Justin Yifu Lin, Against the Consensus: Reflections on the Great Recession, Cambridge University Press, 273 pages
The author, who was chief economist of the World Bank from 2008 to 2012 and is currently Honorary Dean of the National School of Development, Beijing University, has a clear thesis. The origins of the global financial crisis lay in the functioning of the international monetary system and, specifically, excess liquidity created by US financial deregulation and the Federal Reserve’s loose monetary policy. Imbalances were financed by the accumulation of dollars overseas – the counterpart of an outward flow from the US triggered by low interest rates. It was not caused by an alleged Asian savings glut or China’s payments surplus.
The emerging multiple reserve currency system will be inherently unstable, as each of the ‘legs’ are weak – the dollar, euro and yen. US policy has always pursued domestic objectives and these conflict with the policy required to sustain the dollar’s role as a reserve currency. The rapid rise of the Brics (Brazil, Russia, India, China and South Africa) and fall in the share of world output accounted for by the reserve currency countries will cause growing ‘misalignment’ in the system, specifically in the currency composition of reserves. This instability will give rise to periodic booms and busts in major currency areas. Indeed, gross capital flows have already been volatile – booming in 1995–2007 to annual rates of 15% of world GDP, and then collapsing. Without reform, capital flows will continue to experience frequent ‘sudden stops’. All major reserve currency centres will experience weak growth, intractable public debt problems and volatile exchange rates: “The likely outcome is extreme cycles and serious disruptions in cross-border flows,” says Lin.
The tendency towards instability is exacerbated by the role of global banks in reserve currency centres. These, with their related shadow-banking entities, collect and lend funds globally on the basis of a global asset allocation strategy. When perceived risks are low, they expand their balance sheets and the supply of global liquidity on the basis of a generous supply of reserves by central banks, only to withdraw liquidity suddenly when perceived risks rise. There are two approaches to restoring order: new rules or closer cooperation. But the latter is weak. To ensure sufficient reform by this route, each major country’s policies should aim for global stability. Yet domestic pressures for expansionary monetary policies in reserve centres are too strong. In particular, the US’s privileged position in the international monetary system makes it easy to avoid implementing structural policies or reform its public finances. Lin recognises the need for a consensus to be reached on any major reform of the rules, but argues that political pressures will grow as instability continues. He reviews the costs and benefits of major reforms on the basis of key criteria: efficiency, adjustment (incentives to correct external imbalances), equity and feasibility. Three possible reforms are considered:
1. A bigger and better IMF – involving more funding, automatic quota increases, expanding special drawing right (SDR) allocations, tougher surveillance and governance changes; but such a system would still suffer from the same fragility as the present – as it would be based on existing reserve currencies.
2. A global central bank issuing an international currency; drawing on work by Maurice Obstfeld, Edwin Truman and others. Lin outlines proposals for a composite currency, such as the SDR, where a key problem is that of creating a global governance structure that creates confidence in the ‘full faith and credit’ backing for the currency. If this can be overcome, then a composite currency would have the great benefit of providing an additional supply of safe assets, but would still retain the weaknesses of its component currencies; and conflicts of interest in using national currencies as reserve currencies would persist.
3. Closer international policy coordination among new and old reserve currency centres – which in the last analysis would be, according to Lin, simply a continuation of the present non-system.
Lin’s own proposal is for a currency he calls ‘paper gold’. This would be, like gold, ‘outside’ existing national currencies. It would combine the flexibility of fiat money with the stability of gold, issued by a world central bank and act as a store of value, medium of exchange and unit of account. The central bank would supply money following Milton Friedman’s ‘k% rule’ or a modified ‘Taylor rule’ based on an assessment of the global economic outlook by an independent panel of experts. Countries would retain their national currencies but would have to fix their exchange rates to ‘p-gold’. Parity adjustments would require the permission of an international monetary authority. This “could be granted only in cases of severe balance of payments imbalances (when p-gold reserves had reached critical levels – either too high or too low relative to an agreed norm)”, he says. The demand for reserves by reserve centres would be expected to rise greatly in such a system, while member countries’ policies would be subject to annual IMF surveillance. Seigniorage from the supply of the new currency would be used to fund global public goods.
It is easy to dismiss such ideas as unrealistic. Lin recognises the barriers to abandoning existing national currencies may be insurmountable. There are other problems. The term ‘p-gold’ turns out to be at best merely a marketing device and at worst misleading – it would be a pure fiat currency, with no connection to gold. It is not clear how it would cope with capital movements, which brought down the first Bretton Woods system. But Lin is right to insist the global financial crisis highlighted major deficiencies in the international monetary system and that it remains fragile. To believe current half-baked regulatory reforms will stop the deep forces making for increasing instability without a radical rethinking of existing models of monetary and economic policy is to fly in the face of recent experience. Such contributions to a necessary debate from thoughtful economists in China and other emerging markets should be welcomed and given the attention they deserve.