Time overdue for a world currency
by Hossein Askari and Noureddine Krichene
The world economy is suffering from high inflation, stemming from overly
expansionary monetary policy in the United States, as indicated by negative
real interest rates and the rapidly depreciating dollar. Low interest rates
discourage savings, reduce bond yields and cause investors to seek higher
yields in speculative commodities and foreign currency markets. Consequently,
energy and food prices have exploded to levels threatening social and economic
upheavals.
Oil prices, by climbing from US$20 a barrel in 2001 to $135 barrel in May this
year, illustrate the extent of the dollar's depreciation and interest rates
distortions. Whereas a $100 bill would have bought five barrels of oil in 2001,
now it buys only 0.74 barrel, losing approximately 85% of its real value.
Inflation imposes a heavy tax burden on dollar holders, cuts
disproportionately the real incomes of workers and pensioners, redistributes
wealth in favor of debtors at the expense of creditors, and stifles economic
growth.
Given that the US dollar accounted for 41% of total international reserves at
the end of 2007, (against 17% for euros), its fast depreciation makes it a
risky asset for holders and could lead to a run from the dollar toward more
stable currencies or more stable assets, such as gold, commodities, real estate
and safer financial assets. A flight from the dollar could create a liquidity
crisis, in turn disrupting international trade and world economic growth. Oil
and food exporters, wary of the rapidly depreciating value of their foreign
exchange reserves, would be induced to curtail exports, with attendant
consequences for the real world economy.
The current inflationary episode is neither novel nor surprising, but its
severity could prove to be exceptional and it could last for some time. Indeed,
following the collapse of the gold standard in 1914, the world economy became
vulnerable to recurrent monetary disruptions stemming from expansionary
monetary policies in reserve currency centers, suffering deep contractions in
trade and economic growth, most notably the Great Depression.
The present monetary conditions are similar in many respects to the ones that
prevailed in the 1930s. Major reserve currency countries, now and then, fearing
domestic recession and unemployment, were reluctant to contract monetary policy
and incurred large balance of payments deficits, followed by competitive
devaluations, speculative attacks and inflationary spirals.
In spite of the Bretton-Woods Agreement and successive reforms of the
international financial system, a main deficiency of the post-1914 system
remained the absence of monetary discipline and ultimately a reserve anchor
(formerly gold) for monetary policy in reserve centers.
In this regard, the dollar and sterling, by becoming reserve currencies in the
context of the 1922 Genoa (Italy) agreement, expanded monetary liquidity freely
through protracted balance of payments deficits, until reaching
non-convertibility with gold in September 1931 for sterling and August 1971 for
the US dollar. Under the post-1914 mechanisms, known as the gold exchange
standard, Bretton-Woods fixed parities, and flexible exchange rate systems, a
reserve center was able to run extended balance of payments deficits without
loosing foreign reserves, until market forces imposed a disorderly and costly
adjustment, including widespread trade barriers and restrictions.
Frequent and drawn-out financial upheavals of the world economy led to the
formulation of bold proposals for reforms of the international payments system,
such as by John Maynard Keynes (1943), Robert Triffin (1960), Jacques Rueff
(1963), Franco Modigliani and Askari (1971), and most recently Robert Mundell
and Paul Volcker (2000). While the proposals varied in details, they shared
broadly a common objective, namely safeguarding the world economy against
disruptive financial instability and a common reserve currency, called bancor
by Keynes, Fund (International Monetary Fund - IMF) deposits by Triffin, a
reserve asset with constant purchasing power in terms of a basket of
commodities (Modigliani and Askari), or purely restoring gold by Rueff.
A number of the proposals called for establishing a central bank for central
banks, which for Triffin would be the IMF.
The consequences of the financial instability of the 1930s were most onerous
and may have contributed to subsequent wars. The world economy is becoming
increasingly globalized and financial markets are becoming increasingly
integrated. However, with fully flexible exchange rates, combined with
disorderly monetary expansion in the reserve centers, the world economy has now
become more vulnerable to financial instability than at any time before.
Early warnings, such as rapidly rising inflation, tight oil markets and food
riots, call for decisive reform of the international payments system. Reverting
to beggar-thy-neighbor policies between major currency centers and emerging
economic powers can become very costly to the world economy. While drawing
lessons from shortcomings of past reforms is essential, a reform plan may
evolve around three pillars: create a world central bank, create a world
currency, and establish safeguards for member countries' monetary policy in the
form of quantitative ceilings for money growth.
A world central bank is becoming a necessity in a global economy. Such an
independent central bank, not subject to the political whims of a particular
government, would be more likely to apply orthodox and safe central banking.
Contrary to any country's central bank, a world central bank would have no
obligation to accommodate budgetary deficits, war spending, domestic wage and
price rigidities, speculative asset bubbles, or rescue ailing domestic banks.
Its law should be as meticulously applied as any constitutional law of a
Western democracy.
Most important, as prescribed by Triffin, little discretion should be allowed
for this central bank in the conduct of its mandate. Namely, its reserve
currency growth should never exceed fixed annual ceilings, and its operations,
resembling those of any central bank (rediscount, open market, lending and so
forth) should be strictly regulated.
Second, a world central bank would create a reserve currency, not be a
fictitious unit account such as the IMF's Special Drawing Right (SDR), but a
true legal tender represented by a currency bill, the same as a dollar, euro,
sterling, or any other currency bill. Rueff was a strong proponent for a gold
standard. Recently, Mundell maintained that gold could be used as a reserve
asset in a reformed international monetary system for the 21st century.
While there are many schemes for introducing a common currency, as in the case
of a common currency area (for example the euro), the easiest is to define a
world currency in terms of gold (or preferably in terms of a selected basket of
internationally trade commodities as the reserve currency would have a more
stable purchasing power), as gold has possessed over the centuries the
characteristic of money instead of any other commodity or paper money.
Once defined in terms of gold, its value will remain fixed and will be
preserved through strict laws controlling its issuance, including quantitative
annual ceilings that can never be exceeded. The world currency note will
circulate along with national currencies, serve as a reserve asset, and become
part of the international payments system.
By becoming a full-fledged reserve asset, a world currency would cushion the
real value of international reserves against inflationary policies of reserve
currency centers and wide fluctuations in exchange rates. It would restrain
extended balance of payments deficits of currency centers, and may contribute
significantly to promoting financial stability and sustained world economic and
trade growth.
A third area for a world monetary reform is mandatory monetary discipline in
member countries. While member countries in the euro zone have fully
surrendered monetary sovereignty to the European Central Bank, reserve currency
centers may have to surrender partially, not totally, their monetary
prerogatives to a world central bank. Most indicated safeguards would be to
establish rigorous annual ceilings on money supply not exceeding 5% a year (or
a fixed multiple of a country's holdings of the constant purchasing power
reserve currency above).
Observing this law would be like observing the constitutional law of electing a
US president for a four-year term. As constitutional laws have ruled over two
centuries in the US and have preserved economic and political freedom, similar
laws have to prevail in a monetary area to reduce discretionary powers of
central bankers and attain monetary stability.
Monetary instability has had serious consequences at the national as well as
world levels. Promoting safeguards for monetary stability and surrendering part
of the monetary sovereignty to a world central bank would be necessary for
checking selfish policies and eradicating root causes of monetary
instabilities.
Previous reforms of the world monetary system, as well as negotiations under
the General Agreement on Tariffs and Trade (predecessor to the World Trade
Organization), were very slow and moved under forced conditions rather than
through a planned and organized process. Often, conflicts of national interests
undermined these reforms or severely limited their scope.
With long strides in trade liberalization, the formation of a monetary zone in
Europe, and globalization of the world economy, it is hoped that progress in
monetary cooperation will be easier now than in the past. The present system of
flexible exchange rates and unchecked money expansion by reserve centers could
turn into monetary chaos and disrupt trade and economic stability. Progress
achieved in 1980-2000 against inflation has been wiped out by current
expansionary policies in major reserve centers and has created unmanageable
difficulties in oil and food markets.
It will be important, at the level of the United Nations, the IMF and world
governments, to move as quickly as possible in redressing the prevailing
monetary chaos and initiating a reform process for a world central bank, most
likely the IMF, and the creation of a world reserve currency.
Standing put in the face of mounting inflation and financial disorder would
inflict costly stagflation, contraction in trade and disorderly oil and food
markets. Allowing a free hand for central bankers in waging monetary warfare,
or pursuing exclusively domestic full employment irrespective of inflation and
external imbalance, could be even more costly for the world economy than the
monetary anarchy of the 1930s.
Without establishing a full-fledged world central bank, world currency and
safeguards for reserve centers' monetary policy, any reform of the
international financial system will suffer the same shortcomings as the
successive regimes that prevailed in the post-1914 period.
Hossein Askari is professor of international business and international
affairs at George Washington University. Noureddine Krichene is an
economist at the International Monetary Fund and a former advisor, Islamic
Development Bank, Jeddah.
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