December 11, 2007
How to solve the problem of the dollar
By Fred Bergsten
The world economy faces an acute policy dilemma that, if mishandled, could bring on the mother of all monetary crises. Many dollar holders, including central banks and sovereign wealth funds as well as private investors, clearly want to diversify into other currencies. Since foreign dollar holdings total at least $20,000bn, even a modest realisation of these desires could produce a free fall of the US currency and huge disruptions to markets and the world economy. Fears of such an outcome have risen sharply in both official circles and the markets.
However, none of the countries into whose currencies the diversification would take place want to receive these inflows. The eurozone, the UK, Canada and Australia among others believe that their exchange rates are already substantially overvalued. But China and most of the other Asian countries continue to intervene heavily to keep their currencies from rising significantly. Hence, further large shifts out of the dollar could indeed push the floating currencies far above their equilibrium levels, generating new imbalances and a possibly severe slowdown in global growth.
There is only one solution to this dilemma that would satisfy all parties: creation of a substitution account at the International Monetary Fund through which unwanted dollars could be converted into special drawing rights, the international money created initially by the fund in 1969 and of which $34bn-worth now exists. Such an account was worked out in great detail in 1978-1980 during an earlier bout of currency diversification and free fall of the dollar that closely resembled today’s circumstances.
The remainder of this column can be read here. Debate from our panel of economists appears below.
Ronald McKinnon: Fred Bergsten correctly recognizes the seriousness of the dollar overhang problem. In the presence of a weakening dollar, which could be seen as a one-way bet as long as U.S. economists keep stressing the need for further dollar devaluation against the renminbi and other Asian currencies, overseas holders of dollar assets will start to dishoard. Then, Bergsten’s proposal for converting official dollar exchange reserves into Special Drawing Rights at the International Monetary Fund could ameliorate the problem–if the markets don’t take it as a signal of weakness that the dollar will continue to depreciate.
At most, however, this is a second-best solution. The first-best solution is stop talking the dollar down and then take convincing steps to strengthen it. In the 1977-78 run on the Carter dollar to which Bergsten referred, there was joint intervention by the principal European central banks , the Bank of Japan, and the U.S. Federal Reserve Bank, to put a floor under it. The joint intervention was successful and the dollar rebounded. The Fed also kicked in with a tighter monetary policy.
A policy like this is highly desirable at the present time with the additional proviso that the principal holders of liquid dollar assets such as China, Japan, Saudi Arabia, Brazil(?) be included in the negotiations and agree not to exploit the situation by “diversifying” into other major currencies such as the euro. Otherwise the degree of intervention by the ECB to stabilize the dollar-euro rate would have to be too massive. China would readily agree to hold on to its dollar assets if bashing China to appreciate the renminbi was stopped as a quid pro quo.
It should be remembered that Fred Bergsten was the leader in talking the dollar down in 1976-78, and thus was one of the principal creators of the run on the Carter dollar–even though eventually he tried to ameliorate it with his SDR substitution account, which never became operative. So then as now, it is necessary to discard the false doctrine that the dollar exchange rate can systematically affect trade imbalances that are determined by differing net saving propensities at home and abroad. Trying to so manipulate the dollar exchange rate to target a trade imbalance, however, could create (is creating) monetary havoc in the United States and in important trading partners such as China.
Posted by: Ronald McKinnon | December 12th, 2007 at 10:16 am | Report this comment