Tuesday, April 14, 2009

About that Proposal for a New Reserve Currency...

Yes, I am talking about China's proposal that the IMF's special drawing rights or SDR currency be expanded and adopted as the new reserve currency. From Justin Fox we learn this idea is not original. It has been promoted for some time by C. Fred Bergsten. Here is what he had to say about it in December 2007:
There is only one solution to this dilemma that would satisfy all parties: creation of a substitution account at the International Monetary Fund (IMF) through which unwanted dollars could be converted into special drawing rights (SDR)... The idea of a substitution account is simple. Instead of converting dollars into other currencies through the market, depressing the former and strengthening the latter, official holders could deposit their unwanted holdings in a special account at the IMF. They would be credited with a like amount of SDR (or SDR-denominated certificates), which they could use to finance future balance-of-payment deficits and other legitimate needs, redeem at the account itself or transfer to other participants. Hence the asset would be fully liquid.

The fund’s members would authorize it to meet the demand by issuing as many new SDR as needed, which would have no net impact on the global money supply (and hence on world growth or inflation) because the operation would substitute one asset for another. The account would invest the dollar deposits in US securities. If additional backing were deemed necessary, the fund’s gold holdings of $80 billion would more than suffice.

All countries would benefit. Those with dollars that they deem excessive would receive an asset denominated in a basket of currencies (44 percent dollars, 34 percent euros, 11 percent each yen and sterling), achieving in a single stroke the diversification they seek along with market-based yields. They would avoid depressing the dollar excessively, minimizing the loss on their remaining dollar holdings as well as avoiding systemic disruption.

The United States would be spared the risk of higher inflation and potentially much higher interest rates that would stem from an even sharper decline of the dollar...
For these reasons Justin Fox champions the SDR and argues it would be in the best interest of the United States and the rest of the world if it truly became the new reserve currency. The Economist magazine, meanwhile, explains some of the technical details of the SDR while the historian Paul Kennedy wonders if all the buzz about the SDR is just another symptom of a much larger tectonic shift in the global balance of power toward Asia.


  1. Hi David,

    How is Texas? Putting Bretton Woods (i.e., global currencies are pegged to the dollar) aside for a moment, the dollar is the main source of power because key nations are running perpetual current account surpluses, as the US economy is willing to give them freely. This is the problem, current account imbalances, and not the dollar itself. I honestly don’t understand how issuing a global reserve SDR would make a lick of difference in rebalancing current account flows among key economies. It seems to me that if China wants to run huge current account surpluses, it is going to acquire debtor currencies (bonds) no matter what the IMF is doing. The SDR will simply give the Chinese an opportunity to hold a non-US certificate of account, but that SDR will still be backed by a growing stock of debtor (US) nation government bonds. This seems to be the same difference with a new middle man, the IMF.

    Nice post very informative.


  2. Rebecca:

    All is well in Texas. I will note, though, that the variability of weather is high here during this time of the day it is 40 degress the next day it is 80 degrees. Adaptive exepectations definitely does not work here for forecasting winter weather!

    You make a good point as to whether the SDR will really make a difference in rebalancing current account flows. If there are structural and policy reasons why China wants to run a current account surplus I am not sure how the SDR would change it. At best, I can see the SDR giving China a liquid asset that would be a better storer of wealth than the dollar. This, of course, would only matter after China ran the huge current account surpluses. But then, it seems, the risk of holding the dollar would being simply transferred to the IMF. I guess that would be an improvement since the dollar risk would be spread among all the IMF members as opposed to one country.

    You definitely raise some tough questions. I would love hear what others have to say.

  3. I am sort of with Rebecca here.

    I am not sure why the SDR provides any sort of benefit. I realize that China might benefit from holding the SDR, which is weighted by a basket of currencies. However, Justin Fox makes the case that this would be better for the United States, but in reading the article I am not sure that the US receives any real benefit at all.

    We had an international currency once; it was called gold. The reason it failed is because governments and central banks were more committed to inflationary policies than they were the gold standard. Thus, the problem is (and always has been) with bad policies.

    I think that I would have to think about this quite a bit more, but it seems like the SDR is something like a multi-metallic standard (I realize that there is no actual metal involved, but I think it helps to get one's head around such a model first). For simplicity, let's assume that it is a bimetallic standard and the SDR is fixed relative to the dollar and the euro. Such a system (as with a gold/silver system) could easily survive fluctuations in the relative supplies of money. However, if one central bank is following a bad policy for an extended period of time, there is quite possibly an arbitrage opportunity that could serve to "break" the system, so to speak as cheap money would drive expensive money out. Such disconnects between gold and silver supplies were ultimately the death of bimetallism (and those were controlled by market forces rather than central banks).

    If we must change the current institutional framework, I would much rather have a Bretton Woods-type system. Given what we have learned about monetary policy, we could avoid the inflationary policies that ultimately led to its downfall.