New world currency wouldn't solve imbalances on its own, says King

It is no surprise that much of the attention over Mervyn King’s speech on Tuesday night has focused on his double warning to the Government that: 1. this recovery will feel very downbeat for some time and 2. Alistair Darling should beware the market and slash the deficit in the Budget this year. After all, although the Governor may have felt he was doing his best to avoid being seen as overly critical of Downing Street, that wasn’t the impression the speech offered.

However, all this excitement (and I should warn you I’ve written a feature about precisely this topic for tomorrow’s paper, link coming soon) disguises the fact that at its heart the speech was not about domestic policy or the differences of opinion between Downing St and Threadneedle St – it was about the international economy. More specifically, it represented King’s most serious warning yet that we have done nothing to right the immense imbalances in the global economy that were at the very heart of the current crisis.

Although there was plenty bankers and regulators did wrong in recent years, their actions were as nothing in comparison with the effects of these imbalances. In short, China and its fellow surplus nations were borrowing too much (and exporting too much) in the run-up to the crisis; Britain, the US and other deficit nations were borrowing too much. The pressures and strains caused by these imbalances were what contributed to the crisis (this is a horribly short explanation, I’ve written a few longer ones, if you’re interested, a couple of which you can find here and here).

King’s warning in his speech is that to hold out hope for a new Bretton Woods agreement is futile. There are simply too many interested parties involved. He also adds that any economists claiming that these imbalances (and the US dollar hegemony) would be solved by introducing a new world currency are deluded. This would only work if it was part of far broader reforms to the way the entire international monetary system fits together.

Instead, he proposes beefing up the IMF by merging its lead committee with the G20. It is a pretty radical suggestion (at least it will be seen as such in the dusty world of multilateral policy) but that is a testament to the scale of the current problem. It’s worth having a read of the full speech, in which King tries to describe the dilemma as a kind of sudoku for economists.

As he says:

If both groups of countries [in the boxes above] want to achieve full employment levels of GDP, and the high-saving group targets a trade surplus, the low-saving group cannot target a reduction in its trade deficit. Either trade deficits must remain high, which is not likely to prove sustainable, or something else must give. That might involve a recession in the deficit countries, or an acceptance by the surplus countries that, one way or another, trade imbalances must be reduced. Sudoku for economists shows that countries cannot pursue for long incompatible economic policy frameworks.

Some other highlights on this topic:

Today China alone has reserves of over two trillion dollars, and Japan another trillion dollars. Adding inexorably to the stock of international assets and liabilities is like adding one brick on top of another to form a tower. With skill, it can be done for a surprisingly long time. But eventually the moment comes when adding one more causes the tower to fall down. If countries do not work together to reduce the “too high to last” imbalances, a crisis of one sort or another in financial markets is only too likely.

At the Bretton Woods Conference, the British economist John Maynard Keynes identified the asymmetry of the obligations placed on surplus and deficit countries as the main source of the problem. He had argued that,

“the process of adjustment is compulsory for the debtor and voluntary for the creditor. If the creditor does not choose to make, or allow, his share of the adjustment, he suffers no inconvenience. For whilst a country’s reserve cannot fall below zero, there is no ceiling which sets an upper limit.”

Both the British and the Americans put forward proposals for a system with more symmetric obligations – but without success.

Having narrowed somewhat at the height of the crisis, the imbalances are now widening again. There is a risk that countries will, out of frustration, impose unilateral and ultimately self-defeating protectionist responses. Because the number of countries involved in the international trading system is now so large, and the countries so diverse, the idea of another Bretton Woods conference is wholly impractical.

The legitimacy and leadership of the G20 would be enhanced if it were seen as representing views of other countries too. That could be achieved if the G20 were to metamorphose into a Governing Council for the IMF, and at the same time acquire a procedure for voting on decisions.

The economic message from the crisis is clear: low-saving countries will reduce their net borrowing from abroad and so will no longer be able to play the role of consumer of last resort. To maintain levels of economic activity, high-saving countries must expand domestic demand and allow their trade surpluses to shrink. This is easier said than done.

It will require changes in prices and most obviously in real exchange rates – via either nominal exchange rates or domestic price levels. In themselves, proposals such as the creation of a new reserve currency do not solve the inconsistency puzzle unless they alter the desire of high-saving countries to run imbalances that are too high to last.