The Quest for Optimal International Monetary System: Part 1- The Dollar Opprobrium
The U.S dollar is the epicenter of global financial shocks. At least such thinking seems to dictate the debates on both the inherent structure and existing imbalances of the international monetary system. Interestingly, this particularly divisive topic is resurrected consistently in the aftermath of every financial turmoil, such as the recent Great Recession. Although the recent dysfunctional politico-economic developments in the U.S certainly have dubious spillover effects in the interconnected global economic, the perverse doom and gloom calls to end the dollar’s “exorbitant privilege” are merely repetitions of futile politics. That is simply due to the fact that even when the existing dollar based monetary paradigm is more or less asymmetrical and unloved, the scale of potential rivals is discouraging to say the least.
According to the conventional macroeconomic principles, to facilitate international trade and finance, the global monetary system has to embrace an internationally accepted national currency (or currencies) to generate an effective platform for the purpose of conducting multilaterally integrated business transactions. These transactions in turn must be guided by a vehicle currency that fulfills three pivotal functions:
1) Store of value
2) Medium of exchange
3) Unit of account
Currently the international monetary system is by and large guided by the dollar, which has dictated the flow of international trade and finance, accounts for the majority of the global reserves and operates as the most prominent anchor currency for other economies. The economics of the dollar hegemony is based on the economies of scale. If the global monetary system was organized around 150 different currencies, such an arrangement would produce detrimental and overlapping complexities, which would not be only inefficient, but also costly. Robert Mundell’s theory of how governments are forced to choose the Nth currency as the central vehicle currency in order to minimize the quantity of foreign exchange markets argues that without the N-1 currency, the world would have 11,175 different foreign exchange markets. Therefore, trading all transactions against the N-1– in the absence of de facto Gold-Dollar standard — generates greater efficiency gains and minimizes the transaction costs (not withstanding Gresham’s Law).
Mundell’s Nth vehicle currency theory can be further clarified by looking at certain statistical parameters. First, 87% of foreign exchange transactions are denominated in dollars, which strengthens its utility function (network value). In many instances, the dollar is preferred in international trade transactions where the United States is neither the source or destination of the good/service that is traded. Furthermore, the IMF statistical database [COFER] estimates that 61% of the official foreign exchange reserves are held in dollars. In 2011 the Economist reported that 66 countries either pegged and managed their currencies/exchange rates to the dollar or adopted full dollarization. Additionally, the energy and commodity markets are dominated solely by the dollar even among nations, which have held their hostile views of the U.S.
But why is the dollar standard — despite of its ostensible dominance — considered an asymmetrical and unloved system? It is also crucial to ponder why are the other economies voluntarily conducting their macroeconomic policies and strategies under the dollar umbrella? After all, the U.S Treasury Department and Federal Reserve do not enforce the dollar standard upon anybody. Quite the contrary; other countries shadow the dollar by choice. A simplified explanation argues that the U.S does not have to worry about current account deficits and can therefore overspend, thus accumulate excessive debts with the inflowing capital from the rest of the world. As the world economic activities are orchestrated mainly with the dollar, the U.S must by design provide consistently reliable liquidity to lubricate global trade and investment. In other words, the Federal Reserve has to expand the money supply to feed the global demand for a currency that fulfills the previously mentioned three principles (store of value, medium of exchange and unit of account). If the Federal Reserve decided to scale down the printing machine and thus limit the quantity of global liquidity for the purpose of addressing its current-account deficits, global financial and economic activities would suffer from a solemn dollar shortage. Because the global balance of payments in theory must equal to zero, the U.S must run current account deficits and provide dollars to the world if other countries wish to run surpluses. However, relying on one national currency to provide global liquidity has a strong tendency to increase the indebtedness of the reserve issuing economy.
The Great Recession revealed the inherent anomalies of the international monetary system under the dollar paradigm. Even though the international monetary system is considered a global public good, the dollar-standard frequently collides the American domestic economic interests with those of the rest of the world. In specific, the Federal Reserve’s unconventional monetary policies (UMP) — directed at boosting domestic economic performance through the monthly purchasing of long-term assets — have spillover effects in the interconnected global financial system. Printing dollars in Washington D.C for the sake of enhancing the fragile post-crisis U.S economy has produced detrimental counter-reactions around the world. Whether it has been higher food prices in Egypt, exacerbated asset bubbles in Brazil or detrimental central bank sterilization in China, such credit based expansionary economic models weaken the prospects of a stable international monetary system. And herein lies the “exorbitant privilege” of the dollar. As the Federal Reserve simultaneously expands the money supply to provide liquidity to the world and stimulates domestic demand through excessive credit, the rest of the world shadowing the dollar’s performance is forced to obtain self-insurance against the financial volatilities, which are transmitted to their economics through liberalized capital flows.
Especially the emerging economies (EME), who rely on the export led model of growth, need to accumulate dollar denominated reserves to intervene in the foreign exchange markets to prevent their currencies from appreciating. Furthermore, near zero interest rates in the advanced economies (AE) push capital to emerging economies in search for higher yields. However, the emerging economies are purchasing virtually risk-free U.S government treasury bills and sending dollars back to the United States to feed high consumption and low savings rates. Eswar Prasad argued that the dollar tsunami (QE), which washed across the world in the aftermath of the global financial crisis, ended up in the shores of private investors, who claimed over 60% of the newly created liquidity. Interestingly, the recipient economies of large capital flows will have a reverse problem to consider. When the Federal Reserve begins its “tapering” of QE, detrimental capital flight out of the EMEs is going impede still on-going global economic recovery. When the interest rates in the advanced economies return to normalcy, the former curse of excessive dollar inflows is going to transform in to a pernicious capital flight of dollars leaving certain economies’ balance sheets in vulnerable positions.
If the U.S lives beyond its means and accumulates draconian debts, why does the world have such a high demand for the currency of such a dysfunctional state with unsustainable spending patterns? Frequent fiscal cliff kerfuffles at the Capitol Hill surely cast doubts over the dollar’s ability to guide the world economy. As peculiar as it might appear, international investors’ faith in the U.S federal governments strengthens mainly because investors know that the institutional structure of the U.S treats investors fairly and indiscriminately. No other politico-economics symbiosis in the global monetary system has a tendency to become more reliable and trusted even if the fundamental imperfections emancipate from the same source. Therefore, international investors are looking for the safest place to park their assets and the destination is more than often U.S Treasury bills. In times of financial distress, investors can go as far as paying the U.S to hold their capital even though according to conventional economic theory, financial capital should leave the crisis country. However, in the case of the dollar the trend is bizarrely reverse. Investors have become to accept that the only viable lender of last resort is not the IMF, World Bank or the new BRICS coalition, but the Federal Reserve. Consequently even if the U.S is largely relying on the generosity of foreign investors to finance domestic consumption, the investors agree to do so because of America’s institutional framework.
Since the dawn of the American global hegemony, many societies and countries have developed a rather two-folded attitude towards the economic, political and cultural exports that filter from the United States to the rest of the world. Other economies tend to blame foreign authorities and entities, such as the Federal Reserve or the dollar, for the problems that they themselves have created through poor policies. Consequently and for now the dollar can be considered as the glue that holds the global monetary system together. Furthermore, the contest for international reserve currency dominance is not filled with potential contenders that could challenge the dollar hegemony. The dollar does not need to trouble itself about other contenders.
There simply are none.