The paradox of global liquidity

 The rising US current account deficit as a per cent of GDP over the years has led to a build up of dollar reserves in the rest of the world, especially in Asia. The de facto dollar standard has led some to claim that it can be sustainable over the long-term.

 This article tries to present a quick overview of the international monetary arrangements of the past, highlight the global liquidity situation, its consequences and the implications for India.

 The evolution of international monetary arrangements has been driven either by historical forces or by accident. The shift from commodity based money to paper money, centralised control over paper money within a nation state were landmark developments.

 The gold standard era (1879-1913) was known for its incredible free movement of capital and goods. One of the key aspects of this period was that a country with a balance of payments deficit would experience an outflow of gold and a country with a balance of payments surplus would experience an inflow of gold.

 This adjustment mechanism worked through relative prices and prevented persistent deficits or surplus. During the inter war period, a gold exchange standard was adopted. The Bretton Woods conference led to the creation of the International Monetary Fund (IMF).

 The sole purpose of the IMF was to maintain the fixed exchange rates and provide liquidity to enable countries to stabilise their temporary balance of payments problems.

 The post-war economic expansion commenced. US started running current account surplus and helped Germany and Japan rebuild their economies. Between 1969-72, world foreign exchange reserves doubled. An increase that was equivalent to all previous centuries of recorded history.

 Prof Robert Triffin observed that, as the paper-based system became the post-war norm, the US dollar became the source of international liquidity for international settlements and reserve accumulation. The expansion of liquidity can take place only when the US runs a current account deficit.

 Such persistent deficits will undermine the value of the currency and therefore the reserve asset. This became known as the Triffin