IMF adopts irrigation plan during a flood By Hossein Askari
The response of reserve currency central banks to the financial crisis of
August 2007 was to re-inflate their economies with massive financial bailouts
and inject unlimited liquidity to reduce interest rates to just about zero in
the United States, the United Kingdom, the European Union and Japan.
The Group of 20 (G-20) summit in London in 2009 called for unorthodox monetary
policy as a way to boost aggregate demand, not only in the countries that were
deeply affected by the crisis, but also in countries whose financial systems
remained relatively sound. Realizing that demand had collapsed in their own
countries, the major reserve countries looked for non-industrial countries as a
market for their rapidly falling exports.
Accordingly, they decided to revive the International Monetary
Fund (IMF), which had long ago surrendered its role of safeguarding the
international payments system, promoting policy coordination and exchange rate
stability, and supporting countries in need of short-term balance of payments
financing.
The IMF, facing large deficits and undertaking massive personnel layoffs, had
seemed unaware over a number of years that a financial storm was gathering
momentum, despite flashing indicators - loose monetary policies and negative
real interest rates in reserve currency countries, asset and commodity bubbles,
exchange rate instability, unprecedented growth of credit and rapid
deterioration in credit quality, and over-leveraged commercial and investment
banks.
Although many governments have easy access to credit, the G-20 nonetheless
decided to boost the financial power of the IMF to over US$1 trillion and
abolish its conditionality (insistence that a country engage in policy reform
that comes as a part and parcel of IMF financing), transforming it into an
institution that gives loans irrespective of risk, the same as their bankrupt
banks have done to subprime borrowers to fuel the present crisis.
As in any banking crisis, it is very easy to push loans; borrowers will snap
them up, but the recovery of loans is highly unlikely. Even though the IMF
extends loans to governments, it is not unusual that governments default.
In addition to lending, the G-20 agreed to a new allocation of what is called
"special drawings rights" (SDRs) in an amount of US$250 billion. Every member
country has drawings rights in its reserve holdings at the IMF; the special
drawings rights are created by the IMF on its books with the stroke of the pen,
and distributed to member countries as "a reserve asset" largely in proportion
to their IMF quotas or ownership.
Deficit countries can use their SDR allocation to pay for imports or to settle
international obligations; however, any use of SDR is subject to interest
payments, with interest paid to holders who increase their SDR holdings above
their initial allocations. In the past, a number of countries that used their
SDR allocations fell into interest payments arrears to the IMF. While the SDR
interest rate is only 0.31% in August 2009, the rate could rise very quickly if
dollar, euro, yen or sterling (the four currencies that make up the SDR)
interest rates rise. In that event countries that use their SDR allocations
would face burdensome interest payments.
The SDR was created in 1969 following a decade-long debate that started in 1959
on the inherent instability of the gold exchange standard, rising US external
deficits, and rising pressure on US gold reserves. Under the gold-exchange
standard, the deficit of the reserve currency country (the US) kept widening
due to the absence of a market adjustment mechanism for its balance of payments
(that is devaluation of the dollar or revaluation of other currencies).
Moreover, the dollar balances of central banks were re-deposited in US banks
and served as a basis for new credit expansion and for augmenting US imports
and investment abroad, worsening the US external deficits.
Reform proposals for the international monetary system were controversial. One
reform school considered that rising US external deficits were alleviating the
worldwide liquidity shortage. Hence, the world economy faced a liquidity
shortage and reform should aim at creating a reserve asset that would
supplement the dollar in providing liquidity.
Another school considered the liquidity shortage to be fallacious in view of
rapidly rising world inflation. For this school, the gold-exchange standard
(gold and dollars as reserve assets) was characterized by high inflation and
speculation. Accordingly, there was a need to re-establish the gold standard as
the mechanism to prevent reserve currency countries from running deficits and
enjoying an increase in real wealth through printing paper currency.
The creation of the SDR was speeded up following the gold crisis in March 1968,
the termination of gold convertibility by European central banks and the
dismantling of the gold pool. The SDR was intended to prevent the rush toward
gold (from dollars) and was defined initially as paper gold (that is, with its
value defined in terms of gold), but it was not convertible into gold!
With the exit of the US from the Bretton Woods system (the US would no longer
honor its obligation to convert dollars into gold) in 1971, such definition of
SDR became meaningless. The SDR was redefined in terms of sixteen currencies,
then five and now four: the US dollar, the euro, the Japanese yen, and the
British pound.
The new allocation of SDRs can be seen as akin to a water authority developing
irrigation plans only during a catastrophic flood. First, the amount of SDRs to
be created is arbitrary. Since SDRs are created by the stroke of a pen on the
IMF books, the G-20 could have decided to create of $250 trillion instead of
$250 billion; the higher the amount, the greater purchasing power would be
conferred to member countries. This would provide many countries free
purchasing power and would powerfully expand world aggregate demand and
re-establish prosperity.
Second, an SDR allocation does not fill a liquidity shortage, since there is an
oversupply of US dollars as well as other reserve currencies. These reserve
currencies have been depreciating in terms of gold and other commodities.
Third, as in the past, an SDR allocation would placate growing uneasiness of
creditor countries about the depreciating value of the dollar. By offering an
alternative, a diversified asset of four currencies, creditors might accept
holding interest yielding SDRs instead of non-interest yielding gold. Far from
being fooled, creditors know that SDR is not gold, or any other commodity.
Fourth, being created from nothing and distributed as an unrequited purchasing
power to member countries, an SDR allocation of free reserves is a form of
debasing money, is distortive, and is by nature inflationary. It allows debtor
countries to import without offering in exchange a real transfer of resources.
The SDR reform was meant to bolster the Bretton Woods system and reduce
pressure on the dollar's convertibility into gold. However, the SDR failed its
objective when the Bretton Woods collapsed in August 1971. The current crisis
was facilitated by the ability of reserve countries to run deficits without
tears, that is, without loosing any real resources.
Dollars owned by creditors were re-invested in the US banks and fueled further
expansion of bank assets. As corporations have very limited borrowings needs,
essentially for working capital, banks turned to the subprime sectors, such as
developing countries in the 1970s, or consumers in the recent years, that have
no borrowing limit but have very limited debt-servicing capacity.
The outcome in the 1980s was the bankruptcy of developing countries; during the
current crisis, it is the general failure of the banking system, with extensive
real costs to the global economy.
The world remains in dire need for the reform of the international payments
system that would safeguard economic and financial stability: reducing the
impact of destabilizing economic shocks originating in other countries,
encouraging countries to adopt stabilizing policies, promoting exchange rate
stability, establishing symmetry (that is affording no currency a special
reserve position such as the dollar) and justice among countries, and
controlling inflation.
While non-reserve countries have to undertake a balance of payments adjustment,
reserve countries have enjoyed continuous and growing deficits without facing
the need (incentive) for any adjustment or loosing real resources. Such
asymmetry was providing reserve countries with indefinite transfer of real
resources from non-reserve countries.
Reserve currency countries would not willingly restrain their fiscal and
monetary policies in order to reduce their external deficits, since this means
risking a recession in their respective economies, and in turn turning their
electorates against reelection of the government. The alternative to tight
money policy would be administrative controls on imports and capital exports to
reduce external deficits. Again, this is not feasible in democratic states;
moreover, it would entail countervailing measures by rival countries, and would
impede world trade liberalization.
Money creation out of nothing by central banks and the IMF could intensify
inflationary pressure and accelerate the depreciation of reserve currencies. It
could later abort economic recovery. Inflationary episodes following rapid
money printing have been numerous, with startling experiences that included the
French assignats, the German hyperinflation, and the recent Zimbabwe inflation.
The US dollar has already depreciated at an annual rate of 10% relative to gold
since 1971.
As in many inflationary episodes of the past, non-reserve central banks would
have no choice except to hold gold as a safe asset against reserve currency
depreciation. A rush toward gold and other tangible assets could accelerate the
depreciation of reserve currencies, and impede world trade.
World monetary reform has been debated since the collapse of the gold standard
in 1914. The gold-exchange standard or a system of no standard as at present
exists have been conducive to instability as illustrated by the Great
Depression and by the present crisis. In 1943, John Maynard Keynes proposed the
creation of world currency. In 1961, Jacques Rueff proposed a return to gold
standard.
Before the impending collapse of the Bretton Woods system in 1971, others
proposed a system based on a reserve asset defined in terms of a basket of
traded commodities and with features to afford countries the incentive to adopt
policies that are stabilizing for themselves as well as for the rest of the
world. Instead the world limps along from crisis to crisis with no real system
and with no urgency to undertake real reform. Reform is needed now before we
are faced with another global crisis.
In the future, gold could easily become a de facto standard, depending on the
rate of depreciation of the US dollar. If the price of gold jumps beyond a
benchmark, then holding of gold would be the only choice remaining for central
banks. Many central banks have already begun to hold more gold, while European
central banks have opted to restrain their gold sales.
SDR could not be considered as an alternative to gold as it is a basket of
potentially over-inflated currencies, and therefore subject to the same rate of
depreciation.
There are at least two major defects of a system that is based on a on a
national reserve currency system. First, a reserve currency country will not
subordinate its domestic priorities to its role as a reserve currency. Second,
a reserve currency cannot be a paper that costs nothing to print or issue
electronically. But commodities, such as gold, require considerable real
resources in labor, machinery, and raw materials their production and
processing. Hence, when oil is exchanged for another commodity, there is an
exchange of a commodity for another commodity.
These two defects lead to the realization that (i) a reserve country central
bank cannot serve as a world central bank, since the former is always subject
to fiscal and political pressure; and (ii) a reserve currency cannot be
unrelated to gold, or preferably a more general commodity basket.
A reform plan of the world monetary system should aim at eliminating these
defects. Reform should also explore ways (through appropriate exchange rate
system) to maximize the benefits of capital flows - discouraging destabilizing
short-term capital flows and encouraging stabilizing long-term capital flows -
and afford countries the incentive to pursue policies that are stabilizing for
themselves and for the rest of the world, thus reducing the transmission of
destabilizing economic shocks from country to country.
Genuine international payments reform has been avoided in spite recurrent
financial crises, including the Great Depression; fake reforms such as SDR
allocations provide a temporary and dangerous patch. The SDR preserves the
privileges of countries serving as reserve currency centers, but it puts off
real reform and perpetuates instability, inequity, and inflationary taxation of
the world's poor.
Validating the monetary policies of reserve currency centers at the worldwide
level through IMF lending and new SDR allocations will fuel inflation, augment
financial chaos, and precipitate the default of fragile countries.
Hossein Askari is professor of international business and international
affairs at George Washington University.
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