November 16, 2011

Money in a mess

Author: Robert Pringle
Source: Central Banking Journal | 11 Nov 2011
Categories: Financial Stability

In the space of only a few months both major reserve currencies have experienced traumatic crises. The US’s flirtation with default last July may look, in retrospect, like a storm in a teacup, but it unnerved official holders of dollars around the world. Then came the dramatic deterioration of the long-running euro area sovereign debt crisis, with panic over Greece. If this climacteric of the reserve currency system at the heart of the world economy does not spur serious reform, what will? And what lessons will China and other creditor countries take away from Cannes? Those were the longer-term questions arising from the chaotic G-20 summit and the spanner thrown into the works by Greece.

The G-20 has pushed the Financial Stability Board (FSB) into action on bank reform – the policy paper from the FSB on global systemically important institutions (G-sifis) had a list of 29 G-sifis that will now spend much energy trying to bend the Basel rules as they apply to each of them. Then there’s Basel III, for what it’s worth. But it hasn’t made much progress on other items on its agenda, such as the so-called ‘framework for growth’ and global imbalances. As the leading international forum, the G-20 should be the body that looks at issues such as the eurozone crisis, though the euro area governments showed an absurd reluctance to allow eurozone issues to be discussed. It was not until Tim Geithner, the US Treasury Secretary, and George Osborne, the UK chancellor of the exchequer, made it clear such a dog-in-the-manger stance was unacceptable, that euro area governments accepted that the rest of the G-20 had to play its part in their dealings with the eurozone crisis, and that open discussion was vital for this.

At Cannes there was some progress on peripheral issues. However, from the perspective of emerging markets, the big picture was of little readiness to change. The international monetary system and its governing bodies were dominated by reserve centres – the US, euro area, UK and Japan – which had highly indebted, highly leveraged, dysfunctional and downright dangerous banking and financial systems. Why weren’t the dangers posed to the world from these faults discussed?

But the talks on a wider reform of the system have got nowhere. At the early meetings of the G-20, emerging-market countries wanted to discuss ways to protect themselves from the effects of the inflows of ‘hot money’ they were experiencing for most of 2010–11 as a result of ultra-low interest rates and the permissive monetary policies followed by the Federal Reserve. Although these have been partially reversed during 2011, the emerging markets remained highly critical of the policies of credit and quantitative easing, seeing it as little more than a means of depreciating the dollar. Reserve managers in emerging markets worried that this US policy would destabilise the dollar-denominated assets that formed the base of the pyramid of reserve assets. The US administration said that discussion of US monetary policy was out of order; its political interest was in piling up pressure on China and other emerging markets to cut their current account surpluses, which the US saw as a function of undervalued exchange rates. But China was willing to share control over its exchange rate policy only on condition that the US was willing, in effect, to share control of its monetary policy: neither condition was acceptable to the other.
These divisions also reflected the absence of a broadly accepted analysis linking faults in the working of the international monetary system with the financial crisis. The official view of most developed countries was indeed that the system had responded well to a crisis caused – on this view – mainly by faults in financial regulation and China’s currency policy, and that it was to these areas that attention should be directed in the effort to prevent a return of the crisis – hence the emphasis on Basel III and China bashing.

Thus officials of developed countries pointed to progress made in strengthening bank capital and liquidity buffers, financial reform legislation in the US and UK, and the new macroprudential toolkit being bolted onto the existing responsibilities of central banks and other agencies. Central bankers had always essentially blamed financial regulators and lax bank management for the crisis. Their own monetary policy frameworks – versions of explicit or implicit inflation targeting with flexible exchange rates – had, they felt, performed well. On this reading, governments were justified in limiting G-20 discussions of the international monetary system itself to a number of specific issues that needed attention.

Yet the failure to reach agreement even on limited and specific issues did nothing to strengthen confidence that in the next crisis – which could be just around the corner – governments would be able to agree on a united response. Given public displays of disunity, and with a protectionist mood rising in the US, confidence in the capacity of governments to effectively address a renewed crisis was low. Yet, at the same time, it seemed likely that talks on a radical reshaping of the system would only get going in earnest if the global economic outlook darkened further. The global economy has obliged by turning sharply downwards.

Will this and little Greece concentrate minds? There were some hopeful signs. Leaders of emerging markets were well aware that they could not retreat to former policy models of state planning and controls. From Moscow to Brasilia, all remained aware of the need to avoid a relapse into protectionism that had accompanied the currency and diplomatic conflicts of the 1930s with such far-reaching and tragic geo-political consequences. Talk of ‘currency wars’ was seen as the most prominent expression of the threat of protectionism. They also knew they had great difficulties in coordinating policy views among themselves. The way in which the International Monetary Fund’s (IMF) managing director, Christine Lagarde, was selected highlighted their weakness in finding common ground.

What was needed was for the big three – US, euro area (France and Germany) and China to forge a united front on the need for a longer-term reform of the system. They should show the statesmanship, leadership and vision to fend off short-term domestic political pressures and strive to form a joint view about systemic reform – and order officials and the IMF to get on with drawing up a strategy. A coherent view of where the international system as a whole should be heading in the long term would serve to put the internal problems of each centre and currency area into a broader collaborative context.

In this issue, Central Banking makes a further contribution to this debate, with articles by Warren Coats on the case for a ‘real SDR’, Kevin Dowd on the case for a ‘new’ gold standard, and Ousmène Mandeng on the need to integrate the currencies of emerging markets into the international monetary system.
Robert Pringle

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