Governing the Currency: A Political Choice (May 2011)

Rethinking Bretton Woods | Sun, May 1, 2011

By Aldo Caliari

In this article, which appeared in French in No. 320 of Projet, a bimonthly magazine published by Centre de Recherche et d’Action Sociales, Aldo Caliari argues that the international monetary system is a political construct. As such, it is a matter of political choice for the countries giving shape to it to come up with solutions that address its shortcomings.

(Original version of this article appeared in French in No. 320 of Projet, a bimonthly magazine published by Centre de Recherche et d’Action Sociales (CERAS), Paris, February-March 2011 and is available at The English translation of this article is being reproduced here with permission of Projet) 

In 2008-09, the world economy experienced what has been characterized as the worst financial crisis since the Great Depression in the 1930s. This crisis triggered the most intense debate about the international monetary system that the world has seen in the last four decades. Evidence of this is the attention being given to this subject in different international forums, starting with the United Nations[i] and the International Monetary Fund.[ii]The crisis has strengthened a sense of urgency among policy-makers about the need to address shortfalls in the international monetary system. The Government of France has expressed its intention of making a priority within the Group of 20, whose presidency it has in 2011, to establish a “new Bretton Woods.”[iii] 

In a recent speech, French Minister of Finance, Ms. Christine Lagarde set as objectives of such reform to ”protect particularly those least developed countries, and sometimes emerging countries [against the] currency variations”, “diversify, because [the] lack of diversification, [induces]  a level of risk that is associated with the currency variation,” and promote ”a real and better coordination,  because decisions that are made unilaterally are not going to be efficient.”[iv] Here we will review the main issues in a reform of the international monetary system before sketching some alternatives. 

A system inherently imbalanced 

The main concern raised by the crisis has been the impact of large imbalances between countries with trade surpluses and those with trade deficits. In the years leading up to the crisis, the US had a growing trade deficit that was mirrored by trade surpluses and the accumulation of assets denominated in US dollars in several emerging countries, particularly, but not only, China. The reverse of the trade deficit in the US was the need to increase borrowing in order to pay for the excess imports. The reverse of the trade surplus in other countries – such as China—was the increasing need to lend ….to the US, via purchasing the dollar denominated assets and storing them as reserves.    

These growing imbalances played an important role in the crisis. This much is clear: without the excess savings that trade surplus countries needed to maintain—the excess capital that fed the boom and the relaxing of lending conditions and the increased leverage in the system in advanced financial markets would not have been possible.  

So the key aspect from the international monetary system that is perceived as in need of fixing is the tendency of a system where the US dollar is the dominant reserve and trading currency to generate ever-growing imbalances between countries with trade surpluses and those with trade deficits. This gives rise to a problem called the “Triffin dilemma.” Robert Triffin, a Belgium economist, argued that when the domestic currency of one country becomes the international means of payment and reserve, there will be a tendency in the system towards excessive demand for that currency—in this case, the US dollar. In turn, this means that the country that issues that currency is pressed to issue more of it. Because it tends to have an overvalued currency its exports will tend to fall, and because it can actually borrow in easier terms than other countries, its borrowings will tend to increase. Rather than tending to an adjustment the tendency in a system with these characteristics is the opposite. Over time, more countries accumulate reserves in the main reserve currency, and the issuing country has to run ever larger deficits to generate the currency demanded abroad and ever larger financial surpluses as it attracts capital from trade surplus countries. As the issuing country generates more debt, doubts would grow about the sustainability of the debt and the value of the currency. But were countries with large reserves in that currency attempt to diversify into other assets, they risk triggering a collapse in the value of the reserve currency that will hurt the value of their own reserves. They have, therefore, a stake in fueling demand for the currency. 

Recurring instability 

One of these issues that deserves reflection is the inability of the system to generate certain stability among currencies, as seen in the extreme swings in value of the major currencies. Facilitating “the expansion and balanced growth of international trade” was chief among the purposes of agreement reached in Bretton Woods and establishing the International Monetary Fund. The positive influence of a stable monetary system on the evolution of world trade was clear in writings by the intellectual authors of the system. John Maynard Keynes has been famously quoted saying “It is extraordinarily difficult to frame any proposals about tariffs if countries are free to alter the value of their currencies without agreement at short notice. Tariffs and currency depreciations are in many cases alternatives. Without currency agreements you have no firm ground on which to discuss tariffs.”[v] Recently asked whether a stable exchange rate is more favorable to trade, Nobel Prize-winner economist Robert Mundell replied "The whole idea of having a free trade area when you have gyrating exchange rates doesn't make sense at all. It just spoils the effect of any kind of free trade agreement."[vi] 

The increased volatility of exchange rates among the currencies in which most trade is conducted worldwide have a strong impact on trade performance through channels such as the levels of domestic investment, the variations of relative prices of export products (which, in turn, affect competitiveness of the economies), and the price of access to finance for production. For instance, the capacity of local farmers to compete with foreign-owned farms may come to depend, oftentimes, on whether they can match the capacity of foreign-owned farms to hedge the risks of fluctuations in foreign currency risks. This is particularly problematic for developing countries. In the period 1995-2007 their reliance on trade, measured as a proportion of GDP, has more than doubled.[vii] With the rise of the global production chains, many developing countries depend on being able to cut their cost of production as a key factor to attract foreign investment. The small margins –which may depend on a reduction in salaries of local workers—may be quickly erased by swings in exchange rates.  

The movements among major currencies may significantly affect the relative exchange rates in regional trade. This is why the  last few years have seen a revival of interest among developing countries on alternative cooperation mechanisms at the regional level to bypass the volatility generated by the trade in US dollars (see article by Oscar Ugarteche, pp. 31-37). The establishment of clearing unions allows countries in a region to settle trade among themselves in their respective local currencies, having transactions cleared by a central clearing mechanism. In other cases, countries like China are supporting mechanisms for the settlement of trade in its own domestic currency. 

Recessionary tendency 

Second, the current monetary system has a recessionary bias. Trade surplus nations can go on accumulating dollar-based reserves without the threat of adjustment. But the opposite is not true. Trade deficit nations cannot continuously run ever-growing deficits financed by foreign capital. In this case, the increased debt eventually is appreciated by the lenders as a growing risk that should mean rising interest charges. Sooner or later, the borrowing country is facing such high costs to refinance foreign debt that it has to adjust, a situation that squarely reflects the recent reality of several countries in the European Union. The adjustment usually takes the form of “austerity” programs to cut public expenses, services and wages which, in turn, translate into cutting jobs, investment and consumption (including imports). In such a system, the level of aggregate demand is doomed to be systematically below that required for aggregate full employment. 

A means for financing development 

A last issue of concern is the limitation of the main reserve asset to provide fair returns to developing countries on their savings. Developing countries borrowing in international markets typically have to pay interest rates that are higher than the returns that they receive on their assets denominated in US dollars. This translates in a constant transfer of wealth from developing countries to the issuers of main currencies, mostly the US.  

Thus, the international monetary system and the modalities of financing for development are not separate questions.  The generation of alternative reserve or trading assets opens the chance for designing criteria for their allocation that are agreed through a political consensus, and which could include development finance needs. 

Estimates in the lead up to the recent Millennium Summit put the need of resources to fulfill the international development goals and climate change in the range of USD 324-336 billion per year between 2012 and 2017.[viii] The scope of financing needs is put in stark terms by the additional estimates of financing that will be necessary to avoid climate change causing irreparable damage. The 2009 Copenhagen Accord pledged USD 30 billion a year of additional financing in the period 2010-2012 for adaptation and mitigation, and to reach the figure of USD 100 billion a year by 2020. In a time where donors are struggling to, in some cases, merely maintain aid levels either in absolute terms or as a share of GDP, because of budget gaps generated by the crisis, it is unclear where the financing to meet these commitments will come from.  

In that scenario, the fact that a solution –even if perhaps only partial-- would be at hand in the form of a different deal for the international monetary system makes it less morally acceptable to keep the issues of development finance and the shape of the monetary system as separate matters. 

The fruit of a political act 

It follows that to examine the debate on the monetary system as a mere expression of concerns about global imbalances would be taking quite a reductive perspective. Doing so risks missing the political dimensions that, undoubtedly, lie behind it and frame the chances for success of any reforms that are adopted. 

More than a common denominator to facilitate exchanges, money is essentially the fruit of a political act, with underpinnings that are profoundly political, too. If money is accepted as such in a social group it is because a political authority has said it is what it will accept it as the currency of payment of the due of each individual to the community --  taxes. It is also a political authority who orders that it be compulsorily accepted by the victim in reparation for a criminal or civil offense. And so on and so forth. Therefore, money is an essential element of society. As such, the notion of money and of a public sector cannot be dissociated.  

Notwithstanding the proclamations of central bank independence, the frameworks for the operation of Central Banks, all over the world, are also political constructions. This is true even in many countries where a choice has been made to restrain Central Banks’ authority along specific guidelines that the fading political configurations that come to exercise political power are not supposed to disturb. This does not change the political nature of that choice, or of the guidelines in question, for that matter. For instance, the Central Bank in the US (the Fed) has been given its authority by an Act of Congress, which has the power to alter it. The Central Bank is supposed to pursue the promotion of price stability and growth. This is not very different from the guideline of price stability that the European Central Bank (ECB) has been mandated to pursue by the Lisbon Treaty of 2008 – whose legal foundations are, again, to be found in the political will of member countries ratified through the respective Parliaments. While the generalized understanding is that the ECB is supposed to pursue “price stability,” the actual language states that “Without prejudice to the objective of price stability, it shall support the general economic policies in the Union with a view to contributing to the achievement of the objectives of the Union.” Among these objectives, listed in Art. 3 of the Lisbon Treaty, one finds “balanced economic growth and price stability,” “a highly competitive social market economy, aiming at full employment and social progress,”, “a high level of protection and improvement of the quality of the environment,” the combat of ”social exclusion and discrimination,” the promotion of “social justice and protection,” etc. 

If money has such a strong political component, with even greater confidence one can predicate the same of the international monetary system. Because, even in the absence of an equivalent global central authority, it is clearer that such a system is a construction of the will of the public sectors of countries that signed treaties and other instruments to that effect. So, the international monetary system is underpinned by political dimensions that have to do with the power balance in the community of nations and embodies a “global social contract” accepted by Nation-states.

Fostering an orderly exit from the global imbalances is, perhaps, just one of several issues in that “global social contract.” But the current monetary system, centered de facto around the US dollar, provides rather unsatisfactory answers. 

Alternative scenarios 

The debate on what should replace our current international monetary system –if anything-- is quite open-ended at this point. The most promising scenario for facing the shortcomings we have mentioned would be a system based on a revamped version of the Special Drawing Rights (SDRs) or a new supranational currency. The latter hypothesis seems far-fetched , at least in the near term.  

But the possibility of reforms of the Special Drawing Rights (SDRs) is, on the contrary, very doable. Special Drawing Rights are reserve assets that already exist, even if in limited quantities and if with their current characteristics they could not be equated to a currency. The adoption of a supranational reserve asset would not suppress the need for strong mechanisms for coordination among trade surplus and trade deficit countries. But the incentives for such coordination to happen could be a feature of the asset, as opposed to leaving coordination only dependent on the goodwill of the actors involved.  Only in that framework the challenges of ensuring that the system tends to reduce global imbalances and do it in a way that supports full employment, could be satisfactorily met. The challenges of volatility could be addressed by revising the basket of currencies the SDR or the new supranational reserve currency are composed of.  The revision of the basket could also turn the asset into one that better balances the returns that can be obtained –as long as the asset is safe enough that holders will actually want to build their reserves in it. Finally, the overhaul of the SDRs could offer the opportunity to review the role they might play as a development or climate finance source.  

A second scenario could be a multi-polar system, where not one currency, but several – including possibly the US dollar and/ or a current or reformed version of the Special Drawing Rights—co-exist as main reserve and trading assets. Unless accompanied by a very strong coordination among central banks – certainly something beyond any coordination we have seen so far-- would tend to increase volatility as countries switch from one asset to another. It is unlikely that such system could exist for long without one or another of the competing currencies becoming the preferred one. In fact, the current system is, arguably, a multi-currency one, but in practice countries have, de facto, tended to use the US dollar as the preferred reserve and trading asset. 

Towards a provisional “statu quo”?  

The most likely scenario is a continuation of the status quo US dollar-based system. This will mean the persistence of the pressures that the Triffin dilemma predicted. Unfortunately, one cannot rule out the prospect that the response to that, in the future, may no longer be a stimulus accommodated by a US relaxed fiscal and monetary position, in which case the consequences would be recessionary worldwide. Even if the debate yields as a result a decision to continue the status quo, it is hard to see such result as a closure to it. In fact, it might rather be interpreted as the initial salvo in a series of growing debates towards alternatives that will eventually lead to greater change. Rather than asking whether a new monetary system will emerge, the question is whether the transition to it will be a smooth or a bumpy one, a rapid or a protracted and conflicted one. The monetary system that emerges will have to be the result of a new “global social contract”: it will be the result of how much and how fast a new “global social contract” can be shaped to capture the real political dimensions.  

Within those real political dimensions lies the promise that the emerging system might be fairer, more equitable and more pro-development than the current one. Indeed, as long as the monetary system is a political construct, there is room for faith that it is the vision of governments, actively interested in seeking a global common good, what will guide the real political dimensions that inspire that new global social contract.

[i] See Outcome Document of the World Conference on the Economic and Financial Crisis and Its Impacts on Development, para. 36,  and the report issued by a Commission of Experts on Reforms of the International Monetary and Financial System, appointed in late 2008 by the the-President of the UN General Assembly and chaired by Nobel Prize-winner economist Joseph Stiglitz, published in September 2009.
[ii] See International Monetary and Financial Committee 2009, para. 7. (“…the crisis has shown that a further reassessment of the Fund’s mandate is in order. We call on the Fund to review its mandate to cover the full range of macroeconomic and financial sector policies that bear on global stability, and to report back to the Committee by the time of the next Annual Meetings.”).
[iii] Interview with President Sarkozy 2010 (stating ““I have three major objectives: first, a new international monetary order. Bretton Woods is 65 years old. There was only a single currency, the dollar. We cannot continue with the monetary disorders we face now.”). See also Tett 2010 (quoting Sarkozy’s statement “"The prosperity of the postwar era owned much to Bretton Woods . . . We need a new Bretton Woods,").
[iv] Lagarde, Christine 2010.
[v] Quoted in UNCTAD 2004. Communication to the WTO Working Group on Debt, Trade and Finance,” November 24, 2004.
[vi] Judy Shelton, “The Weekend Interview: Currency Chaos: Where do we go from here?”, The Wall Street Journal, October 16, 2010.
[vii] UNCTAD 2009. Global Economic Crisis: Implications for Trade and Development. Trade and Development Board. TD/B/C.I/CRP.1. May 7 2009.
[viii] Report of theCommittee of Experts to the Task Force on International Financial Transactions and Development 2010, 2.