Benn Steil, Special to the Financial Post Published: Thursday, November 08, 2007
Capital flows have become globalization’s Achilles heel. Over the past 25 years, devastating currency crises have hit countries across Latin America and Asia, as well as countries just beyond the borders of Western Europe — most notably Russia and Turkey. The economics profession has failed to offer anything resembling a coherent and compelling response to currency crises.
International Monetary Fund (IMF) analysts have, over the past two decades, endorsed a wide variety of national exchange-rate and monetary-policy regimes that have subsequently collapsed in failure. They have fingered numerous culprits, from loose fiscal policy and poor bank regulation to bad industrial policy and official corruption. The financial-crisis literature has yielded policy recommendations so exquisitely hedged and widely contradicted as to be practically useless. Anti-globalization economists have turned the problem on its head by absolving governments (except the one in Washington) and instead blaming crises on markets and their institutional supporters, such as the IMF — “dictatorships of international finance,” in the words of the Nobel laureate Joseph Stiglitz.
Is this right? Are markets failing, and will restoring lost sovereignty to governments put an end to financial instability? This is a dangerous misdiagnosis. In fact, capital flows became destabilizing only after countries began asserting “sovereignty” over money — detaching it from gold or anything else considered real wealth. Moreover, even if the march of globalization is not inevitable, the world economy and the international financial system have evolved in such a way that there is no longer a viable model for economic development outside of them.
The right course is not to return to a mythical past of monetary sovereignty, with governments controlling local interest and exchange rates in blissful ignorance of the rest of the world. Governments must let go of the fatal notion that nationhood requires them to make and control the money used in their territory. National currencies and global markets simply do not mix; together they make a deadly brew of currency crises and geopolitical tension, and create ready pretexts for damaging protectionism. In order to globalize safely, countries should abandon monetary nationalism and abolish unwanted currencies, the source of much of today’s instability.
The political mythology associating the creation and control of money with national sovereignty finds its economic counterpart in the metamorphosis of the famous theory of “optimum currency areas” (OCA). Fathered in 1961 by Robert Mundell, a Nobel Prize-winning economist who has long been a prolific advocate of shrinking the number of national currencies, it became over the subsequent decades a quasi-scientific foundation for monetary nationalism. Dr. Mundell, like most macroeconomists of the early 1960s, had a now largely discredited postwar Keynesian mindset that put great faith in the ability of policymakers to fine-tune national demand in the face of what economists call “shocks” to supply and demand. His seminal article, A Theory of Optimum Currency Areas, asks the question, “What is the appropriate domain of the currency area?” Dr. Mundell goes on to argue for flexible exchange rates between regions of the world, each with its own multinational currency, rather than between nations.
The economics profession, however, latched on to Dr. Mundell’s analysis of the merits of flexible exchange rates in dealing with economic shocks affecting different “regions or countries” differently; they saw it as a rationale for treating existing nations as natural currency areas. Monetary nationalism thereby acquired a rational scientific mooring. And from then on, much of the mainstream economics profession came to see deviations from “one nation, one currency” as misguided, at least in the absence of prior political integration.
Why has the problem of serial currency crises become so severe in recent decades? It is only since 1971, when U.S. president Richard Nixon formally untethered the U.S. dollar from gold, that monies flowing around the globe have ceased to be claims on anything real. All the world’s currencies are now pure manifestations of sovereignty conjured by governments. And the vast majority of such monies are unwanted: People are unwilling to hold them as wealth, something that will buy in the future at least what it did in the past. Governments can force their citizens to hold national money by requiring its use in transactions with the state, but foreigners, who are not thus compelled, will choose not to do so. And in a world in which people will only willingly hold U.S. dollars (and a handful of other currencies) in lieu of gold money, the mythology tying money to sovereignty is a costly and sometimes dangerous one. Monetary nationalism is simply incompatible with globalization.
For a large, diversified economy like that of the United States, fluctuating exchange rates are the economic equivalent of a minor toothache. They require fillings from time to time — in the form of corporate financial hedging and active global supply management — but never any major surgery. There are two reasons for this. First, much of what Americans buy from abroad can, when import prices rise, quickly and cheaply be replaced by domestic production, and much of what they sell abroad can, when export prices fall, be diverted to the domestic market. Second, foreigners are happy to hold U.S. dollars as wealth.
But the U.S. dollar’s privileged status as today’s global money is not heaven-bestowed. The dollar is ultimately just another money supported only by faith that others will willingly accept it in the future in return for the same sort of valuable things it bought in the past. This puts a great burden on the institutions of the U.S. government to validate that faith. And those institutions, unfortunately, are failing to shoulder that burden. Reckless U.S. fiscal policy is undermining the dollar’s position, even as the currency’s role as a global money is expanding.
The U.S. current account deficit is running at an enormous 6.6% of GDP — about US$2-billion a day must be imported to sustain it. The current account deficit is partially fuelled by the budget deficit, which will soar in the next decade in the absence of reforms to curtail federal “entitlement” spending on medical care and retirement benefits for a longer-living population. In the absence of long-term fiscal prudence, the United States risks undermining the faith foreigners have placed in its management of the dollar — that is, their belief that the U.S. government can continue to sustain low inflation without having to resort to growth-crushing interest-rate hikes as a means of ensuring continued high capital inflows.
It is widely assumed that the natural alternative to the dollar as a global currency is the euro. Faith in the euro’s endurance, however, is still fragile— undermined by the same fiscal concerns that afflict the dollar, but with the added angst stemming from concerns about the temptations faced by Italy and others to return to monetary nationalism. But there is another alternative, the world’s most enduring form of money: gold.
It must be stressed that a well-managed fiat money system has considerable advantages over a commodity-based one, not least of which that it does not waste valuable resources. There is little to commend in digging up gold in South Africa just to bury it again in Fort Knox. The question is how long such a well-managed fiat system can endure in the United States. The historical record of national monies, going back over 2,500 years, is by and large awful.
At the turn of the 20th century — the height of the gold standard — German philosopher Georg Simmel commented: “Although money with no intrinsic value would be the best means of exchange in an ideal social order, until that point is reached the most satisfactory form of money may be that which is bound to a material substance.” Today, with money no longer bound to any material substance, it is worth asking whether the world even approximates the “ideal social order” that could sustain a fiat dollar as the foundation of the global financial system. There is no way effectively to insure against the unwinding of global imbalances should China, with more than a trillion dollars of reserves, and other countries with dollar-rich central banks come to fear the unbearable lightness of their holdings.
So what about gold? A revived gold standard is out of the question. In the 19th century, governments spent less than 10% of national income in a given year. Today, they routinely spend half or more, and so they would never subordinate spending to the stringent requirements of sustaining a commodity-based monetary system. But private gold banks already exist, allowing account holders to make international payments in the form of shares in actual gold bars. Although clearly a niche business at present, gold banking has grown dramatically in recent years, in tandem with the U.S. dollar’s decline. A new gold-based international monetary system surely sounds far-fetched. But so, in 1900, did a monetary system without gold. Modern technology makes a revival of gold money, through private gold banks, possible even without government support.
Virtually every major argument recently levelled against globalization has been levelled against markets generally (and, in turn, debunked) for hundreds of years. But the argument against capital flows in a world with 150 fluctuating national fiat monies is fundamentally different. It is highly compelling — so much so that even globalization’s staunchest supporters treat capital flows as an exception, a matter to be intellectually quarantined until effective crisis inoculations can be developed. But the notion that capital flows are inherently destabilizing is logically and historically false. The lessons of gold-based globalization in the 19th century simply must be relearned. Just as the prodigious daily capital flows between New York and California, two of the world’s 12 largest economies, are so uneventful that no one even notices them, capital flows between countries sharing a single currency, such as the dollar or the euro, attract not the slightest attention from even the most passionate anti-globalization activists.
The world can do better. Since economic development outside the process of globalization is no longer possible, countries should abandon monetary nationalism. Governments should replace national currencies with the dollar or the euro or, in the case of Asia, collaborate to produce a new multinational currency over a comparably large and economically diversified area.
Europeans used to say that being a country required having a national airline, a stock exchange and a currency. Today, no European country is any worse off without them. A future pan-Asian currency, managed according to the same principle of targeting low and stable inflation, would represent the most promising way for China to fully liberalize its financial and capital markets without fear of damaging yuan speculation. Most of the world’s smaller and poorer countries would clearly be best off unilaterally adopting the dollar or the euro, which would enable their safe and rapid integration into global financial markets.
As for the United States, it needs to perpetuate the sound money policies of former Federal Reserve chairmen Paul Volcker and Alan Greenspan and return to long-term fiscal discipline. This is the only sure way to keep the United States’ foreign creditors, with their massive and growing holdings of dollar debt, feeling wealthy and secure. It is the market that made the dollar into global money —and what the market giveth, the market can taketh away. If the tailors balk and the dollar fails, the market may privatize money on its own.
—- - Benn Steil is director of international economics at the Council of Foreign Relations. This is an excerpt from an extensive article by Mr. Steil in Foreign Affairs last June.
