International Law

Bergsten on the Reserve Currency Issue

By Stan

There has been a huge amount of commentary out there on the issue of whether the world needs a new reserve currency (currently the US dollar), and if yes, what that would look like. This comes after the idea was publicly floated by Zhou Xiaochuan, the governor of the Bank of China.

I said at the time, and have reiterated, that I think the idea is purely academic at this point and that, despite all the hand-wringing done by the folks at Fox News and other reactionary US nationalists, the US dollar will continue to be the global reserve currency for some time to come.

In an article in the FT generally supporting Zhou’s proposal, Fred Bergsten, international trade and econ guru and head of the IIE, reminds me how changed circumstances could precipitate real reform in this area. In other words, when could things get so bad that we, the world, might need to move beyond an academic argument and discuss implementation? Here’s the important bit:

The risk is that China and perhaps other monetary authorities, together holding more than $5,000bn in dollar reserves, will lose confidence in the dollar owing to the prospects for huge and sustained budget deficits in the US. Premier Wen Jiabao recently expressed such concerns in a highly unusual public statement, asking for ?guarantees? of China?s dollar holdings that recall the British demand for a guarantee in 1971 that triggered the US decision to break the dollar?s link to gold.

These worried dollar holders have refrained from dumping Treasury securities only because the dollar has strengthened over the past year ? which is almost certainly a temporary phenomenon ? and because of the adverse global repercussions. We ignore at our peril the prospect that they may feel compelled to do so, especially if the US were to provoke the Chinese by taking aggressive trade policy actions against them. Big conversions by China or another large holder, or even market fears thereof, could trigger a massive run on the dollar.

There are two doomsday scenarios here. First, trade conflicts between the US and China. These certainly have escalated in the past couple of years, but they have not yet gotten out of hand. Two things worry me on the trade front: the upcoming Congressional elections in the US in 2010, an opportunity for some anti-trade grandstanding by politicians, and the certainty that US unemployment will worsen for the remainder of this year, peaking (maybe) sometime in 2010. Many Americans are quick to attribute high unemployment with jobs taken by immigrants, with offshoring/outsourcing, and with outright foreign direct investment — politicians are often happy to further these beliefs.

The good news is that because of the recession and the decrease in demand, China’s exports to the US have slowed, reducing the trade imbalance. If China recovers first (and demand for imports goes up), the bilateral trade deficit with the US might not be a huge political issue, although its size is still significant. Additionally, perhaps the dialogue between Beijing and the Obama Administration will be effective in forestalling any huge trade disputes — we’ll have to see how this new SED (Strategic Economic Dialogue) will play out.

The second doomsday scenario is a loss of confidence in the US dollar. So far, this has not happened because with the recession and a lack of safe investment harbors, many in the world have turned to the dollar as a last resort. This has driven up the dollar just at the time when the US is borrowing a huge amount to pay for its stimulus and bailout packages. Thus its status as the world’s reserve currency is by no means an insignificant benefit to the United States.

What Zhou and Bergsten, and everyone else, understand is that the move to dollar holdings is temporary. Once the recession is over, money may go elsewhere and the pricing of the dollar (i.e. exchange and interest rates) will reflect things like the fiscal health of the US government. If the US continues to run enormous deficits, confidence in the dollar may weaken and interest rates will eventually go up, perhaps dramatically. Any devaluation of the dollar will have a serious impact on creditor nations like China.

Obama’s first budget, and the political discussion surrounding it, is quite interesting. At the same time that these guys are spending giant piles of money on bank bailouts and stimulus packages, they are talking down the deficit and trying to build deficit reduction into their budget for the out years. Fascinating to see them thread the needle on this. It’s the right strategy, but time will tell whether they will be able to get spending under control after the recession is over and the US economy no longer needs the stimulus.

One final note. Bergsten has been a major supporter of an IMF SDR-type global reserve currency and has been writing about it for a while (he states in his article that a December 2007 paper on the subject was met with considerable interest by Chinese authorities). He is also an internationalist/multilateralist, so his support for a solution that facilitates usage of an existing international structure like the IMF is no great surprise. In this sense, his FT article is nothing new coming from him. On the other hand, it is a good reminder of how and why we might see this dialogue move beyond the idea phase.

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Full post as published by China Hearsay on April 10, 2009 (boomark / email).