Whether the euro survives or not remains a matter of opinion. However, there is little doubt that the currency has lost its sheen somewhat permanently. Its woes are far from over and if it were to survive, it would remain vulnerable to episodes of severe stress and panic. The fundamental inconsistency of running a currency union without a fiscal union is likely to resurface in different forms and weigh on the currency. Thus, by default, the turn of events in Europe has re-established the dollar’s hegemony as a global reserve currency.
It is useful at this stage to revisit the problem, often referred to as Triffin’s paradox or dilemma (after the Belgian economist Robert Triffin who identified and wrote on this in the 1960s) associated with this monopoly or quasi-monopoly over the global core or reserve currency that the US enjoys. In a brilliant speech at the Triffin International Foundation in Brussels in early October (“The Triffin Dilemma revisted”), European Central Bank executive council member Lorenzo Bini Smaghi did precisely this – had a fresh dekko at the Triffin paradox against the current global monetary and financial backdrop.
But first, a little bit about the “dilemma” itself. To quote Bini Smaghi: “When core countries operate as a monopoly or quasi-monopoly, over time they tend to take advantage of other countries’ high dependence on their domestic money. By exploiting this ‘exorbitant privilege’, the core countries develop policy incentives to accommodate shocks (for example, the financing of a war) or growth models (for example, based on over-consumption) that can ultimately be sustained only if the rest of the world unconditionally demands their own liquid, safe assets.”
The euro’s rise in the last decade had challenged the dollar’s dominance and some economists had claimed that the financial crisis of 2008 had sounded the death knell for the dollar. That has changed in the last couple of years. The dollar has emerged in a new avatar, stronger than ever, secure in the hubris of its exorbitant privilege. Commodity exporters continue to recycle their current account surpluses into dollar-assets. Public capital (in the form of reserves) and increasingly private capital seek the safety of US treasury bills and bonds at the first whiff of risk.
A possible implication is that given this reinforced monopoly of the dollar, there is no guarantee that the US will contribute to bringing back financial stability. To use Bini Smaghi’s words again: “Key issuers and holders of reserve currencies pursue domestic objectives independently of what would best serve the global system… to the extent that these policies pay insufficient attention to negative externalities for other countries and longer-term macroeconomic and financial stability concerns, they tend to produce unsustainable imbalances and fuel vulnerability.”
Let’s take a couple of examples. Despite the financial meltdown of 2008 and the Pandora’s box of problems it opened, reform of financial regulation in the US has been fairly insignificant. The Fed has embarked on two rounds of quantitative easing with little impact on domestic economic activity but massive inflationary consequences in the commodity markets. The financial markets are incidentally factoring in the possibility of another round of easing by mid-2012, likely to be focused on the mortgage market. For those who ask how the US can afford to get away with this patently irresponsible policy-making, the simple answer is that these are the gains from “exorbitant privilege” that Triffin identified.
How does one escape Triffin and fight the asymmetric advantage that reserve-currency issuance bestows on the issuer? Surprisingly, Bini Smaghi seems to believe that recent failures notwithstanding, global cooperation can play a significant role in bringing change. I quote again: “Countries have indeed been looking for a platform to exert some influence on those policies of partner countries that were producing negative spillovers — be they fiscal profligacy, lack of financial sector reform, unconstrained reserve accumulation or the re-introduction of capital controls. To obtain this platform, countries have, at the same time, to allow their partners a platform to influence their own policies.”
The other solution that has found favour with economists is the concept of a supranational currency that acts as the reserve currency. Triffin had advocated the Bancor (that Keynes had first thought of).Today, the demand is for the Special Depository Receipts to emerge as the global core currency. Bini Smaghi is somewhat wary and notices some fundamental contradictions — “a supranational currency would need to be kept strong in order not to depreciate against the other major existing currencies. Any weakening would undermine its attractiveness, and hence its function as a reserve asset. However, if the supply of a supranational currency were to be restricted, it might fail to meet demand and so fall short of its function.”
The bottom line is that the dollar is likely to prove the doomsayers wrong again. Contrary to what many would like to believe, the end of the dollar is not nigh. The US will continue to set the agenda for the global financial economy — its policy shenanigans could change the course for the financial markets. That’s not a happy thought, is it?
The authors are with HDFC Bank. These views are personal
