When China’s Premier Wen Jiabao recently expressed concerns about the future of the US dollar, the currency in which most of his country’s official reserves are denominated, his remarks provoked contrasting reactions among US economists.
Some, like Fred Bergsten (2009) of the Institute of International Economics, exhorted the US government to take Mr. Wen’s concerns seriously and listen to Beijing’s suggestion to create a substitution account in the IMF, which would allow Fund members to exchange unwanted dollar balances for SDRs, as part of a gradual process to replace the dollar with a supra-national reserve currency over the long run. (Mr. Bergsten (2007) was particularly enthusiastic about the substitution account idea since it matched a similar proposal he had made in 2007.)
Other US economists, including last year’s Nobel laureate Paul Krugman, were less enthusiastic. According to Mr. Krugman (2009), China had fallen into a trap of its own making due to its reluctance to adopt a more flexible exchange rate policy in the past. Since any attempt by China or any other country to diversify away from the dollar too much or too quickly would be self defeating, there was no immediate threat to US or world financial stability, hence no need for the US government or the IMF to intervene on China’s behalf.
In our opinion, Mr. Krugman’s view is very simplistic for it fails to take into consideration the effect that a large amount of unwanted dollars and dollar assets will have on inflation once recession fears dissipate. It is possible that Mr. Krugman believes that some increase in inflation is a good thing, as it could help cure the “dollar overhang.” If so, he is not alone. Kenneth Rogoff (2008), the former chief economist of the IMF, has recently written that “a sudden burst of inflation would be extremely helpful in unwinding today’s epic debt morass.” Put in other words, by increasing inflation, the US would “solve” two problems at once. On the one hand, it would debase the value of its national debt, hence preventing it from growing too much relative to GDP. On the other, it would reduce the real value of the debt (unsecured and secured) of financial institutions and other US corporations, hence diminishing the need for explicit haircuts or public bailouts.
The problem with this “solution,” aside from the reputational problems it creates for the US government, is that once the inflation genie is out of the bottle, it will be very difficult to put it back in. As for the solution proposed by the Chinese central bank and Mr. Bergsten, there are, unfortunately, several problems. First, the plan requires a complex multilateral negotiation, including a change in the IMF’s Articles of Agreements, which is unlikely to be supported by the US, if anything because the SDR will compete with the dollar as a reserve currency unit. Second, the proposal restricts the menu of potential dollar substitutes to the SDR, itself a basket of currencies with a predominant dollar share. Third, a substitution account in the IMF makes the IMF rather than the US government liable for losses resulting from the depreciation of the dollar vis-à-vis the SDR, a condition likely to be opposed by other Fund members.
However, the most important drawback of the China/Bergsten proposal is that it does not really protect US official creditors from a persistent fall in the dollar. This is because in the event of a protracted dollar depreciation, it is highly unlikely that the central banks of Europe, Japan, and the UK will stay put and let their currencies appreciate. More likely, these countries will resist appreciation by engaging in a process of competitive devaluations, the end result of which will be an increase in global inflation. If so, the reserves of China and other emerging makets will lose real value whether they are in dollars or SDRs. More importantly, inflation will be high everywhere in the world, and it will take years of high real interest rates and low growth to bring it down.
Fortunately, there is an easier and better way to protect the value of emerging market reserves while reducing the risk of a resurgence in world inflation. This is to reduce the incentive of the US government to “inflate its way out of debt.” For this to happen, all US creditors need to do is demand that the US government swap nominal US Treasury bills, notes, and bonds for inflation-adjusted instruments (TIPS) on demand. Since, at present, the supply of TIPS is very small in relation to the rest of the US national debt, bilateral coordination would be necessary to avoid distorting their value.
One of the advantages of this idea is its simplicity. For starters, it can be executed bilaterally rather than multilaterally. This not only makes it easy to implement, but also gives the US government leverage to extract concessions from the other governments. For example, in the case of China, it would be possible for the US to negotiate a quid-pro-quo, whereby China commits to reforms geared to reducing its structural current account surplus—including, but not limited to, a more flexible exchange rate policy. For this reason, it would be preferable that the swap proposal comes from the US rather than from its creditors.
But, more important than the practical advantages are the beneficial long term effects of such a policy, particularly in averting the specter of global inflation. By substituting TIPS for nominal bonds, the US government would be sending a strong signal that it does not plan to “inflate its way out of debt,” as disingenuously suggested by Mr. Rogoff but, to the contrary, will commit itself to adopting a more disciplined monetary and fiscal policy going forward.
Bergsten, Fred (2009) “We should Listen to Beijing’s Currency Idea,” Financial Times, April 8
Bergsten, Fred (2007) “How to Solve the Problem of the Dollar,” Financial Times, December 11
Krugman, Paul (2009), “China’s Dollar Trap,” New York Times, April 2
Rogoff, Kenneth (2008) “Embracing Inflation,” The Guardian, UK, December 2