A key topic at the G20 meeting is sure to be the future of the dollar as an international reserve currency. The global financial crisis, which started with the US subprime crisis, has eroded confidence in the dollar as an anchor for international payments. Moreover, large US fiscal deficits could add more than US$10 trillion to US government debt over the next decade – on top of trillions of dollars of implicit debt in social security and Medicare.
The US debt bomb poses a growing risk to China and other countries that hold large amounts of their foreign‐ exchange reserves in dollar denominated assets, primarily US government securities. If foreign central banks are less willing to hold US debt, the Federal Reserve may be the buyer of first resort.
Running the printing press to absorb new debt would ignite inflationary expectations. If political pressure prevents the Fed from quickly withdrawing excess liquidity, the purchasing power of the dollar would fall sharply – and all those who hold dollar debt would suffer a loss of wealth. China, with nearly US$2 trillion in foreign exchange reserves, would be the biggest loser if the US were to use inflation to reduce the real burden of its debt. That is why, for the first time, Chinese leaders are openly worrying about the future of the dollar as a reserve currency.
In a now widely cited speech released by the People’s Bank of China on March 23, governor Zhou Xiaochuan raised a fundamental question: “What kind of international reserve currency do we need to secure global financial stability and facilitate world economic growth?” Dr Zhou pointed to the “institutional flaws” in the current global financial system and argued that reform must create “an international reserve currency with a stable value, rule‐based issuance, and manageable supply”. His specific recommendation is to expand the use of Special Drawing Rights, or SDRs, a synthetic currency created by the International Monetary Fund in 1969.
Currently, the value of an SDR is defined by a basket of key currencies (the dollar, euro, yen and pound). SDRs are not accepted for transactions, and are a tiny fraction of total reserves. Creating a global reserve currency under the direction of the IMF would not solve the underlying problem of the lack of an anchor in a pure fiat money world.
The fundamental problem with today’s so‐called global monetary system is that the dollar is a discretionary government fiat money. The Fed neither follows a convertibility principle nor a monetary rule that would commit it to a single objective – long‐term price stability. No government official has been held responsible for the upward drift in the US price level since president Richard Nixon closed the gold window in August, 1971.
What the current debate is missing is the idea that, if exchange rates were free to move with market forces, there would be no need to accumulate a reserve currency to peg exchange rates. A rule‐bound Fed would control the supply of dollars to ensure a stable‐valued monetary unit in terms of goods, while the foreign exchange value of the dollar would be left to market forces. China, meanwhile, would not have to worry about the purchasing power of the dollar because its central bank would not be holding official reserves to peg the value of the yuan.
The danger in the present course is that if the world moves to a “super sovereign” reserve currency engineered by experts, such as the “UN Commission of Experts” led by Nobel laureate economist Joseph Stiglitz, we would give up the possibility of a spontaneous money order and financial harmony for a centrally planned order and the politicization of money.
Such a regime change would endanger not only the future value of money but, more importantly, our freedom and prosperity.