Currency - Who Is in Control of The International Monetary System

Who is in control of the international
monetary system?
PAOLA SUBACCHI *
The recent financial crisis has been a catalyst for a general reassessment of the
functioning of the world economy. After all, to paraphrase President Obamas
adviser Rahm Emanuel, a good crisis should not be wasted. Even if the International Monetary System (IMS) was not at the heart of the financial crisis, attention
has been drawn to its shortfalls by manyfrom President Sarkozy of France to
Governor Zhou Xiaochun of the Peoples Bank of China and Governor Mark
Carney of the Bank of Canada.
The monetary system was reshaped in the mid-1940s in the aftermath of
the Second World War and again in the early 1970s after the first oil price
shock. In both cases, global disruption shook the monetary system and caused
prolonged instability. The question now is whether the current system of
floating currency blocs with dollar-based trade and reserves can withstand the
strains of the global adjustment ahead. It is time to consider alternatives for the
IMS and to address the issue of its governance within the context of the postcrisis world economy.
The IMS is where tensions from globalizationand the conflict between
domestic policy goals and international obligationstend to coalesce. As the
economic recovery kicks in, and we are no longer diving together,1 the intrinsic
asymmetry of the system becomes more evident. Governments may be tempted
by protectionist measures if volatile capital flows destabilize currencies and if
the burden of adjustment is perceived as unfairly distributed. And if countries
devalue, their neighbours may again retaliate with tariffs and quotas of their
own.2
*
This article draws on an earlier version published as Paola Subacchi, Introduction: no new Bretton Woods,
but a system in flux, in Paola Subacchi and John Driffill, eds, Beyond the dollar: rethinking the international
monetary system (London: Royal Institute of International Affairs, 2010), pp. 19. For their helpful comments,
I am grateful to Benjamin J. Cohen, John Nuge, John Driffill, DeAnne Julius, Mui Pong Goh, Vanessa Rossi
and the participants in the International Affairs study group held at the Rockefeller Bellagio Center in March
2010, in particular Chatib Basri, Greg Chin, Paolo Guerrieri, Eric Helleiner, Diana Tussie and Wang Yong.
1
Vanessa Rossi, Synchronized dive into recession: focus on damage limitation (Chatham House: Briefing
Paper, IEP BP 08/04, Oct. 2008), pp. 18.
2
Barry Eichengreen shows that the lesson from the 1930s was that currency instability was incompatible
with a multilateral system of free international trade. Insofar as the recovery of trade was necessary for the
restoration of global growth, so were currency stability and, by implications, limits on capital flows: Barry
Eichengreen, Globalizing capital: a history of the international monetary system, 2nd edn (Princeton, NJ: Princeton
University Press, 2008), p. 229.
International Affairs 86: 3 (2010) 665680
2010 The Author(s). Journal Compilation 2010 Blackwell Publishing Ltd/The Royal Institute of International Affairs
Paola Subacchi
But the IMS is also a system in flux. The policy paths that the worlds largest
economiesthose of the US, the euro-zone and Chinaare taking signal
tensions and possible changes ahead. In the US, domestic priorities for growth
and employment may lead to an attitude of benign neglect vis--vis the dollar,
which generally results in a weaker dollar.3 The current strength of the US
currency, which reflects global risk aversion, with investors attracted to the dollar
because of its role as key reserve currency, undermines this stance. Meanwhile,
Chinanow the worlds largest exporter as well as the largest holder of dollar
assetsfaces inflationary pressures as a result of keeping its currency anchored
to the dollar, yet fears the instability and losses in reserve values that a loosening
of the link would entail. China is also creating tensions by keeping its currency
undervalued while preparing for its internationalization. The governments of
the euro-zone, for their part, are finding it difficult to maintain internal stability,
with some members facing extreme budgetary difficulties and painful adjustment
under the discipline of the Eurobond market and without the escape valve of
devaluation. The recent turmoil on the back of Greeces critical debt position
has curbed the euros strength and removed, at least for a while, the temptation
to respond to the upward pressures on the euro with competitive devaluations.4
At the same time, it has clearly shown the euro areas unwillingness to take the
burdenand responsibilitythat goes with issuing the worlds second reserve
currency.5
In this context, dialogue and policy cooperation play an important role
in helping these countries to coordinate their efforts and rebalance the world
economy. Policy cooperation should aim to avoid any protectionist reaction to
exchange rate movements. It should also help prepare the ground for a smooth
transition to a multi-currency system by fostering the exchange of information
among the worlds main trading areas.
Time for rethinking the international monetary system
That the systemor non-systemwas no longer adequate, given the complexity
of a burgeoning world economy, has been clear for some time. The history of
the IMS is punctuated by recurrent debates and attempts to reform, especially
in times of crisis when the confidence of both public and private actors is on
trial. Awareness of the systems limitations has been acute from the days when
the framework established in Bretton Woods in 1944 was discarded. Many
commentators remember the reform attempts by the Group of 30, the Committee
3
Unlike other countries and despite rhetoric that has often implied otherwisefor instance, the importance of
a strong dollar during the Clinton yearsthe US has often left the exchange rate of the dollar to the markets.
4
Usually the strength of the euro reflects the weakness of the dollar rather than strong economic fundamentals
in the euro area.
5
As the European Central Banks President Trichet stressed in an interview to the French daily Le Monde in
November 2009, the ECB has no intention of strengthening the role of the euro as a global reserve currency:
Pierre-Antoine Delhommais and Arnaud Leparmentier, Interview with Jean-Claude Trichet, President of
the ECB, Le Monde, 17 Nov. 2009, http://www.ecb.int/press/key/date/2009/html/sp091117.en.html, accessed
17 April 2010.
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Who is in control of the international monetary system?

of 20 and the Plaza Agreement, and see very little that is different in the current
debate.6 Is it correct to think that we have been here before?
The world economy has undergone such a rapid growth and change since the
early 1990s that care is required when making direct comparisons with earlier
periods. Not only is the size of the world economy much greater, but the role of
the private sector is much more prominent. Trade and financial integration have
resulted in worryingly large financial imbalances and a substantial accumulation
of foreign exchange reserves by countries with a balance of payments surplus. The
speed and magnitude of the recent crisisgreater than all previous crises in the
postwar yearshave added to international tensions. The exchange rates of major
international currencies are now largely determined by international markets; the
markets also play a major role in governing the creation and distribution of international liquidity,7 and in deciding which businesses, financial institutions and
countries are creditworthy and under what conditions. This degree of integration, and the stronger influence of market forces, surely make the current IMS
different not only from the one that was established at Bretton Woods, but also
from the one that replaced it in the early 1970s.8
As a result the debate has to be reframed and refreshed to include recent developments in the world economy. Such an approach should be holistic rather than
focusing on particular components of the system such as currencies and exchange
rates. Also, the scope of the debate should be broadened to take into account the
shift in the global economic order and the emergence of new economic powers.
The aim of this article is to provide an overview of the IMS as the system that
governs the creation and management of the liquidity necessary to support trade
and investment within the world economy. Looking at the IMS in a systemic
and interconnected way, I argue that in todays larger and more integrated world
economy the dependence on the dollar as the basis of both trade flows and financial reserves has clearly become excessive, creating a system that is fundamentally unbalanced. I will then argue that the existing IMS needs to evolve into
a multicurrency system in which a number of international currencies, ideally
representing the main trading areas, have the functions of storing value and
providing the unit of measure. A multicurrency system would respond more
flexibly to the demand for liquidity and would provide a way to diversify the
accumulation of reserve assets. Such a system would be better suited to a multipolar world economy. I therefore suggest that the IMS needs to switch from being
based on one primary reserve currency to being a multicurrency reserve system
which could include international currencies as well as a supranational currency.
6
See e.g. Edwin Truman, The international monetary system and global imbalances, Jan. 2010, http://www.
iie.com/publications/papers/truman0110.pdf, accessed 17 April 2010; William Cline, The case for a new Plaza
agreement, Policy Briefs in International Economics, PB0504, Dec. 2005 (Washington DC: Institute for
International Economics).
7
This can be reasonably dated to the development of international bank lending in the 1970s. See Benjamin
J. Cohen and Fabio Basagni, Banks and the balance of payment: private lending in the international adjustment process
(Atlantic Institute for International Affairs: Paris, 1981).
8
Fabrizio Saccomanni, Managing international financial instability: national tamers versus global tigers (Cheltenham:
Edward Elgar, 2008), pp. 68.
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Paola Subacchi
This is a long-term scenario that will require a great deal of thought and preparation. A multicurrency system that will eventually replace the US dollar as the
worlds monetary hegemon would be the system best able to support a healthy and
flexible multipolar world economy; but, from a governance perspective, it could
become a leaderless currency system if the transition is not properly prepared.9
My contribution here is to make the case for policy cooperation as a means to
manage the transition towards a multicurrency system. I am aware, however, that
this is only a start, and that more work needs to be done to set out the concrete
steps in policy cooperation.
The focus of this article, though it inevitably discusses the role of the dollar,
is on the goals and principles underpinning the IMS. A key question is whether
the IMS is adequate to respond to the challenges posed by the emerging economic
order. In addressing this question, the article brings in the views of emerging
market economies, China in particular, and their concerns about the limitations
of the existing system and the increasingly asymmetric burden of adjustment that
it imposes.
The article also touches upon the constraints that the country issuing the
primary reserve currency faces in order to maintain confidence in the value of
that currency. This entails avoiding conflict between the domestic policies of the
issuing country and its international obligations, even if they cannot be aligned.
In times of domestic stress, this can prove difficult and burdensome. When the
issuer of the primary reserve currency is seen to put its domestic concerns first, as
is almost inevitable, foreign holders of the primary currency become concerned
about the consequences for and possible losses on their holdings.
The article concludes that the IMS will mutate gradually, through a long process
of incremental change and adjustment. While the rationale for change is present,
any abrupt move away from the dollar carries big risks of trade flow disruption
and exchange value losses. The system is currently locked in a form of stable
disequilibrium where the status quo carries the lowest risk for most players in the
short term. This, however, does not mean that things will remain unchanged. The
steps taken by some countries, notably China,10 create the impression that this
decade is one of transition, rather than a Bretton Woods moment.11 As a result,
there will be not a sudden shift away from the dollar as the worlds major trading
and reserve currency, but a long transitionor interregnum, to borrow the term
in Eric Helleiners article in this issue. The key point is that, whatever the final
outcome, the shape of the IMS for the twenty-first century will be influenced
significantly by the views, interests and requirements of the emerging powers.
Benjamin J. Cohen, The international monetary system: diffusion and ambiguity, International Affairs 84: 3,
May 2008, pp. 45370.
10
Peoples Bank of China, Administrative rules on pilot program of renminbi settlement of cross-border trade
transactions, 2 July 2009, http://www.pbc.gov.cn/english//detail.asp?col=6800&ID=82, accessed 17 April
2010.
11
See Eric Helleiners contribution to this special issue.
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Goals, principles and actors
The IMS embodies the set of rules, standards, practices and institutions that
govern the flow of money and access to international credit, provide stability to
the foreign exchange markets and facilitate the adjustment of balance of payments
disequilibria.12 Barry Eichengreen describes the IMS as the glue that binds the
national economies together.13 It is also the link between the real economy and
the financial system.
When discussing reforms and future developments, it is important to look at
the IMS within the context of international politics and of the balance of power
and its shiftson the world stage. This means considering how the governance of
the system is influenced by the tradeoffs between domestic policy priorities and
international obligations. It is therefore necessary to take into account the interests
of the main players as well as the surfacing of political and military tensions that
can erode the solidarity upon which financial cooperation needs to be based.14
Providing the liquidity necessary to regulate and facilitate the international
trade of goods and services and capital account transactions is the main purpose
of the IMS. We need money that can be acceptable to creditors to settle inter
national transactions, that can be used to invoice trade, that market players trust
as means of payment and store of value, and that can be made readily available
to meet demand. Because money is also used by the official sector, we equally
need currencies that can be used as a reference for central rates, as a means of
intervention in foreign exchange (FX) markets and to form the basis for holding
reserves. This money might take the form of gold or silver, as in the past, or
US dollars, euros and yen, as is the case today.15 Participating countries must
have financial reserves sufficient to meet balance of payments deficits caused by
sudden economic shocks. Provision of optimal international liquidity facilitates
the functioning of the world economy: neither underprovision nor overprovision
is desirable.
This leads to the other feature of the IMS, which is adjustment. An efficient
IMS should help national economies to restore equilibrium in their international
accounts and minimize the costs of making such adjustments. Every adjustment policy results in costs, and some methods of adjustment are considerably
more costly than others, both for individual economies and for the overall world
economy.
The IMS should be stable, without protracted and wide fluctuations. There are
many ways to achieve this objective, from tying every currency to a non-monetary
assetgold is normally the asset of choiceto following a monetary leader
who can ensure future policies conducive to stability on the basis of past policies.
12
For some definitions, see Saccomanni, Managing international financial instability; Eichengreen, Globalizing capital.
Eichengreen, Globalizing capital, p. 1.
This was the case with Britain, Germany and France on the eve of the First World War. See Eichengreen,
Globalizing capital, p. 42.
15
Eichengreen, Globalizing capital, p. 8.
13

14
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Paola Subacchi
Stability is linked to confidence, which is the other principle that underpins the
IMS. In a currency-based system like the current one, currency holders must have
confidence that the reserve-currency country will not pursue inflationary policies
leading to devaluation of their own reserves. Countries that lose that confidence
will shift the composition of their reserves.
The IMS is not only a system for clearing international payments, but also
functions as a market where international currencies are bought and sold every day
for commercial and financial reasons, and where profits are made from fluctuations
in exchange rates. In the last two decades the expansion of the FX market has been
large and fast, as is shown by the daily turnover on the global FX market. Since
April 1989, when records began, FX transactions have grown more than fivefold.16
Growth was particularly strong between 2004 and 2007 as a result of increased
activity by investor groups including hedge funds.17
Market forces and national authorities
It can be argued that a stronger presence of market actors has made the IMS more
unstable and vulnerable, less reactive to automatic mechanisms to restore equilibrium and less responsive to policies. Transactions carried out on FX markets can
generate exchange rate fluctuations that in turn can affect a currencys purchasing
power and balance of payments. Monetary authorities can intervene in the market
by acting as buyers or sellers of financial assets for monetary and exchange rate
purposes. Interventions, however, are expensive and can carry a degree of risk if
their impact is not well calibrated.
The relationship between monetary authorities and financial markets changes
in line with the evolution of the economic, political and institutional context,18
both in individual countries and internationally.19 Market actors and monetary
authorities tend to have divergent goalsor, simply, their short-term objectives
tend to diverge. For the former, the main goal is the optimum combination of
risk and return on investments. For the latter, the goal is monetary and financial
stability.
Because of the fundamental divergence of their goals, and given the global
nature of the market and the national jurisdiction of authorities,20 markets
and monetary authorities are juxtaposed in an intrinsically tense and complex
relationship. Harnessing the market and establishing a regulatory and institutional
16
The survey on which data are based is conducted only every three years, and the turnover levels are measured
only for the month of April of the reference year. See Bank for International Settlements, Triennial central
bank survey of foreign exchange and derivatives market activity in April 2007: preliminary global results,
Basel, Switzerland, Sept. 2007.
17
Bank for International Settlements, Triennial central bank survey of foreign exchange and derivatives market
activity in April 2007, p. 1.
18
Susan Strange identified this environment in terms of mad money or casino capitalism. See Susan Strange,
Casino capitalism (Manchester: Manchester University Press, 1986), and Mad money: when markets outgrow governments (Ann Arbour, MI: University of Michigan Press, 1998).
19
Saccomanni, Managing international financial instability, p. 4. See also Horst Siebert, Rules for the global economy
(Princeton, NJ, and Oxford: Princeton University Press, 2009).
20
Saccomanni, Managing international financial instability, p. 4.
670

framework help to tackle such a problematic relationship in a comprehensive and
systematic way. This was the solution devised at the Bretton Woods conference
in 1944, where rules were drawn up and the institutions established for an IMS
based on intergovernmental cooperation.21 Within the Bretton Woods system,
monetary authorities at both national and international level managed to condition and control the market through the international coordination of economic
policies. The result of this was monetary stability worldwide.22
But the system did not last long. It would be impossible to restore it now,
because of the fundamental changes that have occurred in the world economy
and the role of market forces that have transformed the way the IMS functions.
If the Bretton Woods system was mainly led and influenced by governments and
the IMF, todays system is led and influenced to a much greater degree by market
forces.23
But the current system is also fundamentally different from Bretton Woods
because of the shift that has taken place in the balance of power. The Bretton
Woods system was an expression, and a consequence, of the US hegemonic
position in the western world in the aftermath of the Second World War. Since
the late 1990s the US has been losing relative weight in economic and financial
matters in the face of the economic dynamism of emerging market economies,
notably China.
Confidence and the primary reserve currency
The current IMS is currency-based. The demand for liquidity is met through
the primary reserve currencythat is, the currency most widely used in international transactions and held as an asset. Such a system normally responds more
flexibly to demand for liquidity than a non-currency-based system such as the
gold standard.24 As a currency-based IMS is effectively based on credit, confidence
and trust are critical to its stability.25 Actors within the IMS must have confidence
that the reserve-currency country will pursue policies consistent with the goal of
stability. They must also trust the reserve-currency country to meet the demand
for liquidity. Loss of confidence and trust can trigger runs on banks and speculation and these can endanger the stability of the financial system. For example,
when in 1931 sterlingfollowed by the dollar and the other main currencies
abandoned the gold standard, market pressures were too strong to be contained
and governments further reacted by introducing restrictions on trade and foreign
exchange operations. This marked the collapse of the international economic and
trading system.
21

22

23

24
Harold James, International monetary cooperation since Bretton Woods (Washington DC: IMF, 1996).
The gold standard is the best-known example of commodity-money arrangements that preceded the development of paper money. Under the gold standard regime, maintaining convertibility was governments policy
priority.
25
In economic literature the concepts of confidence and trust are used as synonymous. Here I prefer to keep
them separate as they underlie the two features of money: value (confidence) and liquidity (trust).
671
Paola Subacchi
The country that issues the primary reserve currency has to have a vibrant
economy, deep financial markets and a range of short-term instruments for which
there is strong foreign demand.26 These are the conditions necessary to encourage
the initial adoption of a currency for international purposes. In order to sustain
the currencys international use over time, confidence must be maintained. This
means that the country issuing the primary reserve currency must simultaneously
preserve the stability of the currencys purchasing power and an inflation rate
consistent with the preferences of the primary reserve-currency holders. Ideally,
from the point of view of the world, the supplier of the global reserve asset would
behave in a public-spirited way and so give exchange rate stability priority over
domestic policy objectives such as employment and growth. For much of the time
the two sets of objectivesdomestic and internationalmay be compatible, and the
balancing act sustained. But the risk is that in times of crisis or when the two sets of
objectives are mutually opposed, the reserve-currency country will put its domestic
concerns and objectives first, with the result that confidence will be eroded.
There is an unresolved contradiction in the role of primary reserve country.
To acquire such a status it needs to have a dynamic economy and to maintain
international confidence and trust. However, in order to provide the key reserve
currency/asset it may end up running a deficit in its current account. Confidence
begins to erode in the presence of persistent current account deficits,27 undermining the goal of maintaining confidence and trust. At this point other countries
have the option of taking on the burden of adjustmentthat is, accepting some
degree of revaluation of their currenciesor switching to other reserve assets.
However, in a one-reserve currency system the latter is not an option. If other
countries are not prepared to appreciate their currencies, the current account
deficit of the reserve currency continues to widen. This has been the story over
the past 40 years, even if the lack of viable alternatives to the US dollar has kept
the system locked in stable disequilibrium all this time.
Historical evidence shows that the issuer of the key reserve currency eventually
switches from a current account surplus to a deficit. Immediately after the Second
World War the US ran a current account surplus, mainly thanks to its overseas
investments. But over the years this proved increasingly difficult to sustain, and
the US eventually became a large net importer of goods and services while the rest
of the world became its creditor. In the 1960s Germany, France, Italy and Japan, all
with substantial balance of payments surpluses vis--vis the US, were not willing
to revalue their currencies or increase domestic demand, preferring instead to keep
a competitive exchange rate and to bolster their dollar reserves.28 The result was
26
The country that issues the primary reserve currency enjoys low transaction costs because its currency is used
for many transactions. It also has the advantage of seigniorage.
27
This is not, however, a necessary condition, and no theory argues that a current account deficit is needed. A
key currency can be provided even with a current account surplus, through intermediation on capital account,
as the US did for many years after the Second World War.
28
Germany undertook modest revaluations in 1961 and 1969. For an account of those years, see Eichengreen,
Globalizing capital; Jeffrey A. Frieden, Global capitalism: its fall and rise in the twentieth century (New York: Norton,
2006). Specifically on Germany, see David Marsh, The euro: the politics of the new global currency (New Haven,
CT, and London: Yale University Press, 2009), pp. 5057.
672

the creation of international liquidity denominated in dollars that far exceeded
demand, fuelling inflationary demand worldwide.
The system began to break down in spring 1971 with massive flows from the
dollar to the deutschmark. Concerns about inflation pushed Germany to revalue
its currency, and this move was then followed by other European countries. But
confidence in the dollar was by then eroded, and in August the Nixon administration suspended the commitment to provide gold to official foreign holders of
dollars at $35 an ounce and de facto overthrew the Bretton Woods system.29 The
dollarand the world economy with itsubsequently went through years of
trouble, during which many thought the dollar was doomed. However, because
there was no real alternative, its overthrow never materialized.
An inadequate system for todays world economy?
Increased integration among the primary regions of the worldEurope, Asia and
the USthe expansion of global markets and the rise of the big emerging markets
have contributed significantly to the growth of the world economy in both size
and complexity since the early 1990s.30 The twin forces behind this expansion have
been trade and capital flows. Indeed, they have grown at a far faster rate than world
GDP and have outstripped growth in US GDP, which approximately doubled
between 1993 and 2008. This is important as the implied demand for US dollars
(related to growth in international transactions) has clearly both risen rapidly and
increased as a share of US GDP, putting strain on the US by encouraging the rise
in its current account deficit. As an example of this expansion in the international
economy, world trade in goods expanded more than fourfold, from US$3.7 trillion
in 1993 to US$16.1 trillion in 2008. Of this US$12.4 trillion increase, $7 trillion
came from growth of trade conducted by the US, EU, Japan and China.31
During the same period financial integration also developed significantly, with
big expansion in capital flows and FX reserves, reflecting growing trade surpluses
in Asia in particular. According to the available figures from the IMF, capital flows
increased from just under US$0.5 trillion in 1994 to US$3.4 trillion in 2007.32 Of
this total, foreign direct investment (FDI) rose from about US$0.25 trillion in 1994
to US$2.2 trillion in 2007. Total FX reserves multiplied from US$1.5 trillion to
US$7.5 trillion by mid-2009.33 Two countries, China and Japan, accounted for
US$3 trillion of these reserves.
Trade and investment integration and the expansion of the world economy
have boosted international transactions, highlighting the limitations of a monetary
29
In the private markets the price of an ounce of gold was US$42.73, http://www.research.gold.org/prices,
accessed 11 Feb. 2010. The US did not consult with the IMF, nor did it inform the IMF managing director.
Instead, the US communicated its decision after it was taken.
30
According to World Bank figures, between 1993 and 2008 it grew from US$25.5 trillion to US$40.3 trillion
in constant 2000 dollars.
31
Figures from WTO website, http://stat.wto.org, accessed Dec. 2009 and Jan. 2010.
32
The year 1994 was the first for which the IMF published a world total.
33
IMF, Currency composition of official foreign exchange (COFER), updated 30 Dec. 2009, http://www.imf.
org/external/np/sta/cofer/eng/index.htm, accessed 1 March 2010.
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Paola Subacchi
system and policies that were designed for a less internationalized world economy.34
A well-constructed IMS should allow countries to run current account surpluses
and deficits and accumulate net financial claims on each other. This is a mechanical
clearing role, which the current IMS seems to manage well. The second function
of a well-constructed IMS is to provide some form of mechanism to encourage a
return to more balanced trading.35 This is where the current system seems to have
problems, and it is also an area where policies matter.
Is the dollar-based system coming to an end?
The increasingly important role of market actors has changed the function of
the primary reserve currency that is held not only for intervention reasons but,
increasingly, as an assetto preserve the nations wealth. The dollar remains
the primary reserve currency, representing about 62 per cent of total allocated
FX reserves in 2009, higher than the level reached in 1995 when the IMF started
systematic data collection. In just over ten years since its introduction the euro has
established itself as the second reserve currency, with about 27 per cent of total
foreign exchange reserves in 2009.36 While the euro has not posed any threat to the
dollar in terms of replacing it,37 it has drawn attention to the possibility of having
more than one reserve currency. In particular, the euro market has the liquidity
and stability necessary to make it attractive to FX reserve holders.38
Because of the role of the reserve currency as a store of value and the large
accumulation of FX reserves following the Asian crisis of 1997, countries with
large FX holdings such as China are concerned about the potential fragility of the
current IMS.39 The US, as the main engine of growth for the world economy and
the country issuing the primary reserve currency, runs a current account deficit.40
Even if the recession has contributed to reducing the US trade deficit and boosting
the US aggregate savings rateto nearly 9 per cent in 2008, up from little more
than zero in 2006it is likely that the trade deficit will simply pick up again if US
consumers resume past patterns of behaviour.41 In addition, the fiscal stimulus and
bank rescues implemented in response to the recession have already caused the US
34
Peter Kenen stressed more than 20 years ago that stability cannot be achieved merely by endorsing it. Someone has to act differently: Peter Kenen, Managing exchange rates (London: RIIA/Routledge, 1988), p. 43.
35
These days a desirable outcome would be more sustainable imbalances that still reflect underlying differences
in national savings and investment rates.
36
These figures refer to allocated reserves: http://www.imf.org/external/np/sta/cofer/eng/cofer.pdf, accessed
1 March 2010.
37
In the early days of the euros creation the debate was couched in strongly competitive terms, pitting the
dollar against the euro: see e.g. Barry Eichengreen, The euro as a reserve currency, Journal of the Japanese and
International Economies 12: 4, 1998, pp. 483506.
38
At the time of writing the spectre of Greek default is still haunting the euro area. Although the probability
of this happening is low, it still creates uncertainty and volatility.
39
China holds over US$2 trillion in dollars and dollar-denominated assets as a result of its large current account
surplus and FDI inflows. It is followed by Japan with about half that amount.
40
It reached a peak of about 6% of GDP in 2006 before falling to 4.9% in 2008 when the recession struck and
2.6% in 2009. Data from IMF World Economic Outlook Database, available from http://www.imf.org/external/pubs/ft/weo/2009/02/weodata/index.aspx, accessed 17 April 2010.
41
Data available from the website of the Bureau of Economic Accounts, US Department of Commerce, http://
www.bea.gov/international/index.htm, accessed 17 April 2010.
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deficit to balloon to record levels, and this has dramatically increased the volume
of debt issuance. This high deficit could trigger a crisis of confidence in the US
currency, leading the world community to withdraw its unquestioning faith in
the dollar and dollar assetsand such a loss in confidence would damage the scope
for the dollar to continue acting as the dominant reserve currency. Is the Triffin
dilemma back from the 1960s?42
Despite some reasonable concern that the position of the US dollar as the
primary reserve currency may be challenged and approaching a tipping point,43
the end may still be some years away. This is due to strong network externalitiesthe benefits if many people use the dollarand a lack of strong contenders
to replace it,44 and also to the fact that the global crisis has served to strengthen the
dollars role as a safe-haven currency. More fundamentally, no other countryor
regionis yet close to achieving the dominance that the US economy acquired
in the aftermath of the Second World War.
Whatever the final outcome, the short-term options are clearly limited. Historical evidence shows how sterling was gradually replaced by the dollar as the reserve
currency. Contrary to the popular conception that this change occurred at the end
of the Second World War, in fact the transitional process was much longer, owing
to the structure of the international monetary system and collective global
interest in its continuation.45
From a primary reserve currency to a multipolar reserve currency
The current system is structured in such a way that all players are locked by mutual
interest in a form of stable disequilibrium. Disentanglement is likely to be long
and complicated. This is evident in Chinas position as the largest holder of dollar
reserves: hence its interest in maintaining the status quo. There are few options
for bringing an end to the current system, and all need to take into account what
China wants and the extent of its economic development. As a result, any change
is going to have to be a long-term process.
One option is a partial or total switch to a multicurrency reserve system. This
would respond better to the needs of a multipolar economy and would provide
the necessary liquidity without the constraints imposed by a single primary reserve
currency system.46 Beijing seems to favour a shift to a multipolar reserve system.
42
The Triffin dilemma is named after the Belgian economist Robert Triffin who, in his testimony to the
Congress in 1960, exposed a fundamental problem in the international monetary system.
43
John Nuge, Reconsidering the reserve currency question, in Subacchi and Driffill, Beyond the dollar, pp.
1015.
44
On the role of the euro, see Benjamin Cohen and Paola Subacchi, A one-and-a-half currency system, Journal
of International Affairs 62: 1, Fall/Winter 2008, pp. 15163.
45
Catherine R. Schenk, Lessons from history, in Subacchi and Driffill, Beyond the dollar, pp. 1622.
46
It would also free the US from the burden of providing liquidity. Bergsten makes the argument that the
dominance of the dollar is no longer in the US national interest because it has made it easier for the US to
run large trade and current account deficits, thereby contributing to low interest rates, excessive liquidity and
loose monetary policy and hence leading to the overleveraging and underpricing of risk that have characterized the recent crisis. See Fred Bergsten, The dollar and the deficits: how Washington can prevent the next
crisis, Foreign Affairs 88: 6, Nov.Dec. 2009, pp. 2038.
675
Paola Subacchi
However, such a shift has to be gradual in order to avoid undermining the value
of existing dollar reserves.
The gradual shift to a multipolar reserve system would require two steps,
which can proceed either in parallel or in sequence.47 One step is to facilitate an
orderly diversification to a multicurrency regime in which the dollar, the euro and
a regional Asian currency share the role of global reserve currency, backstopped
by special drawing rights (SDRs)a multipolar reserve currency that could
provide a new competitive mechanism to help discipline the issuing countries.
The other is the internationalization of the Chinese renminbi. Both depend on
Chinas domestic economic policies and on the development of a liquid and open
capital market. The creation in 2009 of a pilot scheme for the use of the renminbi
in cross-border trade settlement signals Beijings intention of moving ahead with
the internationalization of its currency and eventually its convertibility. It is also
possible that a convertible renminbi would be included in the basket of constituent
currencies of the SDR in 2020, if not in 2015, as the SDR is rebalanced every five
years.48
Another option is to switch to the use of a supranational reserve currency. This
is also unlikely to take place in the near future. However, the greater use of SDRs,
through incremental increases in supply and demand, might be an intermediate
step in that direction.49
Harnessing the system through policy cooperation
From the above discussion it is clear both that the current IMS is inadequate, and
that it cannot be easily or quickly reformed or replaced as the options currently
available are either normatively undesirable or politically impossible. Any change
to the current system will take a long time to implement; this process should be
gradual and include complementarity, multilateralism and symmetry of adjustment. In the meantime, however, it is critical to ensure the sustainability of the
old system and to avoid its collapse, with all the related shocks and costs that this
might entail.
As international monetary arrangements imply strong network externalities,
the interim solution of keeping the current system functioning as smoothly as
possible requires a collective effort. This means achieving some degree of policy
47
This depends on how fast the internationalization of the Chinese currency happens and/or whether another
currency, either the Japanese yen or a synthetic, common currency for East Asia, can be used as regional
reserve currency.
48
The Chinese have announced plans to build Shanghai into an international financial centre by 2020, which
suggests that the renminbi might be convertible by then.
49
For instance, the SDR supply can be expanded in two ways: (1) through a regular allocation of SDRs via
a new International Monetary Policy Committee which is linked to the IMF; (2) through the creation of a
substitution account whereby IMF member countries could deposit various currencies and obtain the equivalent value in SDRs. By allowing only one-way substitution in the initial stagethat is, countries are able to
obtain SDRs by exchanging their currencies, but not vice versathe issue of who bears exchange rate risk
will be avoided. By allowing private agents to open SDR accounts with the IMF and by creating an SDR
settlement system, the use of SDRs may be made more attractive to these agents. See DeAnne Julius, A
roadmap for SDR evolution, in Subacchi and Driffill, Beyond the dollar, pp. 3642.
676

cooperation, with countries exchanging information about current and future
policy decisions while retaining their ability to pursue policies that are in their
best interests.50
Greater consultation is necessary to ensure that the spillovers, which include
the adjustment of balance of payments surpluses and deficits, and other imbalances, are minimized.51 Dialogue between the reserve currency issuing country
and individual or groups of countries using this reserve currency should become
mandatory in order to ensure that the parties pre-specify actions to be taken to
address the imbalances. This means, for example, engaging the two big surplus
areas, the Middle East and East Asia, in devising a transfer of the burden of
consumption towards surplus areasa task that Federal Reserve Chairman Ben
Bernanke recently called extraordinarily urgent.52 Many believe that this requires
intervention on both exchange rate flexibility, which involves monetary policy
autonomy, and the level of the exchange rate itself.
Policy cooperation is an increasingly relevant tool for the management of a
complex world economy, but it is difficult to implement. Negotiating costs and
distributional problems tend to increase in proportion to the number of countries
around the table, making the institutionalization of objectives difficult.53 Each
government will be tempted to free-ride by withholding agreement unless it
secures concessions.
For the realignment of exchange rates, which could help put the IMS on a
more stable basis, policy cooperation is essential, especially for those countries
heavily engaged in international trade. As currency appreciation can damage the
international price competitiveness of the country that implements it relative
to that of neighbouring countries, one reasonable policy option is to agree on
collective currency appreciation vis--vis the dollar, which does not differentially affect individual countries relative price competitiveness. Asia, once again,
is the region where countries most acutely need to coordinate their exchange rate
policies so as to avoid competitive devaluations. This requires a convergence of
exchange rate regimes. The existing policy dialogue processes among the regions
finance ministers (such as ASEAN+3) and central bank governors (such as the
Executives Meeting of East Asia Pacific Central Banks: EMEAP)can play a
critical role.54
Strong leadership by a nation or a group of nations with an interest in
maintaining the system is necessary to facilitate cooperation and the inter
nalization of externalities, to reconcile political differences and to discourage any
50

51
Feldstein, cited in Kenen, Managing exchange rates, p. 91.

Christopher Meissner, Systemic changes in the international monetary system and the need for coordination,
cooperation and enforcement, in Subacchi and Driffill, Beyond the dollar, pp. 5763.
52
Krishna Guha, Bernanke warns on imbalance risks, Financial Times, 19 Oct. 2009. It can be argued that, like
the country issuing the primary reserve currency, emerging countries face the dilemma and difficulty of
putting what is good for the world ahead of what is good for their own economy.
53
In policy cooperation/coordination the concept of public goods is central. These are those goods that either
are not supplied by the market or are supplied in insufficient quantity. They have two critical properties. First,
it does not cost anything for an additional individual to enjoy the benefits of the public goods. Second, it is,
in general, difficult or impossible to exclude individuals from the enjoyment of the public goods.
54
ASEAN+3 includes China, Japan and the Republic of Korea.
677
Paola Subacchi
opportunistic or non-cooperative behaviour. This group should take the lead on
a number of issues, from providing and managing the key reserve currency to
monitoring exchange rate arrangements and the building up of potential imbalances. This group could be a caucus within the G20 that includes the issuers of the
main reserve currenciesthe US, the euro area, UK and Japantogether with
the largest holder of FX reservesChina.55
This group should work closely with the IMF to build an institutional framework for the governance and management of the IMS.56 The recent upgrading of
the IMF by the G20 as the main international crisis fighter, and the willingness of
some G20 countries to include reforms to the IMS on the future agenda,57 signal
that the IMF may become a key institution within the process of reforming the
IMS. There are of course several problems with this, from the governance of
the Fundwhich has yet to change to match the altered political and economic
landscapeto the deep mistrust of it that has built up over the years among
developing countries, especially after the poor handling of the Asian financial
crisis in 19978.
Mistrust of the IMF also has roots in the perception that its surveillance is
asymmetric, with the greatest attention paid to the weaker developing states or
those in surplus, while the major deficit and surplus countries, the US and China,
are treated more tolerantly. A preliminary step towards a thorough reform of IMF
governance would be the adoption of stronger and more consistent surveillance,
with, for instance, the IMF issuing its own quarterly report on exchange rate
policies with a set of benchmarks to assess each states adherence to these; assessing
a wider range of policiescovering the monetary, fiscal, exchange rate and financial sectorsinstead of focusing narrowly on exchange rates; and insulating IMF
staff from political pressures from their own board.58
Conclusion
There is a fundamental contradiction and an intrinsic tension in the continued
existence of a monetary hegemon that issues the primary reserve currency as the
world moves towards a multipolar economy. If this is not resolved, other episodes
of financial and monetary instability, of an intensity similar to that of the global
financial crisis in 20072008, could materialize.
55
Paola Subacchi and Alexei Monsarrat, eds, New ideas for the London summit: recommendations to the G20 leaders, a
Chatham House and Atlantic Council report (London: Royal Institute of International Affairs, 2009). Historically the leadership in international monetary affairs was provided by the dominant economic and military
power, but the shift to a multipolar economic order makes this option no longer viable: Robert Gilpin, Global
political economy: understanding the international economic order (Princeton, NJ: Princeton University Press, 2001),
p. 243.
56
The international trade system relies on the WTO as an institutional framework, albeit an imperfect one.
Because of the hegemony of the dollar and the role of the IMF in monetary affairs, an institutional framework
for the IMS was never developed.
57
See Sarkozys comments in Davos in 2010, cited in Katrin Bennhold, At Davos, Sarkozy calls for global finance
rules, New York Times, 27 Jan. 2010.
58
Jeffrey Chwieroth, IMF surveillance: getting tough on exchange rate policies, in Subacchi and Driffill,
Beyond the dollar, pp. 526.
678

As discussed in this article, there is at present no easy solution to resolving
the dilemmas of the current IMS, which relies so heavily on the dollar. A
multicurrency systemthe most plausible scenariois in its infancy. The euro
is suffering from governance problems,59 and the critical fiscal position of a
number of euro member states makes the short-term outlook very unclear. As
for Asia, it is not yet clear which currency will take the lead. Many are prepared
to bet on the renminbi,60 but the internationalization of the Chinese currency
will take many years to be fully implemented. The Japanese yen does not seem
a viable option, given its relatively low degree of internationalization compared
with the dollar and even with the euro. Political issues in East Asia would
make the use of the yen as a regional currency even more complicated. And
the possibility of a synthetic common currency on the model of Europes ECU
seems equally remote. This does not mean, however, giving up the search for
an international monetary system that allows countries to run current account
surpluses and deficits and accumulate net financial claims on each other while
providing intrinsic and symmetric pressures towards more balanced trading. This
is where the current dollar-based system fails, and where G20 impetus for change
is needed.
Even if policy cooperation is still a very imperfect tool and unsuccessful experiments in the past have shaken peoples confidence in concerted action, it is of
critical importance that efforts to reform the IMS are not cast aside. For if they
are, the risk of broadening the scope for governments to intervene by means of
either uncompetitive devaluations or protectionist measures will rise significantly.
The US may be heading towards increasing difficulty in reconciling domestic
policy objectives with policy settings that are consistent with global exchange
rate stability. The governments of the euro-zone, on the other hand, may find it
difficult to justify a strong euro with their constituencies. Such a context calls for
some greater level of international cooperation.
In this article I have argued that the IMS is increasingly unable to embody the
fundamental principles of confidence, stability and adjustment. While managing
the transition and broadening the debate on the future of the IMS, it is essential to
restore and manage confidence, and to get countries to become more engaged in
reforming the existing IMS arrangements. Again, policy cooperation is essential.
In fact, as soon as the FX market regains confidence in the US, the dollar may even
begin to appreciate. This clearly risks triggering further problems with imbalances
unless efforts are made to offset such a trend, for increased confidence in the dollar
sets the system up for a greater fall in the future. A more desirable outcome is for
China to return to its previous policy of steadily revaluing the renminbi once
global growth looks more secure. Such a move could help defuse current concerns
about the imminent collapse of the dollar-based IMS, creating a breathing space in
which to address wider reforms of this creaking system. To open up this space it
59

60
On this see Cohen and Subacchi, A one-and-a-half currency system.

Jim ONeil, A twenty-first century international monetary system: two scenarios, in Subacchi and Driffill,
Beyond the dollar, pp. 435.
679
Paola Subacchi
is important to ensure the sustainability of the system and avoid its collapse, with
all the related shocks and costs that would entail.
And if the country issuing the primary reserve currency is no longer able to
provide the public goods associated with that position, we need some greater
level of provision that is in principle capable of making all participants better
off. The problem that participants in the IMS must solve is how to translate this
into practice. Domestic policy objectives tend to conflict with the provision of
public goods. This is where policy cooperation comes to hand. Only through a
coordinated effort can countriesboth new and old power centresshare the
task of exercising global responsibility.61
61
Paola Subacchi, New power centres and new power brokers: are they shaping a new economic order?, International Affairs 84: 3, May 2008, pp. 48598.
680
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Who is in control of the international

Who is in control of the international monetary system?

Who is in control of the international monetary system?

Who is in control of the international monetary system?

Who is in control of the international monetary system?

Who is in control of the international monetary system?

Who is in control of the international monetary system?

Feldstein, cited in Kenen, Managing exchange rates, p. 91.

Who is in control of the international monetary system?

On this see Cohen and Subacchi, A one-and-a-half currency system.

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