Decouple the world from the dollar
By Korkut A Erturk
Until recently, some economists believed that this economic crisis would end
when investors returned to the stock market and recapitalized banks. But
investors lacked confidence, thinking that they would be throwing good money
after bad. The dubious assets buried deep in balance sheets of US banks still
had to be cleansed, but trying to sell them off would further decrease their
market value and compound banks' losses. Thus the bottom could not be reached
until the investors returned, but investors would stay on the sidelines until
asset prices hit bottom.
The initial rescue package from former US Treasury secretary Henry Paulson was
aimed at addressing this dilemma by trying to provide a floor to falling asset
prices. The Paulson plan failed to change investors' expectations or persuade
financial markets that it could provide the bottom that the market would not,
and it is
doubtful that the latest plan from Treasury Secretary Timothy Geithner and
White House economic advisor Larry Summers will do so either.
It is clear that this is no ordinary recession. While there is no consensus on
how to revive banks, there appears to be considerable agreement that extreme
monetary easing and a massive fiscal stimulus are necessary to prevent the
current slump from getting even worse. There is, however, a panacea of sorts
for the broken machinery of the global economic system.
While an emphasis on reviving banks and an injection of public spending are
both important, the trouble is that neither one directly addresses the main
source of global deflation, which is that global imbalances are no longer being
recycled effectively. Because US households and banks are now bankrupt, the
United States has lost much of its capacity to absorb and recycle foreign trade
surpluses. That, in a nutshell, is the driving force behind the global
Substituting massive public spending for private consumption and putting banks
on life support are at best stopgap measures, and it is unlikely that they will
bring back the ability to recycle trade surpluses. Even in the best-case
scenario, where confidence in the dollar holds up, the broken machinery that
produced the world's credit supply cannot not be reassembled because too many
borrowers and intermediaries are insolvent. There is no easy way to make the
debt overhang go away, and neither tax cuts nor cleansing banks of toxic assets
will bring about a lasting increase in private consumption.
If confidence in the dollar ebbs and a slide/rush to gold occurs, the situation
will be further complicated. The 1920s and 1930s offer a lesson on the dangers
posed by a potential slide/rush into gold.
Following the Federal Reserve's shift to tight money in 1928, the capital flow
from the US to Europe began to reverse and the deficit countries were forced to
deflate, increasing doubts about the overvalued sterling and the dollar. A
destabilizing dynamic was set in motion - more confidence eroded through fear
of devaluation, which led countries to liquidate foreign exchange (sterling and
dollar) in favor of gold in their reserves, and the devaluation risk rose
further. The extinction of monetary reserves caused by the dwindling foreign
exchange led to a progressive contraction of money supply and credit, making
the slump worse and further undermining the confidence in the monetary system.
There are no fixed parities to defend today, whether against gold or any other
currency, and the Fed is doing exactly the opposite of what it did then.
However, there are also unmistakable parallels. Just like then, a process of
deflation driven by the disruption of the recycling of trade surpluses is
threatening global financial disintermediation. Similarly, the erosion of
confidence is again liable to cause a massive monetary contraction and
fragmentation of trade around the world in the following years.
This time, the stakes are higher and there is less room to maneuver, given that
the share of dollars in international reserves is far larger now than it was in
the late 1920s. If financial sentiment forces the US to choose between trying
to keep unemployment from rising further into double digits or defending the
dollar, the US could probably succeed in neither. Reversing its policy of
extreme monetary easing and fiscal stimulus in order to defend the dollar could
be as disastrous as letting its value fall. Unlike in the 1930s, depreciating
the dollar is much less of an option, as its deflationary impact abroad would
come back to haunt the US.
The advantage the US enjoys in being able to issue its liabilities in its own
currency can turn into a liability. The US has been spared the worst ravages of
this financial crisis because of this ability. There is a potential downside,
though. Most countries that had a currency crisis in the 1990s experienced a
speedy, V-shaped recovery mainly because the sharp capital account reversals
they experienced provided an unambiguous market signal that asset price
deflation had hit bottom and overshot, which led to a strong surge in capital
inflow and a speedy end to the crisis. The trouble now is that no quick obvious
market-driven bottom to asset price deflation can conceivably exist in the
event of a dollar crisis because of the massive size of the dollar reserves
outside the US. Sharp dollar devaluation can cause these reserves to unravel
and would result in a massive dollar overhang, causing serious damage to world
The current US policy ignores the possibility that changes in financial
sentiment might eventually force its hand on the dollar. The extreme monetary
easing and a massive fiscal stimulus being implemented amounts to fighting
deflation by trying to destabilize the monetary standard to induce inflation.
If it fails, the current slump can turn into a great depression worse than the
last, and if it works, the resulting inflation will probably make the 1970s
look good. But, given the severity of the situation, what else can be done?
Given that the problem is not the global imbalances per se, but how financial
deregulation and the global order absorbed and recycled them, a safer approach
would target the following three objectives: first, the reassertion of public
control over the credit creation process; second, preparing for the possibility
that the value of the dollar dives; and third, resuming recycling trade
surpluses before contraction begins to destroy them.
We have to wean the world of its dependence on US overspending without sticking
the US and the world economy in a depression. That requires that the global
monetary standard, and by extension the integrity of monetary reserves, is
safeguarded as more stimulus is implemented.
A credible plan to achieve this would involve figuring out a way to draw a
wedge between the global dollars accumulated in foreign reserves and the
domestic dollars that the US will be creating at a much faster clip. That way,
the world economy can reinflate at the same time, since everyone would be able
to devalue in relation to a stable monetary standard.
Technically, this wouldn't be hard to do. An idea such as setting up a
substitution account at the International Monetary Fund (IMF) to convert
unwanted dollars to special drawing rights (SDRs) can be considered. The idea
was considered before in the late 1970s when international confidence in the
dollar was ebbing, only to be shelved once the political swing to the right
made it redundant. In principle, the IMF could issue as many new SDRs as
demanded without being inflationary and could even refashion itself as the
asset manager of the world. The IMF could even help generalize new instruments
such as the proposed Asia bond by using Chinese reserves.
The real question is whether there will be the political will to carry out
these proposals. Will the United States have the wisdom to decouple the world
economy from the dollar? Will the US and China, who have the most to gain from
cooperation, be able to do so? Will the Group of 20 nations be the driving
force behind a new global accord? Much rests on whether the Barack Obama
administration can move past a dollar-centric economic paradigm.
Korkut A Erturk is an associate professor and chair of the department of
economics at the University of Utah. Recent publications include "Revisiting
the Old Theory of Cyclical Growh: Harrod, Kaldor cum Schumpeter" (Review of
Political Economy 14:2, 2002) and "Overcapacity and the East Asian Crisis"
(Journal of Post Keynesian Economics 24:2, 2001-02).
(Published with permission of the Global
Policy Innovations program at the Carnegie Council for Ethics in