Last week I set out, in broad terms, 7 areas that need to be addressed if we are to create an economy that provides enough for everyone. This week’s post is an exploration of the 6th of these points, addressing global trade imbalances, just because it has been neglected on the blog so far.
I included this point last week because it is one of the explicit recommendations in Pozsar’s work. He makes a brief statement, suggesting we “just imagine” that excess foreign exchange reserves “would be distributed among households equally”. However, I haven’t written about the foreign exchange system on the blog, apart from in this post. When I started the blog I intended to have a whole section on this system – it’s absolutely fascinating, but really difficult to find to find clear and accurate descriptions of how its component parts work. But as the blog ended up being much longer than I expected, I decided to skip this – given how horrifically detailed and technical the rest of the blog is, can you imagine what a nightmare me writing about this system would be!
However, my study of this system, informed in part by the economists mentioned last week, has separately led me to conclusions similar to Pozsar’s, that there is a need for global cooperation to address global trade imbalances. This would include, as Pozsar suggests, the redistribution of foreign reserves from trade surpluses. But already it seems like we’re going into fantasy world, imagining a global monetary system with global cooperation, and even global institutions, to manage this system. Well, the point is we already have a global monetary system, and in fact the first steps in global cooperation have already been taken, out of absolute necessity, following the financial crisis, and that’s what I’m going to look at today.
First of all, to explore this area we need a basic understanding of the current foreign exchange system.
Most international trade is conducted in US dollars, making it effectively the global currency. But unlike national currencies, it doesn’t have the backstop of a global central bank (i.e. a “lender of last resort” for when banks run short of reserves, need to borrow, but cannot do so from each other). Until the crash, the Federal Reserve was only concerned with the dollar domestically in the United States, and in fact foreign currency trading is conducted primarily in London – hence, the dollar of international trade is known as the “Eurodollar”. The banks conducting such trade all have dollar denominated accounts with US banks, and the means of final settlement takes place between these accounts. With no central bank backstop, the banks engaging in foreign currency trades have very precise systems to ensure that they can always settle all accounts (this is part of what I would describe if I were to include a section on foreign exchange on the blog).
If a bank in London has insufficient reserves to meet its domestic payment requirements, the Bank of England steps in as the lender of last resort and lends it the reserves (which it can simply create with the click of a mouse). But if that bank has liabilities demoninated in US dollars, the Bank of England cannot create the reserves in the same way, and the London bank has no recourse to the Federal Reserve. The Federal Reserve has never been interested in Eurodollar markets, but in the 2008 credit crunch the crisis in the Eurodollar market threatened the domestic dollar and the Fed had no choice but to intervene.
Since the crisis, the 6 major central banks have agreed a system of unlimited currency swaps (known as “swap lines”). Each central bank has committed to lend the others its own currency, accepting as collateral the counterparty’s currency. So to go back to my example of a struggling London bank, the Bank of England now has the guaranteed capacity to lend it the needed dollars, because the Fed will “swap” these dollars for British pounds. This is the significance, as I understand it, of this being an agreement for unlimited swaps: the 6 central banks have all agreed with each other to make these swaps, in unlimited amounts, and this now provides a guaranteed backstop on runs on the currency of international trade. This achieves what a national central bank would do with respect to its own domestic currency, and more to the point achieves what a global central bank would do for the global monetary system, if such an institution existed.
And there’s more – this system of swap lines cascades through the international economy, with more than 70 swap agreements now in place between central banks in over 50 countries. What remains to be seen, of course, is how robust this network proves to be come the next financial crisis!
I find this all riveting. I would particularly recommend this paper by Perry Mehrling – it’s so interesting it’s a real effort to constrain myself to such a brief summary! To avoid getting your information from one source, other very clear accounts can be found here and here.
It’s important to note that the central banks are not consciously trying to create a managed and coordinated international monetary system. Rather, each central bank is trying to safeguard the stability of their own national currency and economy. But this does in fact require this degree of coordination. Conspiracy nutjobs terrified of “world government” would be going berserk on the internet if they had the intellectual capacity to understand what is happening!
Another striking example of the recognition by mainstream institutions of the need for global cooperation is a 2010 paper by the IMF’s Strategy, Policy and Review Department on “Reserve Accumulation and International Monetary Stability”. In the wake of the financial crisis, the paper considers the threats to the stability of the international monetary system, particularly the “unprecented” trade imbalances and resultant reserve accumulation by surplus countries (the “excess reserves” Pozsar writes about).
The paper sets out a wide range of options for action. All of the options require some degree of international agreement and cooperation. Some of them are quite short term and straightforward to implement, while others require such a degree of cooperation that they would be extremely challenging politically. The paper actually presented the options on a graph, with timescale on one axis and potential political resistance on the other. Of these, by far the most radical was the development of an international currency, managed by the IMF. The consideration of the technical issues and the steps required to do this is fascinating (honest). The paper was asking the IMF Executive Board which of the options staff should research further, so when I first read this paper I searched online and found the minutes of the relevant Board meeting. Unfortunately, IMF Board minutes are no longer online, so I can’t now go and review their conclusions on all the options, but I do recall that they outright rejected this latter option (so this paper is not, in fact, evidence that the IMF is trying to create a world government, as some conspiracy websites maintain)!
But the significant point here is that when staff working for an institution as famously conservative as the IMF considered the workings of the global monetary system, one of the areas they saw as being relevant for further investigation was the possibility of a global currency. And all the options required some degree of international cooperation. We cannot have an international monetary system without it being managed and coordinated. Every modern monetary system (since the Greeks first minted gold coins around the 7th Century BC) has been managed by the state. Our economy has evolved to the point that we now have a de facto global monetary system but we don’t have the corresponding international monetary institutions. In their absence, national institutions have no option but to enter into agreements to cooperate in order to stabilise the system.
The system of foreign currency swaps described earlier is a significant example of such cooperation. And the IMF paper shows that when even the most conservative institutions examine this system they see the need for further cooperation. It’s a sign that we are capable of taking steps in the right direction to develop an economy that provides enough for everyone.