Part two: Six Major Dilemmas of the International Monetary System and Prospect of Reform

ⅠSix major dilemmas under the current USD-dominated international monetary system

ⅰ The New Triffin Dilemma

The concept of “new Triffin dilemma” was suggested by Robert. N. McCauley in 2003. By analyzing capital flows between the US and East Asian countries, McCauley argues that the US needs East Asian capital to sustain current account deficits through low-cost debt. In other words, East Asian countries become “sub-banks” of the US. However, the supply of the USD from these sub-banks depends on the US FDI in East Asian countries as well as the US current account deficits. Once the US current account deficits become unsustainable, the amount of the dollar flowing back to the US will shrink and in turn influence the US financial market.

Therefore, the international trade is essentially a game in which the US issues dollar bills, and the other countries produce commodities to exchange dollar bills and finally these bills flow back to the US. In other words, the stability of the existing international monetary system relies on stability of the US dollar, while the dollar stability depends on the US balance of international payments. However, as the supply of international liquidity depends on the US current account deficits, the US privilege of “seigniorage” will further expand the US current account deficits and affect balance of international payments as well as international status of the US dollar. That is the “New Triffin Dilemma”.

ⅱ The N-1 problem

In terms of the coordination mechanism of international balance of payments, any region composed of N countries with free capital flow and fixed exchange-rate regime will encounter “the N-1 problem”. In such kind of region, given N-1 countries holding fixed exchange rate policies, there is one degree-of-freedom left. Therefore, theoretically, there will be one currency which can artificially determine its internal and external values. How to distribute and use this degree-of-freedom is called “the N-1 problem”. There are three major solutions as follows:

The first solution is asymmetric solution. The N^th country is assumed to use the degree of freedom and implement its monetary policy independently, while other N-1 countries are responsible to maintain fixed exchange rate. The N^th country is thus the “core country”, while other N-1 countries are “periphery countries” as their monetary policies depend on that of the core country. As a result, they have to passively maintain fixed exchange rate and interest rate parity.

The second solution is symmetric solution. The N countries use the degree-of-freedom together and share the responsibility of maintaining N-1 fixed exchange rates. In other words, this is to establish a single super-sovereign currency. There is no “core country” or “periphery countries”. This solution can be achieved through members’ joint coordination or through establishment of a common central bank that implements a unified monetary policy.

The third solution is to introduce the N+1^th independent variable that is called “external anchor” or “super-sovereign independent currency”. By pegging their currencies to the external anchor, N countries experience fixed exchange rates with each other. Furthermore, the price of the “external anchor” is determined by external factors, while the N currencies are determined by internal factors, and thus producing a compatible system.

Overall, the first solution has been implemented in the current international monetary system, while the second and third solutions are still at the theoretical level.

ⅲ The problem of “conflicted virtue”

The concept of “conflicted virtue” or “the effect of conflicted virtue” was suggested by Ronald McKinnon in 2004. McKinnon indicates that currency mismatch, i.e. the “conflicted virtue” will take place in any creditor country which is unable to lend in home currency. East Asian countries with high saving rates tend to maintain current account surpluses that will lead to an increase of foreign claims. However, East Asian creditor countries are unable to lend in home currencies. Amid the rise of foreign claims, there will be two results: As the US dollar claims accumulate, USD asset holders in East Asian countries increasingly worry about that this trend will push home currency towards appreciation. Meanwhile, as some East Asian country continuingly maintains its trade surpluses, debtor countries will accuse them of artificially manipulating their currencies at unfairly low levels.

Consequently, there comes the problem of “conflicted virtue”. The more complaints rose from trade-deficit countries, the more pressure is imposed on home currency towards appreciation, and the stronger expectation on home currency appreciation is from domestic USD asset holders. This process will then lead to a currency run through self-fulfilling mechanism. So long as there is currency run, the country will find itself in a dilemma that is difficult to select appreciation or depreciation of its currency. If currency appreciates, the economy will ultimately fall into a liquidity trap with deflation and zero interest rate bound. If not, the country will suffer from trade sanctions by foreign countries and then incur enormous loss. However, for creditor country with its home currency as international currency, the problem of “conflicted virtue” does not exist.

ⅳ Various USD traps

The first is the trap of economic development model. The “periphery countries” generally prefer USD reserve and most of them have adopted an export-oriented strategy. Finally, there comes an economic development model over-relying on exports but with insufficient domestic demand.

The second is the trap of foreign exchange reserves. The “periphery countries” with a great amount of USD assets will fall into a dilemma that the increase in USD reserves will lead to higher exchange rate risks, while the reduction in USD reserves will cause USD depreciation and shrink of USD assets.

The third is the trap of investment loss. The “periphery countries” mainly purchase US treasury bills with the yield of 2%~4% as the major channel for investment of foreign exchange reserves. In addition, to attract FDI, these countries have paid expensive costs in finance, environment and society. Moreover, although some of these countries have higher saving rates, these savings cannot be converted into real investment due to inefficient investment channels.

The sovereign-debt crises in UAE and Greece uncovered the tip of the iceberg of the global sovereign-debt crisis. Currently the greatest systemic financial risk in the world is that the US is heavily in debt. The US gross debt has reached 12.3 trillion USD and the expenditure on the payments of debt interests, social security, health insurance and other welfare will account for 80% of overall federal income by 2020. In fact, the US government has been insolvent for a long time and the expenditure cut has become inevitable. Without USD’s international status, the US government would have already gone bankrupt. In other words, the whole world has been kidnapped by the USD and the US liabilities.

ⅴ The ratchet effects of the current financial crisis

The ratchet effects of the current financial crisis mean that the USD-dominated international currency system exacerbates the accumulation and spread of financial risks. According to Stiglitz (2002), over the last 25 years before 2002, about 80~100 countries had experienced financial crises. The features of these crises are as follows: Firstly, financial crises in certain periphery economies are closely related to the US macroeconomic policies, such as the Mexican and Asian crises in the 1990s, and their financial risks can only spread between each other, but is hard to affect the US.

Secondly, the US financial risks and financial crises mainly arise from its own reasons, but these risks and crises have easily spread around the world through channels of trade, finance and confidence, such as the2008 global financial crisis. Financial markets of developing countries have always been the main speculative target of international capitals. It should be noticed that the US dollar always played the role of global “safe harbor” and the US was the major beneficiary of the crisis during almost each financial crisis,

ⅵ the global excess liquidity

Under the USD-dominated international monetary system, the US monetary policy leads to periodic depreciation of the US dollar, global excess liquidity, and then global inflation. In recent years, the fundamental reason of dramatic increase in global oil and commodity prices is over-issues of the US dollar. Since the US dollar was cut loose from gold in 1973, USD exchange rate has been negatively correlated with the prices of commodities, gold and crude oil. In the half year after the outbreak of the 2008 financial crisis, the amount of the US monetary base has risen by over 1 trillion USD, which sowed the seeds of global inflation, speculation of overseas hot money and financial instability.

Ⅱ Prospective reform approaches

Xiaochuan Zhou (2009), the governor of the Chinese central bank, believes that the aim of international monetary system reform is to create a super-sovereign reserve currency. He indicates that establishing an international currency unit proposed by Keynes is a bold initiative that requires extraordinary political vision and courage. In addition, because the Special Drawing Rights (SDRs) has features and potentials of acting as a super-sovereign reserve currency, Zhou suggests promoting reform of the SDRs distribution system. From this perspective, both Zhou and Keynes are idealists given their insightful but infeasible ideas. At present, the urgent mission for the international monetary system reform is to break the monopoly of the US dollar and establish a brand-new multi-polar international monetary system.

ⅰ To promote international financial institutions reform

First is to strengthen organizational function of IMF and members’ coordination of monetary policies. Second is to reinforce the important role of the World Bank in stabilizing the existing international financial system. Third is to establish a lender of last resort on world-wide basis. Fourth is to establish a BIS-centered financial risk warning system.

ⅱ To improve the existing international financial regulatory system

Specific steps include: to enhance information transparency; to strengthen over the monitoring of hedge funds; to strengthen the supervision of offshore financial industries; to limit leverage ratios; to prevent excessive financial innovation; to improve the capacity and execution of financial regulators.

ⅲ To reinforce international cooperation and coordination in terms of economic and financial issues

First is to coordinate the relationships between developed and developing countries, to protect and support developing countries and regions. Second is to coordinate the relationships among developed countries. Third is to improve cooperation and coordination in terms of international financial issues, such as business condition, internal control, market discipline and financial regulatory.

ⅳ To strengthen China’s participation in the reform

First is to promote the transparency of the IMF decision-making mechanism. Second is to coordinate monetary policies among Asian countries referring to the EU experiences and then to form a competitive structure of “three pillars” including the US dollar, the Euro, and RMB. Under this competitive situation, it will be easier for the EU and the US to accept reform plans proposed by China, and it will finally strengthen the discourse, the right to know as well as the power of rule-setting of developing countries in the international financial system.