations has meanwhile resolved to rebalance the global economy, using peer pressure to force the irresponsible to shape up and the overly tight to start spending at home.

The world’s central bankers and politicians just received an object lesson in what a good idea it is to have a bunch of reserves piled up against a bad day. Even putting China aside, responsible leaders in places like India will have a very tough time trusting in an international body to protect their own best interests. And because that body doesn’t have any real power to compel, it will be ignored. That means that there is a good risk, G20 or not, that everyone is trying to simultaneously keep their currencies low and exports high.

The only body seemingly exempt from market discipline, the United States, is not going to be in a position to resume eating up everybody’s exports. This is a recipe for very slow growth and for rising international economic tension. That doesn’t make the changes proposed at the G20 a bad idea, but they are not sufficient and threaten to be a resolve-softening time waster.

So not so much as rebalancing but a re-basing of growth expectations. Look for continuing dollar weakness alongside that, with the real drama being not the decline but the rate of decline.

–At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.–

The world is witnessing a shift in the balance of power, from the West to the East. This shift will take place over decades, and the winners will be:
- Those economies that have financial clout, such as China
- Those economies that have natural resources, whether it be energy, commodities or water, and will include countries, some in the Middle East, some across Africa, Brazil, Australia, Canada and others in temperate climates across, for instance, northern Europe
- And the third set of winners will be countries that have the ability to adapt and change. Even though we are cautious about growth prospects in the U.S. and UK in the coming years, both of these have the ability to adapt and change.

China is at the center of this shift.

The scale and pace of change in China is breathtaking. Against this backdrop of dramatic change, let me look at China’s impact on the global economy, especially in the aftermath of the financial crisis.

It is now clear that the financial crisis was a result of three key factors: an imbalanced global economy; a systematic failure of the financial system in the West; and a failure to heed the many warning signs.

The world needs to move towards a more balanced economy. But that will take years. The imbalanced nature of the world economy led some to point the finger of blame at the savers, such as China. The 1944 Bretton Woods agreement placed no obligation on savers, countries with current account surpluses. The obligation to change was put on those countries with the deficits. This has to change.

Whilst China and other savers may not be the main source of the recent problem, they are part of the solution.

To move to a balanced global economy, the West, or at least countries like the U.S., the UK and Spain, need to spend less, save more. In contrast, regions like the Middle East and Asia need to save less and spend more. It sounds easy. It is not. It requires a fundamental shift in China and in Asia’s growth model.

At the recent Asian Development Bank (ADB) meeting in Bali, the President called for Asia to rebalance its economy by: expanding the social safety net; providing assistance to small and medium-sized enterprises; and deepening bond markets.

Amongst those present, I detected more enthusiasm for the social safety net than for further financial sector innovation. One of the lessons of the 1997-98 Asian economic crises was the need to open up the financial sector at a speed best suited to domestic needs. One speed does not fit at all. Yet, it is important that if Asia is to see a shift in its growth model it needs to see a reduction in savings and this will be achieved sooner by deepening and broadening its capital markets.

This involves many changes, such as increased personal finance and allowing people to borrow against future income. It requires deep and liquid corporate bond markets, shifting the region’s culture away from equities, and giving firms alternative sources to bank lending and, in China particularly, reducing corporate savings, possibly through higher dividends.

China will play an important role in this process. It has already helped regional integration, building on the Chiang Mai Initiative, and it has engaged in a number of bilateral swap arrangements with countries around the world.

Another important global impact is the importance of China in helping world trade, investment and financial flows. Over the last decade the three words seen most regularly were “Made in China”. Over the next decade the three most common words might be “Owned by China”. China’s stock of overseas direct investment is one-thirtieth of that of the USA. The stock of foreign direct investment in China far exceeds the total amount China has invested overseas. Last year, China’s investment overseas was $50 billion. Now this is changing. Chinese firms are taking advantage of a strong renminbi and of strategic backing from Beijing to expand overseas purchases.

The impact of China on global commodities is already evident. China’s rapid growth and its strategic needs saw it accumulating increasing amounts of commodities. For instance, it accounts for about one-third of global demand for aluminum and copper, and as much as 38 per cent for zinc. In the first half of this year there has been stockpiling by China of a range of commodities. This stockpiling could be explained by many factors, including the strength of the Chinese yuan and the weakness of commodity prices. In future years one would expect this to continue. And it will not just be metals. Demand for food and soft commodities will be important. As incomes rise, food tastes will change.

Furthermore, 28 per cent of Europe’s land is arable, while this figure is 19 per cent for the U.S., but for China it is only 10 per cent. As a result, China will not only buy commodities, but it will also invest in countries producing commodities. This will reinforce the new corridors of increasing trade and investment flows between China and Africa, Latin America and the Middle East.

China’s purchase of commodities has a direct link into the inflation outlook globally. In previous years, CPI figures around the world could have been renamed China Price Indices, as China exported deflation. In the next few years, if there is an inflation issue it is likely to be through higher commodity prices, with China’s demand exerting a key influence.

China will have a big bearing on the dollar. There is a slow burning fuse under the dollar. Even if the U.S.’s economic power were to wane, it is important to stress that the U.S. is still the world’s major economy. There are no credible alternatives to the dollar. Long after the UK ceased to be the world’s major economy a century ago, sterling remained the world’s reserve currency for some time. During this crisis it was noteworthy that, despite much negative sentiment towards the dollar, in the time of trouble the depth and liquidity of U.S. financial markets helped support the dollar as a safe haven.

Furthermore, it would not be a surprise if - as a result of this crisis – more countries learned the lesson of Asian economies after their crisis, and decided to accumulate foreign exchange reserves. During this crisis those countries with high FX reserves were afforded an additional degree of protection. Of course, not all reserves need be in dollars. Even now, countries with large reserve holdings do not actively want to sell the dollar. It is not in their interests to do so. Instead of this active diversification – or outright selling of U.S. assets - there is what I call “passive diversification”, whereby a smaller but still sizeable proportion of their net new reserves are allocated to dollars.

For its reserve currency status the dollar needs to retain its status as the medium of exchange and as a store of value. Interestingly, China and Brazil recently agreed to pay each other in their own currencies, not in dollars as is the norm, whilst the pressure China has put on America regarding the dollar’s value highlights the concern some have over its future value.

China still has a huge balance of payments: its surplus reached 9.6 per cent of GDP last year. The authorities have kept the yuan stable versus the dollar, although this has meant it has appreciated on a trade weighted basis. The Chinese are also, it seems, encouraging trade settlement in Chinese yuan. Yet the reality is the Chinese yuan needs to become fully convertible for it to challenge the dollar and that is not going to happen any time soon. In the future I would expect to see more countries manage their exchange rate against the currencies of the countries with which they trade. This, plus the new trade corridors I mentioned earlier, and the likelihood of increased investment flows into emerging economies with higher growth rates, may all suggest downward pressure on the dollar. But this is likely to be a slow process.

On the global stage, China’s rise is also leading to the rise of State Capitalism. A couple of years ago we looked at this in the context of Sovereign Wealth Funds. Add in large foreign exchange reserves, government pension funds and state owned enterprises, and the role of the state has become far more important.

Finally, China’s influence on global policy forum is important. Already this crisis has seen a shift, with the G20 (Group of Twenty) taking a prominent role. The Chinese took a pro-active role ahead of the London Summit, which was welcome, and is perhaps a sign of things to come. One wonders, however, whether it is the G2 of the US and China that might emerge as the real power. Earlier this year President Obama signaled a shift from the Strategic Economic Dialogue, to the Strategic and Economic Dialogue. This extra word “and” signals perhaps a significant change.

The G20 summit must be considered a disappointing failure, even by the relatively low expectations set for the event. Leaders produced a long agenda of further studies, reports and work, but failed to provide a clear direction or tackle even the most fundamental decisions.

On the key issues, leaders displayed a worrying irresolution. Without unambiguous instructions from the top, discussions between finance ministers and officials will prove protracted and risk getting bogged down in detail. Negotiations between officials can fill in the details; they cannot make the kind of fundamental choices about strategic direction that leaders avoided at the weekend.

A SENSE OF HISTORY

The summit has been bedeviled by comparisons with the Bretton Woods conference in 1944. Intended as a rhetorical device to restore confidence by suggesting governments were taking bold action in an unprecedented spirit of agreement, the ghost of Bretton Woods has raised impossible expectations and distracted both leaders and officials from the real issues facing the global financial system:

(1) The three-week conference at Bretton Woods was the culmination of more than two years of detailed work at official level and more than a decade studying the issues. There was substantial prior agreement about the problem (poorly coordinated monetary and fiscal policies, leading to payment imbalances and protectionism) and the solution (a gold-exchange system, with multilateral surveillance of national policies, and national reserves supplemented by IMF drawing facilities on a conditional basis).

The system was buttressed by a new multilateral development bank to help fund infrastructure and post-war reconstruction, and later by the General Agreement on Tariffs and Trade (GATT) to prevent a slide back into protectionism.

Comparisons with Bretton Woods thus created unrealistic expectations of what top-level leaders would be able to achieve without detailed preparatory work.

(2) The more serious problem is that the comparisons frame the issue in the wrong way and encourage leaders to pursue the wrong solutions to the wrong problems.

Bretton Woods occurred against the backdrop of the Great Depression - when countries had tried to defend fixed gold parities by raising taxes, cutting expenditure, and hiking interest rates to deflate domestic demand and cut imports, while introducing trade barriers to reduce deficits and limit outflows of bullion.

The current crisis is very different. It is occurring under flexible exchange rates, not fixed ones. No one is suggesting governments raise interest rates, hike taxes or cut expenditure to maintain the external value of their currencies rather than support domestic demand. Most countries seem quite happy with depreciation and easy monetary and fiscal policies.

But the ill-conceived comparisons with 1944 have caused leaders to focus on the spectre of renewed trade protectionism and the need for international policy coordination - while more targeted but relevant proposals to improve financial regulation risk being lost in a sea of other ideas.

Like generals fighting the last war, the G20 leaders seemed more comfortable solving the problems of the 1940s than the 2000s.

FAILURE OF WILL

The summit made some progress agreeing on the nature of the problem and locating it in the financial system: “weak underwriting standards, unsound risk management practices, increasingly complex and opaque financial products, and consequent excessive leverage combined to create vulnerabilities in the system”.

The communique went on to note: “Policymakers, regulators and supervisors, in some advanced countries, did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovation, or take into account the systemic ramifications”.

However the real problem was not a failure of understanding but a lack of regulatory will:

(a) Long-Term Capital Management’s collapse highlighted the systemic risks posed by highly interconnected institutions as long ago as 1998.

(b) Enron’s demise in 2001 showed the risks arising from the use of off-balance sheet vehicles that were only independent entities in a narrow accounting sense but risked being consolidated back onto the parent company’s balance sheet in a crisis.

(c) The Commodity Futures Trading Commission (CFTC) warned about over-the-counter derivatives with poor transparency, limited oversight and unknown risk concentrations in the late 1990s, but was banned from trying to regulate them, partly at the behest of the U.S Treasury and Federal Reserve.

(d) With subprime mortgages, the Fed had been aware for several years about a relaxation of lending standards, but regulators did not nothing beyond issuing half-hearted warnings.

(e) Repeated warnings about serial asset market bubbles and the over-inflation of house prices were dismissed by the Fed as localised “froth”. Officials preferred to provide post-crisis relief rather than interfere with market mechanisms to prevent bubbles inflating in the first place.

Each time regulators attempted to quantify risk or force financial institutions to adopt more conservative practices, they were seen off by heavy lobbying from the major investment banks and insurance companies.

Top policymakers, from Greenspan downward, systematically dismantled regulatory safeguards that had been in place since the 1940s.

With no support from the top, junior regulators appear to have given up trying to enforce even the existing rules and were forced to adopt the interpretations most favorable to the institutions they were meant to be regulating. Wall Street controlled the regulators, rather than the other way around.

Adding to the pressure, the major financial institutions were able to successfully arbitrage among regulators in different countries, and even between different regulators within the same country. Tough rules-based regulation by the SEC was contrasted unfavorably with the light-touch principles-focused regulation adopted by the CFTC and Britain’s Financial Services Authority.

Regulators themselves seemed more anxious to promote the competitiveness of their local jurisdictions in a race to grab market share by offering the lightest touch - which often meant no effective regulation at all.

It was this regulatory arbitrage and capture of the regulatory authorities by the institutions they were supposed to regulate that lay at the root of the crisis. While G20 leaders seem to understand this, their response suggests a hesitancy that could be fatal to reform.

LITTLE THRUST FOR REFORM

There is a brief mention in the communique of the need to strengthen regulation and avoid regulatory arbitrage. But too many proposals in the document are either irrelevant or reveal a disinclination to challenge the status quo.

Proposals for a “college” of supervisors to assess risks in large cross-border institutions look like a solution to the lending crises of the 1990s (when institutions failed to understand their aggregate country exposure) rather than the 2000s (when the crisis largely stemmed from risk concentrations in a single country and a single financial system).

Proposals to examine the pro-cyclicality of regulatory policies and the valuation of illiquid securities suggest a willingness to accept industry efforts to blame accounting treatments and capital requirements rather than poor lending. Asking the Basle Committee to help firms’ new stress-testing models is a fairly ineffectual response to the wholesale failure of risk management processes the crisis has revealed.

Calls to avoid regulatory arbitrage were coupled with the need to “support competition, dynamism and innovation in the marketplace”. No one could argue against the importance of innovation, but the very mixed remit gives finance ministers and officials no real support for toughening regulation.

The communique lacks focus, with favorite but irrelevant themes about terrorist financing, uncooperative tax havens, voting reform at the IMF and completing the Doha round of trade negotiations all making an appearance. While these are worthy objectives, rolling them all into the communique has simply weakened it.

The G20 was timid and confused where it needed to be bold and clear. As ministers and officials sit down in a dozen working groups to discuss detailed reforms, they are more likely to tinker with a failed system than produce a successor to Bretton Woods.

Far from the confines of Washington, Reuters readers launched into a lively debate, sparked by Reuters columnists and experts, on what this means for the global financial crisis.

One of the more lively discussions arose from a column theorizing the financial crisis is the greatest threat to international security. Paul Rogers, Professor of Peace Studies at Bradford University and Global Security Consultant to Oxford Research Group argues:

Unless global responses are made to the current economic crisis, the biggest threat to international security will be the impoverishment of hundreds of millions of people, leading to radical and violent social movements that will be met with force, resulting in still greater conflict.

Reader Jonathan Cole contends:

When the “me” impulse overcomes the “we” impulse to the point that it creates a dysfunctional, unjust concentration of wealth and comfort in the hands of a minority, while consigning the rest to poverty, bad health, and early death, it is only a matter of time before the anger bubbles up from the masses.

Reader James Harris counters:

Maybe it is time for better thinking and not these emotional reactions, that are ultimately an innate desire for finger pointing at U.S. Leadership in causing the financial crisis.

While reader Michael Anderson comments:

I think it would be very beneficial if we had leadership which could promote a mindset whereby we didn’t think of it as us versus them. When underdeveloped nations begin sharing in the wealth to a larger degree we all win.

“Move over America! Make space Europe!”

Reuters columnist Paul Taylor writes that this summit of 20 nations sets a precedent for a new international order. Emerging economies such as China, India, Brazil, South Africa and Mexico are invited to share responsibility for the economic fate of the planet with the established Group of Eight industrialized nations.

No longer mere appendages invited for lunch at the end of the annual G8 summit, the rising powers are in demand because they have either mountains of cash, vital natural resources, fast-growing economies or regional security responsibilities.

Reader RC comments:

India constitutes around 17% of the world population whereas the whole of Europe constitutes only around 5% of the world population. Europe have 3 permanent UN security council members with veto power, which India does not have. What kind of democratic world is this?

“Risk-taking is the engine of economic innovation”

Diana Furchtgott-Roth, former chief economist at the U.S. Department of Labor puts forth the argument that the U.S. won’t stomach a new Bretton Woods. She writes:

Whatever the wisdom of more far-reaching international financial regulations, many Americans don’t want binding rules administered by a bureaucracy unaccountable to the public. They prefer to do the job themselves. They want sovereignty over their own affairs, and are suspicious of international organizations.

What are your thoughts on the issues world leaders face as they tackle the financial crisis?

Leaders of the Group of 20 countries meeting in Washington on Nov. 15 are hoping that America’s role in the global financial crisis will shame President George W. Bush, or maybe President-elect Barack Obama, into supporting greater international financial regulation, diminishing America’s role in international financial institutions.

But America is unlikely to give up control over its financial sector, certainly not under Bush, and probably not even under the internationally-popular Obama.

International leaders demand a replay of the 1944 wartime conference at Bretton Woods, New Hampshire, at which delegates from 44 nations created the World Bank and the International Monetary Fund. The World Bank made loans to war-torn countries and now lends to developing countries. The IMF supervised fixed exchange rates centered on the U.S. dollar and gold, a regime abandoned in the 1970s, and made rescue loans to troubled economies, a role that continues.

When European Union leaders met in Brussels on Nov. 7 to prepare for the financial summit, they proposed a course that might be as far-reaching as Bretton Woods.

An EU statement, sweeping but vague, proposed that financial institutions of “systemic importance” be made subject “to rules or at least to oversight wherever they operate” and that “no market segment, no territory, and no financial institution should escape.” That proposition is a dangerously empty vessel into which all manner of regulatory mischief could be poured.

Such international regulation would be unprecedented.

British Prime Minister Gordon Brown and French President Nicholas Sarkozy, now the EU president, want the IMF to enforce the new regime, building up an institution traditionally headed by a European. Standards would be promulgated and enforced by the IMF, similar to the way that the European Commission enforces rules among EU member states.

Their goal is to offer principles for a new international financial system that would be translated into workday regulations for all manner of financial institutions, even ratings agencies. Ambitiously, the Europeans want another summit in 100 days to consider draft regulations.

But it’s unlikely that Congress or any American president, Bush or Obama, would sign on.

Whatever the wisdom of more far-reaching international financial regulations, many Americans don’t want binding rules administered by a bureaucracy unaccountable to the public. They prefer to do the job themselves. They want sovereignty over their own affairs, and are suspicious of international organizations.

Americans’ distrust of international regulation stems from international organizations that are perceived to be anti-American. For example, the United Nations Oil for Food program, intended to allow food to reach hungry Iraqis, wound up profiting Saddam Hussein’s family and political supporters, leaving southern Shiites to starve.

Congress gains power by regulating the financial sector because companies donate campaign funds to members. The securities and investment industry, which stands to lose the most from international regulation, is particularly generous.

The Center for Responsive Politics reports that securities and investment houses donated over $1 million to Senator Chris Dodd, now Senate Banking Committee chairman, and over $540,000 to Alabama Republican Richard Shelby, then-chairman of the Senate Banking Committee, in 2004, the year they last ran for reelection.

Obama received $13 million from the industry for his presidential campaign, and Senator John McCain $8 million.

The fundamental question is whether more international financial regulation can resolve the current crisis and prevent another one– without hindering innovation. Since risk-taking is the engine of economic innovation, we don’t want to stifle it by regulation and all financial innovations will carry some new risks.

The huge crowds that cheered Obama in Europe last summer will not persuade him to cede control over his country’s financial system to the IMF. The most that the G20 can hope for under the new president is that Congress adopts its new principles and America regulates itself.

Diana Furchtgott-Roth can be reached at dfr@hudson.org.

– Do you want to contribute to The Great Debate? Please send your ideas to debate@thomsonreuters.com.–