The International Monetary System: Towards a New Era

Speech by Lorenzo Bini Smaghi, Member of the Executive Board of the ECB,
at the Asia-Europe Economic Forum,
Paris, 10 January 2011

Introduction

It should not be difficult to agree, in the context of a conference like today’s, that the current international monetary system has several shortcomings. It’s not particularly difficult to imagine or even design a better system. It’s enough to make some simplifying assumptions – an exercise we economists excel in – about the behaviour of economic agents, public authorities and international institutions. For instance, if national governments are assumed to take into account the impact of their actions on each other, and thus have an incentive to cooperate, and if international institutions are assumed to have the appropriate instruments and treat all their members equally, we would probably have a better international monetary system.

But these are very big ifs. These hypotheses are quite distant from the current state of international affairs. This is why the international monetary system (let me call it the IMS) differs from the design that we would like to produce. Expressed in simple terms, the problems of the IMS arise from the fact that economic and financial linkages have greatly increased over the last few years, while decisions continue to be made largely at national level, and are usually based on short-term domestic objectives. In other words, the economy is global but the policies are local.

There are two ways to address this contradiction. One way is to make the policies more global, under a global architecture. The second is to accept that the policies will continue to be largely national and then try to reduce their negative impact on the global economy. For simplicity’s sake, we can call the first a maximalist approach, the second a minimalist approach. But even the minimalist approach would be very ambitious if implemented properly.

Before getting into the more analytical part of the discussion, let me step back and try to get to the heart of the problem with the current IMS. We are currently experiencing a transition from a unipolar – some call it hegemonic – system to a multi-polar system. Such a transition takes place at different speeds in the three dimensions of international relations: economic, financial and policy. The difference in speed creates tensions, fuels imbalances and may trigger crises.

Let me consider briefly these three dimensions in turn.

The current juncture…

First, from an economic point of view the crisis has shown pretty clearly that we already live in a multi-polar world. The crisis has affected the global economy from top to bottom, but the pace of recovery differs substantially, with the US and Europe still struggling while Asia and Latin America started to grow much earlier and at a faster pace. The long-awaited de-coupling has taken place, not between Europe and the US, but between the emerging and the advanced economies. This doesn’t mean that there is less interdependence but that there can be autonomous poles of growth in the world economy.

Second, from a financial perspective, the world is not yet multi-polar because the various regions are at different stages of development in this respect, which explains why the dollar remains the most used currency worldwide. This is not the result of some deliberate decision by the US to impose the dollar on other countries, but rather the result of the decision of those countries and market participants to use the dollar as a means of exchange, store of value and unit of account. Recent developments have shown that in a crisis, even one stemming from the US, the dollar maintains its safe haven status. This is unlikely to change rapidly.

In its short lifetime, the euro has become the world’s second most important currency. This is the result of the economic weight of the euro area and of the stability of its currency. However, the euro still lacks some of the characteristics that would make it as competitive as the US dollar, such as the depth and liquidity of its markets or the existence of a major financial centre. The current sovereign debt crisis in the euro area has exposed these shortcomings. An enhanced international role for the euro would require a higher degree of policy cooperation. European initiatives remain instead largely driven by the Member States’ domestic policy agendas rather than the global agenda. For instance, the integration of the euro area financial markets would greatly benefit from initiatives such as the creation of eurobonds, the aggregation of the major financial centres in continental Europe or the consolidation of prudential supervision with a view to achieving a deep and liquid financial system. However, the institutional framework underlying the euro still assigns key responsibilities to national authorities, particularly in relation to taxation and prudential supervision. This certainly prevents the whole area from achieving important synergies and from playing a stronger role at the global level.

The explicit reference to sovereign default risk in official discussions at the highest political levels over the Fall has created confusion in global financial markets on the institutional framework underlying the euro. Even if such an event would appear to be extremely rare, it has lead to a reassessment of the risk characteristics of the euro, which in the short run might penalize its international development. Much effort will be needed to restore confidence and convince global markets that the new framework actually makes the euro more solid.

In the case of other relevant players, such as China, their financial development is lagging behind their economic development. The renminbi is still not convertible and the Chinese financial system remains subject to multiple controls. A process of liberalisation has started but it will take quite some time before China and other major emerging economies in Asia achieve the financial sophistication of the advanced economies. Progress in this respect would make the international monetary system more balanced.

This considerable imbalance implies that – all things being equal – the dollar-denominated financial market is likely to retain its relatively important role in the coming years, in spite of the emergence of new economic powers in Europe and in Asia. This is not entirely the result of some US plan, and even less the responsibility of that country. Rather, it’s the result of the slow pace of financial development and integration of Europe and, even more, Asia.

Finally, from a policy perspective – which is the third dimension of the global economy – the world is far from being multi-polar. In particular, many countries in Asia and the Middle East do not yet have independent monetary policies, conducted on the basis of domestic requirements, but rather ‘import’ their monetary policy from the US by pegging their currencies to the US dollar.

Even a simple model shows that this asymmetry produces distortions in the global system which are proportionate to the size of those countries and to the difference in economic performance. If the countries pegging to the dollar are small – Panama, for instance – the impact of any developments in that country on US monetary policy is limited. Furthermore, the systemic risks associated with the pro-cyclical policies adopted in the pegging countries are likely to be contained. If, however, the country pegging its exchange rate is large, in fact the world’s second largest economy, as China currently is, what happens there directly affects US monetary policy. Remember when Alan Greenspan was puzzled by low real long-term interest rates persisting even after the Federal Reserve System started raising policy rates in June 2004? The peg by systemically relevant countries to the dollar was one of the main reasons for this. As a result, US monetary policy was too expansionary for the US, leading to asset price bubbles and imbalances. It was not well calibrated for China or the rest of Asia either, given the underlying growth in these economies, and it led to capital inflows which fuel goods and asset price inflation.

To sum up, we have a multi-polar economic world, but no multi-polar financial or policy world yet. This asymmetry may cause a misallocation of resources at global level, resulting in misalignments of asset prices, such as the exchange rate, and producing policy incentives which lead to sub-optimal results at national and global level.

…and its consequences

Let me consider a few examples of these distortions and disincentives:

  • The existence of one major reserve currency makes exchange rate fluctuations subject to abrupt shifts in risk aversion, rather than to changes in economic fundamentals, and it may thus exacerbate longer-term imbalances instead of correcting them. The appreciation of the dollar after September 2008 vis-à-vis most currencies is a clear example of this and has probably been a factor in the slow US recovery.

  • The lack of independent monetary policies and the peg of systemically relevant countries to the dollar affect the exchange rate of third currencies in a way that is not necessarily in line with fundamentals. For instance, the peg of Asian currencies to the dollar has contributed to distort the exchange rate of those countries which have a flexible exchange rate system against the dollar.

  • The limited diversification of reserve currency assets limits the scope for markets to discipline macroeconomic policies, dragging out the financing of unsustainable imbalances which may turn into a crisis. The ease with which the US has been able to finance its external deficit has prolonged unsustainable imbalances and delayed the policy adjustment needed to increase national savings.

  • The insufficient adjustment or the overshooting of exchange rates may lead to disorderly policy reactions and encourage beggar-thy-neighbour policies. The pegging of exchange rates prevents an exchange rate adjustment which is then compensated for by other policies which may in turn have repercussions for other countries.

The way forward

In the light of the prevailing conditions, how can we improve the functioning of the international monetary system? We can do so with a twofold strategy.

The first avenue is to start building a new institutional framework will have to be designed for this new multi-polar world. To be sure, we will need a cooperative framework to manage the various interactions between the main economic powers and their effects on markets.

Such a cooperation framework will have to address the problems arising from the interactions between the various centres of power, and their impact on the global markets, both in normal times and at times of crisis. Even in a complete multi-polar world financial markets will be characterised by instability, self-fulfilling expectations, overshooting, etc. Whatever the number of economic powers, there is a need to have a forum which brings together those responsible for monitoring market developments, assessing underlying conditions and, if needed, intervening to counter instability and avoid overshooting. This will require a G3, G4, G5 or more, depending on the number of systemically relevant players. They are needed in particular in order to manage highly sensitive issues such as exchange rates, address major financial market instabilities and be able to act quickly and in a coordinated way. Such groupings will not substitute for stronger multilateral institutions, in charge of multilateral surveillance such as the IMF or the G20. Indeed, the larger the number of power centres, the greater the need for an independent assessment of the policies pursued by each of them and their impact on the others. A multi-polar system should be able to better protect institutions like the IMF from interference by an economic heavyweight and to give it stronger powers.

What role would there be in such a multi-polar system for a global reserve currency such as the SDR? In a well-functioning multi-polar system there should be no shortage of reserve assets to invest in. Furthermore, excessive reserve accumulation should be discouraged, as this would be the result of exchange rate misalignments. Moreover, any replacement of international currencies that have established themselves as a result of the autonomous decisions of private and official agents with a synthetic, ‘policy-imposed’ international currency could have some undesirable ‘unintended consequences’. For instance, large increases in the stock of SDRs may have serious implications for the conduct of monetary policy and the independence of central banks issuing the international currencies included in the SDR basket. Furthermore, it would be difficult to agree on who would bear the exchange rate risk associated with the redenomination of existing reserves into SDRs.

The second avenue involves implementing policies consistent with the transition to a more complete multi-polar world, in all its dimensions. This means in particular a speedier shift to an independent policy framework in Asia, especially in China, with a progressively more flexible renminbi. I believe that there is a consensus also in China to go in that direction, but the pace might be too slow to avoid the problems I raised above. The international community should thus convince the Chinese authorities that there are only gains to be made from for the Chinese economy as a whole speeding up the process, even though some protected sectors, which are currently subsidised by the currency peg, might lose out in the short term. The experience of Japan and Germany in the early 1970s, right after the breakdown of the Bretton Woods regime, show that a country can prosper and remain a strong exporter with a strong currency.

A more balanced multi-polar world also requires deeper financial and economic integration in Europe, particularly in the euro area. This requires addressing some of the uncertainties and inefficiencies affecting the current institutional framework underlying the euro. If they want the euro to be a key pole in the emerging new world Policy-makers in Europe should look at the current problems not only from a closed-economy perspective and be able explain to their constituencies the implications, and advantages, of being a global player. If Europe cannot find its place in the new multi-polar world, it is likely to be squeezed between the other centres of economic power, and to suffer from their spillovers.

With its severe impact on advanced countries, the crisis has accelerated the transition to the G20 as the core group for global economic cooperation. Its Mutual Assessment Process (or MAP), in particular, represents a new approach to global oversight, in that leaders formulate a shared objective and engage in a dynamic process of data analysis and policy adjustment to achieve that objective. MAP also acknowledges that there is no single solution to the adjustment of global imbalances. Neither monetary, exchange rate, fiscal, nor structural policies suffice on their own. Moreover, the policy mix that is required differs considerably from country to country. This implies a need to take account of all relevant policies in systemically important countries in the process of international cooperation aimed at rebalancing the global economy.

The G20 also creates the opportunity for smaller sub-groupings, which can deal more efficiently with market or politically sensitive issues that need to be resolved under firm time constraints. The G20 is thus destined to become an over-arching groupings, capable of tasking institutions like the IMF, World Bank or FSB with specific mandates but also to give guidance on politically sensitive issues, in the way the G7 operated in the past. In any case there are no better alternative fora for international cooperation.

Thank you for your attention.

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