Last week, I attended the second annual meeting of the Institute for New Economic Thinking, at the Mount Washington Hotel, nestled in a beautiful valley in Bretton Woods, New Hampshire. In 1944, the historic meeting on the international monetary system was held there.
The British delegation was led by Lord Keynes, the foremost economic thinker of his day. The American delegation was effectively led by US Treasury adviser Harry Dexter White. Even though all the Allies attended the meeting, including China and India, it was essentially a debate between the declining superpower, Britain, and the rising superpower, the United States.
Keynes understood full well the problem that Britain faced as the issuer of sterling. Since Britain was running large current account deficits because of the two world wars, it was having a tough time maintaining sterling as the main reserve currency. By the end of the second world war, the US emerged as the dominant global power, since it ran large current account surpluses by supplying food and raw materials to Europe in exchange for gold. To avoid the Triffin dilemma, Keynes argued for the creation of a new international currency, called Bancor, that would not be related to the issue of a national reserve currency.
The Triffin dilemma is the problem the issuer of the global reserve currency faces in having to continually run large current account deficits to meet the liquidity needs of the world. In the short term, the issuer country benefits from an 'exorbitant privilege', since it could pay for its imports by printing more currency, whereas other countries could only import by paying in foreign currency.
However, White rejected the idea of the Bancor because he did not like the idea of a global central bank issuing a global currency. Instead, the idea of the special drawing rights (SDRs) was adopted, where the SDR is an international reserve asset created by the International Monetary Fund through the exchange of national currencies. As the dominant IMF shareholder, the US could reject the issuance of SDRs, thus ensuring the US dollar remains the dominant reserve currency.
There is common confusion that the SDR can eventually become a reserve currency to replace the US dollar. It is a unit of account between the IMF and its member countries, but it cannot be used for international payments. Currently, it is issued to member countries to increase their foreign exchange reserves. However, when the member country needs foreign exchange, it must exchange its holdings of SDRs with the IMF in four component reserve currencies, namely, the US dollar, the euro, sterling and the yen.
Thus, the components of the SDR can change, but the reserve currency role remains national, not global.
Keynes was right. Sixty-seven years later, the US had become the leading global borrower, whereas the net lenders are Japan, China, Germany and the oil producers, creating a global imbalance.
Last year, the former finance minister of Italy, Tommaso Padoa-Schioppa, gave a speech about the international monetary system titled ''The Ghost of Bancor'. Padoa-Schioppa, who died later that year, had a major role in the creation of the euro and was a member of the board of the European Central Bank. In his speech, he drew parallels between the Bancor and Banquo from Shakespeare's Macbeth. In the play, Macbeth and Banquo meet three witches who predict that Macbeth will be king. Banquo will not, they say - but his descendants will be, leading Macbeth to view him as a rival, and later kill him. The ghost of Banquo then returns to haunt Macbeth.
To Keynes, the Bancor would be the steward of the king, which was gold. But today, when fiat money is the standard, the SDR cannot yet replace either gold or the US dollar.
At the heart of any global currency remains the Triffin dilemma: what is the hard budget constraint to prevent the global currency issuers from printing too much money and therefore creating global inflation?
Padoa-Schioppa's speech basically argued that no national central bank or a global central bank can resist the temptation of printing too much money.
Currently, the deficit countries blame the surplus countries for saving too much, and the surplus countries blame the deficit countries for printing too much money. The reality is that it is the current international monetary system that is flawed. We cannot return to the gold standard, but a fully flexible system of fiat money is also not desirable.
We are in a global collective action trap, where everyone must share the burden of being part of the global game. The difficulty lies in how to allocate that burden in a fair manner.
My opinion is that the crisis of fiat money is due to excess consumption financed by excess leverage. That excess consumption is also the fundamental cause of global warming, as natural resources are depleted, while fiat money keeps on increasing. No one wants to go back to the gold standard, because there would be deflation that would rein in consumption. That is too painful, so everyone keeps on printing money and passing the pain to savers and future generations.
If there is more and more quantitative easing (money printing) and fewer and fewer natural resources in a shrinking world, should we be surprised that gold and oil prices keep going up?
Who speaks the truth: the ghost of Bancor, or his successors, the current reserve currency issuers?
Perhaps it is the witches in the misty forest, the shadow banking system. That story will be told in the next article.
Andrew Sheng is author of From Asian to Global Financial Crisis