x Abu Dhabi, UAEMonday 24 July 2017

A global reserve currency to remedy our bad behaviour

World leaders keep papering over cracks in the world's financial order, but lacking a moral anchor, currency and financial markets will remain a mess.

Last week's modest gains on global stock markets were nothing but a false dawn. The world economy remains on the edge of a precipice. With the US and European economic engines slumping to stall speed, the debt crisis is extending to a growth crisis. Hope for a global recovery has given way to fear of stagnation or even a "double-dip" recession.

As Black August unfolds, the collapse of consumer and investor confidence in the US and Europe seems to confirm the self-fulfilling prophecy of Western decline. Consumers are squeezed by falling incomes and rising commodity prices. Investors have lost trust in the political leadership of eurozone countries and the US (as evidenced by the cool reaction to Tuesday's Franco-German summit in Paris).

That is why Robert Zoellick, the American president of the World Bank, was right to argue in a speech on Monday that financial markets are entering a "new danger zone".

Little wonder that panic returned to global stock markets on Tuesday. New figures show that Germany, the eurozone's powerhouse and the world's fourth largest economy, virtually ground to a halt between April and June. Germany's economic growth was just 0.1 per cent, well below the predicated rate of 0.5 per cent. It marks a dramatic slump from the 1.3 per cent growth between January and March.

Germany's standstill spooked global investors. It led to another round of mass sell-offs, with financial shares plunging.

These latest figures come just days after evidence of stagnation in the US, UK and French economies. Confirmation of the West's slump coincides with growing signs of a small yet significant slowdown in China's economic expansion.

Amid weak growth and unsustainable debt, virtually every country is trying to manipulate its currency to export its way out of the crisis. What beckons is a moderate measure of protectionism with a heavy dose of competitive devaluation. Such currency and trade wars would almost certainly tip the world economy back into recession. Moreover, draconian cuts to public spending in the West will undermine private consumption and investment on which growth and jobs so clearly depend.

To get out of the mess the world economy is in, it is important to know how it got there.

It is 40 years this week since the end of the post-1945 Bretton Woods system. That system consisted in fixed but adjustable exchange rates, pegged to the US dollar that was itself linked to gold. Under the Bretton Woods agreement, countries could deploy capital controls to boost their domestic economies without having to fear a speculative run on their currency.

The world changed on 15 August 1971, when the then US President Richard Nixon suspended the dollar convertibility into gold and let the American currency depreciate to boost exports. That, coupled with abolishing capital controls and raising tariffs, transformed the US dollar into the global reserve currency.

At first, the end of the gold standard seemed liberating. Exporting countries could hold down the real value of their currencies by investing their surplus in US dollars. Through the purchase of US Treasury bonds, foreign capital continuously flowed into Wall Street. Awash with cash, America could pay for cheap imports and boost the world economy as the "consumer of last resort".

But over time, Mr Nixon's unilateral rejection of the Bretton Woods system inaugurated the era of global imbalances between deficit countries like the US and the UK, and surplus countries such as China and Germany. Foreign surpluses came to finance America's growing debt addiction. Thus, the US mutated from the world's ultimate creditor to the world's largest debtor.

Moreover, global imbalances underpinned the bubble cycle of boom and bust that failed so conspicuously in 2008-09. They also fuel the flow of "hot money" moving in and out of stocks and shares at the speed of light. All this generates the kind of financial market volatility that is currently de-stabilising the world economy.

The current hybrid arrangement bequeathed by Mr Nixon, where some exchange rates are pegged and others float, is neither serving short-term nor long-term interests. It does not lead to a better allocation of financial resources for productive activities that boost employment and growth.

Nor can it avert the real threat of currency and trade wars. Washington and Beijing have been at loggerheads over the need for the Chinese yuan to appreciate vis-a-vis the US dollar. In retaliation China has threatened to stop buying US treasury bonds.

A return to the gold standard is currently undesirable as the gold price is subject to the vagaries of commodity speculation. That speculation is itself fuelled by the forces of global finance. Only a new system of commodity trading would make gold a genuinely viable peg.

There are a number of possible solutions, though none is perfect.

One would be a system of freely floating exchange rates. But that would require governments to stop manipulating their own currencies for competitive advantage, which seems a remote prospect.

Another would be a new fixed yet adjustable exchange rate mechanism using a basket of world currencies as its anchor. But that would require fundamental changes to the convertibility of currencies such as the Chinese yuan or the Russian rouble, which seems just as unlikely.

The growing uncertainty over the fate of the euro makes either system even less sustainable. That leaves another option - creating a world reserve currency based in large part on IMF special drawing rights. But the technocratic nature of such a project is in conflict with the need for popular consent and legitimacy.

What is clear however is that both currency and financial markets need some moral anchor. Without restraint and limits to bad behaviour, there is no hope for a robust recovery and a virtuous economy.

 

Adrian Pabst is lecturer in politics at the University of Kent, UK, and visiting professor at the Institut d'Etudes Politiques de Lille, France.