Wednesday, June 25, 2014

The Case for a New International Monetary System

One of the primary reasons for the world’s economic ills is because the international monetary system has yet to adapt to the structural shifts that we’ve seen in the world’s financial system. Since the Bretton Woods agreement, the US Dollar has been the world’s reserve currency and the USD went off the gold peg in 1971.  The US is also one of the world’s richest countries per capita and is the world’s largest in terms of pure output and has been that way since around World War II (in 1945, the US was around a third of world output). However, we have seen countries like India, China, and other emerging markets grow very rapidly over the past few decades, which created a shift in the power struggle across the world.

Historically, the world’s reserve currency usually belongs to the world’s most powerful superpower, which is still (and still will be for some time) the US. However, we’ve seen a very large housing bubble in the US in the previous decade and we’ve also seen the US run persistent current account deficits. A country without capital controls that’s running current account deficits MUST necessarily be experiencing an inflow of capital. Since the dollar is the world’s reserve currency and payment system, the US cannot impose any form of capital controls. This has led to the world’s most capital rich country importing capital from much poorer countries. We must also remember that the capital account is the inverse of the current account, which means that when the US runs a capital account surplus, the country must run a current account deficit. Also note that a country’s output is equal to the total amount of consumption (both private sector and government) plus the total amount of investment (both private and government investment) plus the net balance of trade. Since the turn of the century, the US has experienced a rise in the current account deficit which has led to a fall in output. Until 2008, this fall in output was counterbalanced by a rise in debt-fueled consumption. This rise in consumption was fueled by an increase in both public and private sector debt (mostly private sector) that forced up both private and public debt/income ratios. Since debt/income ratios cannot be rising forever indefinitely (as debt servicing costs eat up a larger and larger portion of the income), the result was a massive debt-fueled asset bubble that led to a financial crisis, which occurred in 2008.
Basic Identities/Formulas:
·      Rather than define Y=C+I+G+NX, we’ll define Y=C+I+NX where C=Cp+Cg (total consumption = private consumption + government consumption) and I=Ip+Ig (total investment = private investment + government investment)
·      NX is defined as the current account balance
·      (capital account)+(current account)=0

The advantage for the world’s reserve currency is that the inflows of capital allow the country to fund wars and imperial expansions. In the case of the US today, the wars and imperialism of the United States has created major conflicts and utter chaos in most of the world. In the previous decade, the US has started two unnecessary wars in two third world countries (Iraq and Afghanistan), has taken up nation-building in those same countries, and when the US has left one of them (Iraq), the country fell into absolute chaos. So while the run-up in private sector debt led to an asset bubble, the unsustainable run-up in government debt led to two reckless wars and poor spending policies that ended up bailing out large corporations (ex. Medicare Part D). The result of the War in Iraq has forced the country to completely fragment as the map in that region of the world has changed more in the past few months than it did in the previous two decades.

Another important point of note is that every time there is debt, there is also a transfer of real resources. If the transfer of resources isn’t productive, then the debt servicing costs will act as a drag on future growth. Over the past few decades, we’ve seen American debt/income ratios explode in both the private and public sector while we have an economy that’s suffering from a lack of capacity utilization and clearly not producing at capacity. What we’ve witnessed is a transfer of resources from the middle and working classes, who are paying for these reckless wars in taxes, debt servicing costs, and higher unemployment to large corporate organizations like the big banks (who have made poor decisions, lost a lot of money, and got bailed out), big oil companies (who benefit from the US having the ability to dictate terms to countries with large reserves of oil and gas), and the military industrial complex (who supplies weapons, ammunition, etc.). The resulting depression (we’re in a depression, not a recession) caused asset prices to collapse while the liabilities remain. This has left the balance sheets of the working and middle class completely decimated while the banks and other large corporates all got bailed out for their decisions.

What current US monetary policy faces is the age old Triffin Dilemma. The Federal Reserve is currently forced to choose between supplying enough international currency for foreign nations to hold or for domestic policy objectives. If the Federal Reserve chooses to provide enough currency in the system for international demand of the currency, this forces the US to run persistent current account deficits which reduce production and create capital inflows which will either create asset bubbles, unemployment, and often both. However, not providing enough international currency in the system can create some major problems like creating financial crises and liquidity problems in other parts of the world—primarily third world nations.

It’s obviously in the interests of other nations to have an alternative global currency as they don’t have to rely on the Federal Reserve to provide enough currency in the system to make payments, but it’s also in the interests of the American people to have an alternative currency. The current system effectively transfers resources from the lower and middle class while rewarding large multi-nationals. The current monetary policy also fuels the American warfare state that is not only unnecessary, but also counterproductive. Therefore, the international monetary system with the dollar as its centerpiece needs to be torn apart. It no longer makes any sort of sense for the dollar to continue to be the world’s reserve currency—the hallmark of the current international monetary system.


  1. A decent first post. But why the absence of a reference to Professor Michael Pettis?

    1. Some of my comments are very similar to Pettis' arguments. I guess I could (and probably should) have. However, a lot of my arguments were different ones and I touched on a lot of topics that he refuses to touch/cover (probably for political reasons).

      Pettis is one of the few people who actually does understand the structural issues about the world's financial system. However, most economists don't. I will give him credit where credit is due in this comment. He's one of the best economists we have.

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