Dollar's Status As Reserve Currency Coming Under Increasing Pressure
Nobel Prize-winning economist Joseph Stiglitz, the former World Bank chief economist, said on Thursday that the use of the dollar as a reserve currency was "contributing to the weakness of the global economy," and that a reserve currency system based on IMF Special Drawing Rights (SDRs), instead of the U.S. dollar, could be phased in within a year.
"The dollar reserve system is deflationary, unstable and it also has some inequity associated with it," Stiglitz said.
Stiglitz is currently the head of a U.N. panel charged with analyzing the global financial crisis and recommending reforms. Its report released last Thursday included a proposal for a new SDR-based reserve system which in their view "could contribute to global stability, economic strength, and global equity." The U.N. panel also said an SDR-based system was "feasible, non-inflationary, and could be easily implemented."
Stiglitz said the effect of the dollar reserve system is that developing countries have been lending the United States trillions of dollars at almost zero interest rates when they themselves desperately need that money.
"It's a net transfer, in a sense, to the United States of foreign aid," he said.
Heidemarie Wieczorek-Zeul, Germany's minister for economic cooperation and development and also a member of the U.N. panel studying the financial crisis, said the panel's recommendation of using SDRs needed further development.
"This is one of the long-term issues," she told reporters. "But it's clear that even though it's a long-term issue, it has acquired a certain momentum now that countries have spoken positively of it, such as China."
"I'm absolutely certain that we will need further work on this from Stiglitz," Wieczorek-Zeul said. "We'll need to discuss not only the timeframe, but also in what steps it could be could be achievable."
People's Bank of China Governor Zhou Xiaochuan said on March 23 in a report posted on the bank's Web site that SDRs should be used for international trade, financial transactions and commodity pricing instead of the dollar. The IMF should aim in the longer term to create a “super-sovereign reserve currency,” Zhou said.
The Kremlin's senior economic aide Arkady Dvorkovich said today that Russia supports expanding the basket of currencies which are now used to make up SDRs.
"It would be logical for the set of currencies (that make up the SDR) to be expanded, and it could include other currencies, including the rouble, the yuan and perhaps others," he said.
SDRs were created by the IMF in 1969 to support the Breton Woods fixed exchange rate system. However, the move to a floating exchange rate system which occurred after the collapse of Breton Woods in 1973 and the growth of international capital markets, which facilitated borrowing by creditworthy governments, lessened the need for SDR's.
SDRs are made of a basket of currencies consisting of the euro, Japanese yen, pound sterling, and U.S. dollar. The U.S. dollar-value of the SDR is calculated as the sum of specific amounts of the four currencies valued in U.S. dollars, on the basis of exchange rates quoted at noon each day in the London market. The last changes made in the composition of SDRs became effective on January 1, 2006 and the next review of their composition by the Executive Board of the IMF will take place in late 2010.
The SDR has only limited use as a reserve asset, and its main function is to serve as the unit of account of the IMF and some other international organizations. The SDR is neither a currency, nor a claim on the IMF. Rather, it is a potential claim on the freely usable currencies of IMF members. Holders of SDRs can obtain these currencies in exchange for their SDRs in two ways: first, through the arrangement of voluntary exchanges between members; and second, by the IMF designating members with strong external positions to purchase SDRs from members with weak external positions.
The dollar's pre-eminence since the end of WW II stems from a range of factors including deep capital markets (the transfer of savings into investment), a diverse economy with a history of innovation and military power. The problem with talking now about moving off the dollar as the reserve currency is that it can be taken as a metaphor for the fall of the U.S. as a political and financial power, something which in and of itself is likely to be de-stabilizing.
At the same time, the U.S. is now dependent on other countries to fund its bailout which is why it's important to maintain a strong dollar policy, something which is becoming more difficult to do as the Fed embarks on quantitative easing which essentially involves the printing of dollars. The risk is that once you get a weaker dollar, other nations could become reluctant to invest in U.S. assets.
Economists long-argued that the large current account imbalances created over the past decade would lead to instability as the foreign savings glut found a home in the U.S. A current account surplus is a form of national savings and as dollars from countries like China and the oil producers, which were running large current account surpluses, flowed back into the U.S. it led to a situation of lower interest rates which enticed consumers to spend and use credit, helping to fuel the housing bubble which has now burst.
The flood of dollars back into the U.S. was procyclical, meaning that just as money should have been withdrawn as the economy overheated and assets like housing and stocks over-appreciated it became more and more available, a situation which lessened the ability of the Fed to control the economy via the transmission of monetary policy.
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