THE BEAR'S LAIR Beyond the dollar
By Martin Hutchinson
People's Bank of China governor Zhou Xiaochuan said last week that the Special
Drawing Rights (SDR) of the International Monetary Fund (IMF) should replace
the dollar as the world's main currency. The political reasons for his proposal
are clear, its merits rather less so. Could the world economy work better with
a global central bank, whether in the form of the IMF or some other body, and
with a global currency as its main reserve unit?
There is certainly a good argument for the world ditching the dollar. It's
estimated that the US budget deficit for the current fiscal year that runs
through September will be 12% of gross domestic product (GDP). Broad money
supply, whether measured
by M2 or the St Louis Fed's MZM, has risen at annual rate of 17% in the six
months through March 16, before the start this week of the Fed's potentially
hyper-inflationary purchase of US$300 billion of Treasury bonds over the next
six months.
There is thus no reason to believe that the dollar represents a sound store of
value, the principal function of a reserve currency. While liquidity in US
dollar debt instruments is enormous and ever increasing as their supply
skyrockets, there must be a danger of disruptions in the Treasury bond market
similar to that caused by the "failed auction" last week in the UK gilts
market, potentially causing price discontinuities and liquidity outages. In
criticizing US economic management, therefore, Zhou is on solid ground,
reflecting many of the criticisms this column has made of US monetary policy
since 1995 and fiscal policy since 2002.
Other major world currencies don't look any more solid than the dollar. The
pound is equally affected by the financial services disaster, and the UK has a
budget deficit that is as large as the United States in terms of GDP, has been
much worse managed over the last several years, and has an economy with very
little raison d'etre outside the shrunken financial services sector. The yen
has been strong recently, but that strength has caused a collapse in Japanese
exports, down in February by almost half from the previous year. Domestically,
the Japanese economy had been quite well run until September 2008, but Prime
Minister Taro Aso represents a reversion to the worst tendencies of the 1990s,
with four wasteful public spending "stimulus" plans announced, a budget deficit
as large as that of the United States, and a government debt three times
larger.
Only the euro represents a haven of stability, particularly if the German and
French reluctance to indulge in excessive public spending spreads to the
remainder of the currency's members. While the Mediterranean group of countries
have structural weaknesses, their membership in the euro will force discipline
on them, and so the chances are that the euro bloc will hold together. If it
does, the euro will provide a satisfactory store of value, since the European
Central Bank's policy has been far less inflationary than that of the United
States and its members' budget deficits are much smaller. The danger is that of
the unit's relative novelty; in a deep and prolonged recession, it is possible
that Italian, Greek and Irish profligacy will overwhelm German and French good
management, either debauching the unit or splitting it apart.
Zhou no doubt regards China's monetary management as a model of solidity. That
is nonsense. For one thing, in spite of its $2 trillion in reserves and massive
balance of payments surpluses, China has still not allowed its ordinary
residents to invest abroad on a free basis. Doubtless that policy results from
a desire to maintain the apparatus of a police state rather than from balance
of payments paranoia. Still, it is highly immoral, blocking one of the most
fundamental and important economic freedoms and protections against arbitrary
government. No currency that is subject to an exchange control regime has any
claim to be included in the international monetary system, the essence of which
is the free movement of capital.
There are also, incidentally, remaining questions about the Chinese banking
system. The $911 billion of bad loans in the system estimated by Ernst &
Young in the boom year of 2006 will certainly not have diminished and may well
have increased further in the current downturn, which appears to be more severe
than the Chinese authorities are admitting.
Nevertheless, whether or not his own currency is in a fit state to travel, with
$2 trillion of international reserves Zhou has a perfectly reasonable desire
that the value of those reserves should not disappear in an orgy of
inflationary monetary policy and "Yes, We Can" deficit spending. US authorities
may object to this desire, since a withdrawal of any significant portion of
China's reserves would irretrievably doom the Treasury bond market, but their
right to object is vitiated by their responsibility for the spendthrift
policies that led to the dollar's vulnerability.
As the proprietor of a non-convertible currency, Zhou doubtless has only a
limited grasp of the purpose of a reserve currency. This is threefold. First,
it must provide immediate liquidity for the world's pools of international
reserves. Second, it should provide a store of value, preventing those reserves
from being artificially devalued. Third, it should as far as possible be
"politician-proof", gaining its value through some automatic mechanism that is
not dependant on the whims of central bankers and politicians. As the current
unpleasantness has demonstrated, central bankers and politicians are only too
likely to panic in crises and engage in value-destroying currency debasement.
The gold standard, in place with a few interludes for more than 200 years from
its establishment by Isaac Newton as Master of the Mint in London in 1717 until
its final collapse in 1931, fulfilled all three purposes admirably. Since gold
could be melted down and re-minted in the form of any of the world's
currencies, it was admirably liquid. It provided a superb store of value,
although that value fluctuated by as much as 20% to 25% with periods of new
gold discoveries (California and Victoria for a decade from 1849-51, South
Africa and the Klondike in the 1890s) when prices rose, and periods of economic
expansion faster than the rate of gold discovery (1870-93) when prices
declined. Most important, it was automatic and independent of political and
central banker control. Under it, bubbles were throttled fairly early by
shortages of specie and downturns were ended by natural means rather than by
dissolute floods of money creation.
In an ideal world, we would satisfy Zhou's requirements by a simple return to
the gold standard at a parity, of perhaps $1,000 per ounce, that was high
enough not to be excessively deflationary. There would doubtless be a few years
of disruption, as there were in 1815-19 when Britain was forced into deflation
to return to the gold standard at its pre-1797 parity. However, in the long
term, the world's monetary system would settle down on the basis of the major
currencies being linked to gold. Central banks and politicians would be
deprived of much though not all of their power over money creation. Damaging
bubbles such as those of 1995-2007 would be cut short by a drain of gold from
the banking system, forcing higher interest rates before prices of stocks,
housing and commodities got too far out of line.
In the world we live in, that option is not politically available. In any case,
with global population growth running at around 1% annually, it is doubtful
whether gold can be discovered fast enough to prevent an excessively
deflationary price regime under a gold standard. Contrary to the absurdly
overblown view of Federal Reserve chairman Ben Bernanke, deflation of 1% to 2%
per annum is harmless, even beneficial, but in extreme cases such as that of
1930-33, when US prices fell 25% in terms of gold dollars, it stifles
productive investment because holding cash becomes highly profitable in real
terms.
Gold mine production in 2008 of 2,407 tonnes, higher than in recent years
because of high gold prices, was only 1.4% of the gold stock of 170,000 tons.
If velocity were constant, that would not be sufficient to accommodate 1%
population growth and desired global economic growth of 3% without an
unpleasant average annual deflation of 2.6%. (In the 19th century, gold mine
output was higher in terms of the existing gold stock while population increase
averaged only about 0.5% annually. The faster population growth and relatively
slower gold stock increase after 1900 made the 1920s' gold standard
unpleasantly deflationary.) Thus a global return to the gold standard is at
present impossible, though it would certainly be feasible and possibly
attractive for an individual country.
Zhou's proposal for increasing SDR issuance passes none of the above tests for
a reserve currency. Before 1971, the SDR was linked nominally to gold, but it
is currently a basket made up of 63 US cents, 41 euro cents and smaller amounts
of yen and sterling. The total of SDR quotas is currently SDR 21.4 billion; a
proposal has been outstanding since 1997 (effectively blocked by the United
States), which would increase that total to SDR 64.2 billion (about US$100
billion.) Smaller than the money supply of Malaysia, that is a laughably
inadequate amount of money to provide adequate liquidity for the world's
reserves.
Zhou would propose - with the breathless endorsement of senior IMF officials -
that new SDRs be created to raise the SDR money supply to an adequate value
comparable to the broad US money supply of $9.6 trillion. Needless to say, this
would be extraordinarily inflationary.
Spurred by the grossly over-expansionary US monetary policy, and later by
similar follies elsewhere, international reserves more than quadrupled in the
decade from 1998, rising at an average annual rate of over 16%. Since
September, most monetary authorities have pursued even laxer monetary policies,
so an epidemic of high global inflation is inevitable once the recession
bottoms out. A large expansion of SDRs would greatly worsen that problem,
preventing the SDRs themselves or any other currency from representing an
adequate store of value, for international reserves or any other purpose.
However, the most serious reason why the SDR should not be used as a reserve
currency is its control by the unaccountable bureaucrats of the IMF. Far from
being immune to political control, SDRs would be managed by international
bureaucrats subject to no outside control by electorates or the market. Such
bureaucrats would be at least as prone to damaging panic as domestic monetary
authorities. Even more dangerous, they would be free to manage the world's
money by whatever cockamamie left-wing economic theories they chose, and to
siphon off resources from the world's money supply to every corrupt Third World
Marxist regime they wanted to support.
Allowing the SDR to become the world's reserve currency, even on a
non-exclusive basis, would place global monetary policy entirely on a
non-market basis, without individual countries having any recourse but to purge
their international reserves of SDR assets and refuse to accept SDRs in payment
- which would defeat the point of the exercise. It is a proposal worthy of the
impoverished and genocidal China of Mao Zedong, not the hopeful market-oriented
China of today.
If China is really worried about the value of its reserves and wishes to
provide a long-term benefit to the world economy and its own citizens' wealth,
it has an alternative to the SDR, which would weaken rather than strengthen the
trans-national bureaucrat class. The IMF, typically enough, forbids its members
from linking their currencies to gold. Governor Zhou should break that
prohibition and put the yuan on the gold standard. With $2 trillion in reserves
and a structural balance of payments surplus, China can well afford it.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-2009 David W Tice & Associates.
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