The so-called international monetary non-system has four serious weaknesses. They are as follows: first, the absence of incentives to governments to correct global payments imbalances; secondly, the system’s dependence on one national currency, the US dollar, to serve as the major international reserve currency; thirdly, a dysfunctional financial sector and, fourthly, the systemic liability to destabilising cross-border capital flows.
These four weaknesses may play a positive role in helping to bring existing arrangements – the non-system – into disrepute, and thus hastening its demise. However, it is also true that they present challenges to any new system. Any new monetary order would need to find a credible way of dealing with them. The next four chapters of “The Money Trap” examine each of these issues in turn.
8. Those Global Imbalances: At the time I wrote the book, it was already clear that with growth in import demand held down by austerity policies, and the sovereign debt crisis in the eurozone, protectionist pressures in trade in goods and international services were likely to increase. With no agreed adjustment process or rules to spread the burden of adjustment in an equitable manner, the open multilateral trading system would remain vulnerable.
2013 Update: Although a complete breakdown has been avoided, trade protectionism has continued to increase across the world. Prospects for the Doha round appear bleak, to say the least (hence its nickname, the Do-ha-ha Round).
9. The Reserve Currency Overhang: the central weakness here is the reliance on a national currency, the dollar, to serve as the world’s principal reserve currency. This role can be regarded either as an ‘exorbitant privilege’ for the US, enabling it to finance deficits without tears, or as a service to the world – with the US acting as a ‘bank’ providing convenient (and until recently ‘safe’) liquid assets for the convenience of official and private holders globally. Clearly, accumulation of dollar balances in the reserves of countries around the world removes the discipline on the reserve centre country to adjust its external deficit. This permits the adoption of highly expansionary policies by the US at times of crisis. This leads to further growth of indebtedness while facilitating the persistence of global imbalances.
2013 Update: The political impasse about measures to curb the US deficit and debt in October 2013 reinforced fears by central banks and other investors about the future of the US currency. It was widely expected to lead major surplus countries such as China to search for an alternative to the dollar-based system.
10. Unsafe banks: the GFC is linked in deep-seated ways to the absence of a real international monetary order. Governments succumb to the temptation offered by the apparent freedom from external constraints to follow ultra-loose monetary policies in a vain attempt to boost domestic demand, creating serial asset bubbles and undermining their long-term fiscal solvency. Unsustainable booms are followed by sudden stops. Banks and other financial intermediaries exploit the predictable cycle to take easy pickings – central banks always leave money ‘on the table’. Meanwhile, banks enjoy cheap funding thanks to the government fear they will go bust – which means they have access to the fiscal backstop and state guarantees. The result are chaotic banking systems that are unable to perform their proper economic functions in a satisfactory way. As Alan Greenspan says in his new book, banks have ended up by being folded into the central bank, so that bank employees have become highly-paid civil servants.
2013 Update: as after previous financial crashes over the past 40 years, governments have again responded in the usual way – loose money, further regulation, financial repression (requiring financial institutions to hold more government paper). This time these have been supported by new “macro-prudential tools”, which are thinly disguised ways of returning to physical controls over financial flows. These are already been touted as ways to avoid or postpone any tightening of monetary policies – thus allowing the next boom to go on even longer and have even worse eventual results.
11. Markets, States and Bubbles: Like typhoons, repeated cross-border credit and asset price booms and busts have repeatedly wreaked havoc to individual countries caught up in them – notably emerging markets – and in the world economy. Exchange rates and currencies are treated as asset classes by investors, leading to self-fulfilling appreciations and depreciations in accord with investor risk appetite, fuelled by low-interest rate financing courtesy of central banks. All the major banking crises of the past 50 years – since the LDC debt boom and bust of the late 1970s and early 1980s – have been characterised by such cross-border speculative flows. Again, this has led many to advocate capital controls and other forms of financial suppression.
2013 Update: the debate about whether asset prices in this or that centre are already “in bubble territory” is reminiscent of the very similar debate in 2003-04. As that time, governments and central banks have continued to keep their feet firmly on the gas pedal. It is also seen as the only way to keep the inert banking sector from collapsing yet again. Policies in the two years since the book was written have not passed the one test that really matters: they have not restored market confidence in the broad direction of official policy.
A strong international monetary system is the indispensable condition required for these challenges to be solved or managed. Prospects are discussed in the following two posts.