25 June 2020
The U.S. dollar remains the dominant international currency. But is it really international? The dollar is the national currency of the U.S. and the availability of dollars is firmly determined by monetary conditions in the U.S. The rest of the world uses dollar funding but has no say in its issuance. It means that when the rest of the world needs more dollars it may not be able to get them. This problem has for some time been recognised but remains unsolved. Greater diversification in international payments would be the best answer. Both the Euro Area and China are taking aim. Private currencies could also offer a viable alternative.
If Mercedes Benz, a German car manufacturer, were the Federal Reserve it would only produce as many cars as demanded by its Germany-based car dealership. But Mercedes-Benz produces cars depending on demand in different countries. If China wants more cars but Germany does not, it would still produce and ship cars to China. The Federal Reserve only issues dollars, or changes the price for dollars, if local demand warrants it. The Fed is led by U.S. interests represented at its Federal Open Market Committee, is accountable only to the U.S. Congress and will not subordinate its national policy objectives to the needs of the rest of the world. The Fed is not an international company like Mercedes Benz.
The vulnerabilities of the current set-up are numerous. A recent BIS study points out: “What makes global U.S. dollar funding markets special is the broad participation of non-U.S. entities from all around the world. These participants are often active in U.S. dollar funding markets without access to a stable U.S. dollar funding base or to standing central bank facilities which can supply U.S. dollars during episodes of market stress.” Many are using dollars without recourse to the Fed and that poses a risk.
It is not to say that the Fed may not occasionally cater to the rest of the world. The reactivation and augmentation of the Fed dollar swap lines with foreign central banks in response to covid-19 to accommodate a rising demand for dollar liquidity is a sign that the Fed has become more international. But the dollar swap lines address exceptional circumstances and remain limited to a small set of central banks. By dealing only with foreign central banks, the Fed also maintains some distance to the needs of foreign banks that are the actual users of the dollars.
The problem of using national currencies to manage international liquidity has long been associated with the Triffin Dilemma. It postulates that there is an inherent conflict between the national and international needs. If U.S. monetary conditions are aligned with the rest of the world, it may not matter but when they are not, the rest of the world will suffer from having too many or too few dollars. Large external imbalances and high exchange rate volatility are indicative of these misalignments.
Historically, the dilemma of national currencies was solved with parallel currencies. In nineteenth century, custom union gold and silver coins (Vereinstaler) to facilitate exchange across the German custom union and Austria circulated in parallel with state-issued currencies, were legal tender and minted exclusively on demand by end-users as a function of their transaction needs. The eighteenth century Austrian Maria Theresa Taler silver coin was a major international trading currency through the twentieth century in Africa and the Middle East and issued by decentralised mints strictly on the basis of local demands.
To address the Triffin Dilemma, today there are further options. More currencies used for international transactions would mean more sources of liquidity and less dependence on a single one. While it would not solve the limitations of national currencies, it would spread the risk. The Eurosystem has hinted the euro should play a greater role internationally and China is pushing internationalisation of the renminbi. A truly international currency issued by an international entity like the IMF could be another option though international currencies are hard to design and consensus for the IMF to assume such a role very limited. Similarly, the adoption of a common currency like the euro, offers advantages to its members but remains national in character to non-members. A multilateral currency with broad membership to be used as a parallel currency and that can respond to local demands could be envisaged including as a common regional settlement currency. Private currencies, like libra, could emerge to accommodate international liquidity demand and be able to redraw currency areas outside existing national borders and were issuance is driven by wider and not only national considerations.
The dollar was an international currency. Under the defunct Bretton Woods System through the early 1970s, all currencies were pegged to the dollar and importantly all currency realignments required approval of the IMF. Currencies that were misaligned due to internal or external shocks were revalued and considerations for a revaluation were based on a multilateral dialogue, for example, what are the effects on other IMF members of a sterling devaluation? It is unlikely the Fed will grant a seat at the FOMC to a representative of the rest of the world. So alternative approaches will need to be found. National currencies will always be limited by the fact that they are national. International currencies need to respond to the international environment. Whoever does it best, will be a winner.