A golden opportunity for monetary reform

Three cheers for Robert Zoellick. Writing in the FT this week, the World Bank president set out an ambitious agenda for the Group of 20 leading economies to “rebalance demand” and “spur growth”. He recognises that the reduction of current account imbalances is a necessary condition for a non-protectionist trading system.

Global imbalances lie at the heart of the current recession; failure to address them will abort recovery and lead to currency wars. Gold can play a minor part in the necessary rebalancing, as Mr Zoellick suggests – although history shows that a gold standard would be too deflationary.

Put briefly, the underlying cause of the present crisis was an increase in reserve “hoarding”, chiefly by China. This was made possible by the deliberate undervaluation of the renminbi against the dollar; its motive was to insure against another flight of “hot money” from east Asia as happened in 1997-98. Under a gold standard, increased reserve accumulation would have been deflationary, since it would have drained the rest of the world of liquidity. Had Chinese reserves been held in gold rather than in US Treasury bills, the Fed would have been obliged to raise interest rates; as it was, it could run a cheap money policy. But in the absence of new investment opportunities, “recycling” of Chinese reserves produced an unsustainable asset and consumption boom in the US. It was the perverse nature of the world monetary system that allowed it to happen in the way it did.

The chief step needed to prevent this situation recurring is to weaken China’s incentive to accumulate reserves. In April 2009, Zhou Xiaochuan, governor of the People’s Bank of China, proposed the creation of a “super-sovereign reserve currency”. This new currency, to be developed from the International Monetary Fund’s Special Drawing Rights (SDRs), would in time entirely replace national reserve currencies. Significantly, the governor referred to Keynes’s “far-sighted” plan of 1941.

The Keynes plan was designed to overcome a previous episode of creditor “hoarding” – in this case by the US – which, as he saw it, had led to the Great Depression. His genius was to combine an automatic mechanism for liquidating surpluses and deficits with measures to reduce incentives to accumulate excessive reserves.

The first was to be achieved by bringing pressure on both surplus and deficit countries to balance their international accounts. All transactions giving rise to surpluses and deficits were to be settled through “clearing accounts” held by member central banks in an International Clearing Bank. Keynes proposed an escalating set of penalties for running persistent credit and debit balances: ultimately, credit balances would be forfeited. If all countries achieved perfect external balance at the year’s end, the sum of member banks’ balances in the ICB would be exactly zero.

The proposal for 4 per cent caps on current account surpluses and deficits by Tim Geithner, the US Treasury secretary, is a nod towards the Keynes plan, but without sanctions, or understanding of why countries such as China feel the need to accumulate such large reserves in the first place.

This was addressed by Keynes’s proposal for capital controls (to guard against capital flight) and, more imaginatively, to create a new international reserve asset that he called “bancor” (short for “bank money”), which would replace gold as the ultimate reserve asset of the system. Gold would remain as a reference point for the value of bancor, thus limiting the capacity of the ICB to create credit – which seems similar to Mr Zoellick’s idea. Keynes’s famous description of the gold standard as a “barbarous relic” does not quite capture his opinion of the metal, which he thought would be useful as a constitutional monarch but disastrous as a despot.

It was not to be: the Keynes plan was vetoed by the US at Bretton Woods in 1944 and the mighty dollar took bancor’s place as the world’s main reserve asset. Today, the difficulties in moving to an international currency reserve system are formidable. But the rationale for the Chinese proposal is clear: collective insurance is cheaper than self-insurance.

A “super-sovereign reserve currency” should be the central aim of structural reform of the world’s monetary system. But it should be part of a wider package. This would include capital controls at least in the transitional period and agreement on a more stable system of exchange rates. Both are wanted by east Asian countries. There is justice in the American insistence that China expand its domestic demand; but also in China’s insistence that America learn to live within its means. This rebalancing of global demand would underpin a balanced monetary system. It is also fully in line with the evolution towards a more plural world order.