Indeed the Idols I have loved so long Have done my Credit in Men’s Eye much wrong: Have drown’d my Honour in a shallow Cup, And sold my Reputation for a Song.
Read fiscal and monetary policies fashioned in the post-war period for Idols, and Omar Khayyam may well have been talking of latter day economic policy-makers in his Rubaiyat. Although policy-makers seemed blissfully unaware, the forces of globalisation were straining and blunting the domestic macro-economic policy framework honed in the post-war period.
In particular, the ageing of Western societies was straining the fiscal framework. The “good deflation” triggered by the entry of China and India into the global market, rising cross-border capital flows arising out of Bretton Woods II, and financial innovation that gave rise to shadow banking were straining the monetary framework. Policy spillovers were also making the task of macro-economic management enormously complicated.
The European Currency Union was an attempt to adjust to the forces of globalisation. But it had one fatal flaw that was masked by the Great Moderation but became painfully apparent in the wake of the Great Recession. The latter has also further eroded the legitimacy of the international monetary system.
Macro-economic policy and the international monetary system now seem to be at a historic tipping point, just as they were during the Great Depression. Reshaping them are the great challenges for the future. How might this be done? Does the past provide some guidance?
The Euro area’s fragilities can theoretically – but not of course politically – be overcome by also returning to basics through an institutional re-unification of monetary and fiscal policies. How monetary and fiscal tools themselves need to be reshaped is less clear. Coordinated macro-economic policies and structural reforms across borders are clearly part of this reshaping. However, except in crises, the G 20 has still to figure out a way of how to go about this expeditiously and effectively. The benefits of policy coordination are nevertheless manifest. Apart from policy spillovers in an increasingly integrating global economy, it is apparent that even the unstable status quo is perhaps better than an un-coordinated rebalancing of the global economy. A rise in savings in one part of the global economy in the absence of a rise in consumption in some other part would lead to lower growth in the aggregate.
Could the World Trade Organisation serve as a model for arriving at a global agreement, or consensus, on the use of macro-economic policy tools? Welfare gains from trade are symmetric, since most countries have at least some comparative advantage. However, gains from macro-economic policies may be asymmetric, on account of the inherent advantages accruing to the issuer of the global reserve currency. An agreement on macro-economic policy coordination within the G20 is, therefore, closely linked to the overhaul of the reserve currency system.
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This looks unlikely at this stage. There is no good reason for the reserve currency issuer to give up its enormous advantage in the matter of financing internal and external deficits at low costs. No other currency appears to have the market depth or intrinsic strength to take over the mantle of an alternative reserve currency from the dollar. The Euro in its current form suffers from obvious structural weaknesses. The much touted SDR does not have the essential requirements of a currency. The reserve currency itself might change in future with shifting geo-political and economic fortunes, just as it transitioned from the pound sterling to the US dollar in the inter-war period. However, a shift to a more legitimate multi-currency system would be against the tide of history, which is moving towards greater universalisation and integration through trade and investment. The rise of money itself as a form of universal exchange on the back of barter was a manifestation of the universalising trend inherent in markets. A globalised world has space for just one reserve currency. The problem of the reserve currency advantage, attendant moral hazards and legitimacy issues will not go away. So where do we go from here?
Both fiscal and monetary policies have been debased within just 40 years of the end of the gold standard. Consider the seventies and the current spike in public debt, or the Greenspan “put” and the current quantitative easing, and their inflationary outcomes. This indicates that despite certain inherent weaknesses, the gold standard may have been no worse than, and arguably superior to, fiat money.
The gold standard imparted a degree of inflexibility to using macro-economic policies to stabilise growth, since money could not be created at will. Fiat money, however, suffers from the obverse problem that has seen policy-makers succumb to moral hazards inherent in excessive policy flexibility. The gold standard at least delivered on price stability over the long term. Since the stock of gold is limited and finite, its value could not be eroded significantly. The stock of fiat money, on the other hand, is potentially unlimited and policy-makers cannot be trusted to use it wisely.
A return to fiscal and monetary rectitude may well entail re-anchoring fiscal and monetary tools, and with it money itself, to gold (or some other natural material whose supply is limited) in some manner. This was underscored recently by Robert Zoellick, president of the World Bank.
How this re-anchoring should be done is not clear at this stage. However, the concept itself might not be entirely fanciful. The market response to the debasement of macro-economic policies since the onset of the recent financial crisis seems to be to turn to gold as a safe haven, a status long occupied by the US dollar. The Rogers International Commodities Index (RICI) and gold prices represented by the World Gold Council (WGC) series, that moved in tandem from 2000 right up to 2007 have diverged ever since. Gold prices have been moving steeply upwards, while commodities have been volatile.
Gold now seems to be behaving more like a currency than a commodity. Is this a classic illustration of the age-old Gresham’s Law that bad money drives good money out of the market? The question is whether this is a temporary trend or a structural shift. Be it as it may, some long-term damage has been done. The gold standard and its variants have been around for millennia, outliving several disastrous monetary experiments. Fiat money has been with us for just four decades. Why should this time be different? The experience of the last four decades makes the historian fear for the future of fiat money.
The author is a civil servant. These views are personal