A new emerging landscape for financial stability

The monetary system established during wartime at the Bretton Woods conference (1944) allowed the US dollar to be at the center of the international financial markets until the present time. Such a system had flaws and limits which were exposed already in the early 1960s, when trade imbalances caused tensions within the group of the advanced economies and led to the US abandoning the agreement (de-pegging the dollar from gold) in August 1971.

But that was only the beginning of a second life for the system: on the one hand the US gained an “exorbitant privilege” as the sole issuer of the international reserve currency, with no constrains; on the other, it is precisely by leveraging several Bretton Woods-like mechanisms in the years after 1973 (starting from the Werner plan, which actually predated the crisis) that the European countries built on the process which led to the euro.

 

Today the US dollar (and to some extent the euro as well) still confers the US and its allies an undisputable leadership, even beyond military and geopolitical aspects: It might even seem that, precisely because of the dollar’s characteristics, there are no alternatives, as neither other currencies nor digital surrogates can challenge its dominance. But, whilst already after the 2008 crisis it was perceivable on global markets that the US dollar was slowly losing ground as the international payments currency and the US treasury bonds were also suffering as the key international safe asset, recent developments, including the current’s administration statements and policies, seem to suggest an acceleration.

The step change that we are all watching in the present days looks like a game changer, as the US government, for the first time since 1945, is suggesting a gradual disengagement from the international role of the country which has sustained the value and the role of the dollar for decades. But this would mean that the closest US allies will also need to lessen their dependence on the dollar sooner rather than later.

The reasons for the new policy approach partly reflects the awareness that the US finds itself on a long-term unsustainable path: The country piled up public debt to sustain internal demand, and in turn imports. In more recent years also the stock exchange’s continued growth had a role in creating further spending capability. The combination of all these facts points to a moment when the credibility of the US, and the sustainability of this ever-expanding monetary growth will come to an end. Only, whilst before the consensus was on the quest for a smooth landing over a long time, now it seems that everything might need to change soon.

Is this a bald move or a calculated gamble by the current administration, based on the assumption that there are few alternatives (if any) and that the unwilling Europeans and Chinese will have to adapt to the new wind in any case?

We might recognize that it is very unlikely that any kind of new credible reserve currency could suddenly emerge on the markets. First and foremost, it would likely lack the most precious asset for a currency: trust and credibility. This – taking stock of the euro’s example –  might require a significant political commitment from its constituent members, an empowered central bank to provide liquidity and a clear inter-county coordination and governance rules given that all members would maintain independent central banks and functions.

Everybody is aware of the efforts required so far to establish the euro as a strong international currency, and its flaws – such as the limits to ECB in its monetary actions and the peg on inflation – which are still not wholly resolved.

To even imagine a new replica of the euro scheme managed by the International Monetary Fund – for example building on the existing Special Drawing Rights scheme – would seem an unlikely scenario, given the constraints of the IMF governance (where the US has a veto power), the lack of political commitment by most members, and, last but not least, the fact that an eventual supranational currency in competition with the dollar and the euro is not in the interest of the U.S. and of the EU countries.

A conceptual starting point is the fact that the US might have an interest in developments which would help them to solve the current issues but not being detrimental to the US economy and its baseline role. Therefore, a possible idea could be to consider what happened in Europe in the early 1970s, when the dollar was de-pegged from gold and the European countries had to follow that path (to avoid the risk of depleting their gold reserves): the European new scheme was, actually, a replica of the Bretton Woods one, with free-floating currencies in fixed bands, centered on the German Mark, anchored to an inflation target.  The US did not see this move as hostile: in fact, understanding the European predicament, the fact that stability was assured gained both political and the market consensus.

Today the euro already represents around 20% of the world’s foreign exchange reserves, but there could be a renewed interest and opportunity to increase this role, given the current US position. We could easily imagine a scenario where the euro, still pegged on inflation, would take the place that the German Mark had for Western Europe after 1973, and the British pound, the Canadian and the Australian dollars, and potentially some other currencies, become part of a scheme centered on the euro, with free-floating currencies with fluctuation bands (e.g. as the original ones at 2.25% and 6.25%, but this might be discussed) – such were the values of the bands in the original Bretton Woods scheme as well as in the European system that led to ECU and then the euro.

Floating within limits, including necessary targeted national interventions, could manage currencies to keep them relatively stable, and no longer too exposed to the US dollar’s swings. The creation of such new reserve currency basket could serve to lessen the pressure on the oversized role of the US dollar in the monetary system and help to create a new vehicle for shared Transatlantic interests. This mechanism could also help to relief pressure on the US capital accounts by partially reducing excessive global demand to hold dollars as reserves.

 

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This might be also seen by an early intermediate step along the road toward building a new reserve currency over the longer term, potentially akin to the role assigned to Keynes’ “Bancor” in his first theorization (essentially a currency to be used to settle trade, not a substitute for national ones).

Is this just a pipe dream or a realistic plan? Uncertainty on the future role of the dollar caused by the policies of the current US administration is producing market turmoil and political instability. Which means that there is a “demand” for a new stable currency. And the euro is the only existing credible alternative to the dollar. And if the United Kingdom, Canada and Australia would consider linking their currencies to the euro, markets might suddenly perceive this new pool as the only stable alternative to the dollar, likely even a better alternative for long term settlement purposes (less volatile because there would be a pledge to keep a moderate level of inflation according to the ECB statute). If the purpose is to help international trade, even emerging economies could be lured to join the scheme with their currencies.

How could this idea become reality without prejudice to the interests of both the European countries and the US? The G7 could perhaps be the right forum to establish a new monetary agenda, taking stock of the US positions and allowing the other partners to build up a credible scheme, not as a competitor to the dollar but as a kind of sparring partner. In a second phase even the G7’s own composition and governance might need to be updated to form a new “G7-like” organization which should include all the needed partners.

This scheme might be perceived by markets as trustworthy and credible, given the reputation of its members, but also be seen as an open-ended work in progress.

The main flaw of the whole idea – that would need addressing – would be that there will not be a large common debt as a safe asset. Yet, from a different perspective, this might be its strength: on the one hand, precisely this feature might make it acceptable and even attractive to the US, as the dollar would retain an advantage, at least in the first phase, and see the new euro-centered scheme as a stability tool and not a competitive one. On the other hand, it is exactly by leveraging a Bretton Woods-like agreement that this new scheme might have a very credible positive appeal for markets, being rooted in past successful experiences.