7.2 Reforming the Global Reserve System
The second problem is associated with the use of a national currency as the major international currency. The essential problem is that the provision of international liquidity requires that the country supplying the reserve currency run balance-of-payments deficits, a fact that may erode the confidence in that currency. Its major manifestation since the collapse of the original Bretton Woods arrangement has been a tendency of the net investment position of the US to deteriorate. A fact that implies that the currency at the centre of the system has an unstable value.
Having a fiduciary (fiat) currency at the centre of the system also implies that the world economy is hostage to the monetary policy of the main reserve-issuing country. However, although this is a potential problem, the dollar has continued to be the dominant reserve currency.
The third flaw of the system is the inequity bias. Since foreign exchange reserves are invested in safe industrial countries’ assets, and particularly US government securities, reserve accumulation by these countries is nothing else than lending to rich countries at low interest rates. So, this inequity potentially contributes to the instability of the system. There are alternative ways to reform this system. Go to back to Keynes’ proposal for an International Clearing Union or the second would be to fully exploit the role of the SDRs, gradually approaching the aspirations of the 1969 reform of the IMF Articles of Agreement. In practice, these two alternatives can be mixed. Such a combination may be politically more acceptable for the issuers of reserve currencies, particularly for the United States.
The recent crisis has thus clearly shown that the ‘network externalities’ have continued to favour the use of the US dollar as the major international currency, largely as a result of the fact that there is no alternative to the market for US Treasury securities in terms of liquidity and depth. The second reform route would be to enhance the role of the only truly global reserve asset that the world has created: the SDRs.
The most important reform, in any case, would be to finance all IMF lending with SDRs, thus making global monetary creation similar to how central banks create domestic money. This would follow the proposals made by the IMF.
Such reform could also face strong opposition by the United States.
For these reasons, it may be better to think of a mixed system in which national or regional currencies continue to play the major role in private transactions and the SDR performs the functions of reserve asset and medium of exchange in transactions among central banks.
The most important reform would involve, therefore, counter-cyclical allocations of SDRs that help fund counter-cyclical IMF financing. It would also involve designing criteria for SDR allocations that take into account the very different demand for reserves by industrial versus developing countries. The introduction of a substitution account would make this system complementary to a multi-currency system, which would make the reforms more attractive for the United States. This mix is probably the best practical option for moving forward.