The international financial system, based on the US dollar as the dominant reserve currency, faces an unprecedented bout of flu. Following the outbreak of the financial crisis in 2007, the drawbacks of the dollar-based system have become ever more glaring, prompting a number of world leaders and central bankers to voice their concerns, with Chinese President Hu Jintao and President Nicolas Sarkozy of France becoming its most vocal and influential critics. The Asia Times has published a comment on the issue as follows: The recent decision of the US Federal Reserve to inject 600 billion dollars into the economy, on top of the prevailing abundance of dollar liquidity, and to maintain near-zero interest rates, has created more tensions around the globe, inciting fears of a currency war. In the aftermath of the financial crisis, the US Federal Reserve has been expanding liquidity at a merciless rate. This planned money creation by the Fed on top of what was done in the aftermath of the financial crisis would lead to a total increase exceeding 2.3 trillion dollars. Meanwhile, the US can be expected to lift its debt ceiling above the 15 trillion dollar mark. There is no letting up of liquidity expansion.
As a result of record-low US interest rates and massive dollar injections, there are pressures for dollar outflows to attractive emerging markets in pursuit of higher interest rates. Central banks around the world that want to avoid the depreciation of the dollar are forced to use their own currency to buy up dollars. This results in a forced expansion of their own money supply, which in turn exerts inflationary pressures in their own markets.
In this way, what started as a monetary expansion and low interest rates in the US is transmitted and exported abroad. Namely, US policies are forced down the throats of other countries. At the same time, commodity prices, including the price of basic foodstuffs, are rising as seldom before because these prices are denominated in dollars while the dollar is depreciating and inflationary pressures are fueled around the world. The current international payments system is an asymmetric system because the dollar, the currency of one country, has a special position that no other currency enjoys. Moreover, the US can do whatever it wants with impunity and little or no regard for the problem of other countries.
This was exactly the problem of the Bretton Woods system that prevailed from 1944 to 1971. Its demise can be attributed to two interrelated facts - European countries and Japan were forced into following the policy decisions of the US or there was no policy independence for other countries to pursue their own domestic agenda. And while the US ran increasing current account deficits, they acquired dollars that could not be exchanged for gold, and the dollars were also loosing real purchasing power in terms of buying internationally traded commodities as is the case today. Well, it became obvious that the fixed asymmetric Bretton Woods system of exchange rates had to go, as countries did not want to be tied to US policies through fixed exchange rates and accumulate dollars that they did not want.
The world opted for a system that allowed countries to adopt whatever type of exchange rate they wanted - fixed to another currency, such as the dollar, or floating. Well things have not turned out as promoted. Flexible rates did not afford the policy independence that was touted. This is because of the high mobility of capital that responded to even small interest rates differentials between countries. A policy divergence in one country as a different interest rate would lead to capital inflows or outflows, in turn nullifying the desired policy divergence. Some economic experts said that this would happen but it unfortunately fell on deaf ears. However, today, we see the whole thing playing out again much the same as it did during the problematic period of 1969-1971. Just the names and the countries are different.
Because the dollar is the world’s reserve currency, the US is no Greece or Ireland; it faces no limit to fiscal and monetary expansion. For years, it has been running external deficits without tears, that is, without facing any balance of payments constraint. Such is not the case for Burundi, for example, which cannot expand deficits without running into foreign exchange constraints.
The dollar depreciation has hurt a number of economies as it essentially exports inflation to these economies; the rates of inflation have exceeded tolerable levels in China, India, and in a number of other countries. US policy makers have little concern for soaring gold, food and energy prices. They are narrowly pre-occupied with domestic political and economic agendas, including coping with a massive unemployment rate of more than 9.9%.
The priority of domestic policies was emphasized by President Barack Obama at the Group of 20 summit in Seoul last year when he flatly dismissed calls by a number of G-20 members to renounce the US Federal Reserve's injection of an additional 600 billion dollars of liquidity. Similar policies and practices in that earlier era were coined as the policy of "benign neglect". There is little difference today.
Since 2008, the G-20 summits have been calling for near-zero interest rates and enlarged fiscal deficits. But these policies have turned out to be at odds within the G-20 itself. While calling upon China to inflate at a rapid rate, the US and European countries have been critical about insufficient Chinese currency appreciation. In similar fashion, the European zone, while agreeing within the G-20 on the Fed’s expansionary policies and US deficit spending, has been severely critical of the dollar's sharp depreciation and has no choice but to inflate at the same rate to prevent a sharp appreciation of the euro.
Frustrated by the US Federal Reserve's deliberate depreciation policy, the French President Nicholas Sarkozy stated: "We cannot increase the competitiveness of our businesses in Europe and have the dollar lose 50% of its value against the euro. When we produce in the eurozone and sell in the dollar zone, are we supposed to just give up selling?" Elsewhere, the Chinese President Hu Jintao was critical of the Federal Reserve decision to stimulate growth through huge bond purchases to keep down long-term interest rates, a strategy that China has loudly complained about in the past as fueling inflation in emerging economies, including its own.
The prevailing asymmetric dollar-based system is essentially unstable. It leads to a self-multiplying expansion of US external deficits because dollars acquired by the rest of the world are placed in US banks as reserve assets of foreign central banks. These deposits in turn serve as a basis for further money creation by US banks as they lend it out, more demand and more external deficits.
By the way, many reform plans could be considered; most important would be willingness for monetary cooperation and establishment of a monetary system that does not confer advantages to some countries at the expense of others and that would preserve monetary stability and enhance long-term economic growth. While the present system is not yet a barbarous relic, it is rapidly becoming so.
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