> > But this can't go on forever - something's got to give. The U.S. can't
> > keep running current account deficits this large forever
>
> Why on earth not? As long as the dollar plays the role of world money,
> you'd expect demand for dollars to expand roughly in line with world
> trade. So yes, the US can run big current-account deficits forever, just
> the way gold-exporting countries could under the gold standard. In fact,
> it has to -- this is what's called Triffin's dilemma, I think.
Actually what Triffin's dilemma says is that it has to but it can't. That's what makes it a dilemma. And it couldn't under the gold standard either. That's exactly why the gold standard collapsed.
In Doug's original answer to this post:
http://mailman.lbo-talk.org/pipermail/lbo-talk/Week-of-Mon-20031222/031016.html
he laid out a detailed set of quantitative comparisons between the period before the collapse of the gold standard and today. And the more I think about this comparison, the more enlightening I think it is.
Also the IMF capsule history of the global monetary system Doug linked to:
http://www.imf.org/external/np/exr/center/mm/eng/mm_sc_03.htm
is really quite a good summary. And together with Doug's comparison and the Triffin paradox, I think the three of them go a long way towards putting the current dollar problem in perspective and making it clear.
We don't use the term "dollar glut" these days the way we did in the 60s. But I think that gets right to the heart of the problem.
It starts with exactly what Josh said. So long as the dollar is the reserve currency, the supply must keep growing steadily so that the world economy can keep growing steadily. But because it is also the money of a particular country, the amount of dollars in other countries' possession can only grow by the US running a deficit -- it has to give out more dollars than it gets so other people can have them to hold. In the 60s, the US ran an investment and aid deficit: we spent more in other countries than they did in ours, and bought or created lots of assets in their countries. Now, it's a current account deficit: we buy more goods and service from other countries than they buy from ours. In both cases, in accounting terms, it's equaled out by a corresponding surplus, but that that accounting balance completely obscures the important point. If in an alternative universe this accounting balance was produced because there was a zero on each side -- if the US didn't give out more dollars than it took in (and get extra goods or assets in reply) -- then nobody else would have any dollars to use as reserves. The accounting zero *has* to be produced through a deficit -- we have to get more assets or goods so the rest of the world can get the dollars they need to put in their reserves. And that deficit must keep growing steadily if the world economy is to keep growing steadily. BUT it can't grow too big, *no matter which kind of deficit it is,* because that imperils the value of the dollar. This is Triffin's dilemma.
In the 60s, this was obvious because of the dollar's fixed exchange value with gold. It was clear to everyone in the mid-60s that this had become a fiction because everyone could count up and see that countries held more dollars than the US had gold. It was clear to all that if they all brought their dollars in, there wouldn't be enough gold [unless the dollar devalued]. The last bracketed clause -- "unless the dollar was devalued" is usually left implicit because when the dollar devalued gold convertibility stopped, even though theoretically it could have continued at a much, much lower exchange rate. So people just describe the final state as "there wouldn't be enough gold." But that obscures the parallel to the present. Because now we are in essentially the same position: if all the countries holding US treasuries decided to sell them, the dollar would lose so much value that it have would be abandoned as the reserve currency -- at a certain tipping point, people would have to dump it as lost value, which would make it lose more value, etc.
In both cases, before the fall, it seems as if there is a kind of twilight zone you enter into before the system breaks. In a normal bank run, once people start to think like this there's no stopping the accelerating downward spiral. But here the main holders are a very small number of central bankers who can see the prisoner's dilemma aspects of their common situation: if the dollar falls precipitously, they all lose massive amounts of the value of their reserves, in addition to (they fear) the effects of a global depression. So they have an interest in propping it up until they can think of an alternative. And of hoping for the best, which is always a favorite policy alternative when people are actually in office.
There is, however, at least theoretically, a way in which the system could be kept from breaking. Triffin's dilemma is essentially a statement of the problem you have once you have a dollar glut: To keep the reserve currency from collapsing, you have to slowly cut back the deficit that has gone too far. But if the world economy is to keep growing, you have to keep the reserve currency growing. You can't do both with one currency.
But the theoretical solution is simple: you create a new reserve currency that isn't linked to one country and so isn't distributed through deficits. And that's exactly what world monetary authorities did in the 60s, precisely to solve Triffin's dilemma. They created SDRs, a footnote in global monetary history that I think I just now finally understood.
The solution to Triffin's dilemma was to cut back the dollar outflow while replacing the dollar reserves with SDRs -- and SDRs would then be increased at a steady rate on top of that replacement rate that would allow the global economy to grow -- say 3% a year.
That would solve the problem. That way the global reserve currency could keep steadily growing while the supply of dollars steadily contracted. And carried far enough, it would entirely solve the basic contradiction inherent in having one country's currency serve as everyone's reserve, thus forcing that one country to run deficits in order to provide the world with those reserves -- deficits that have to reach their limit once the world has so much of that currency in reserves that its collapse became a real possibility.
But the reason SDRs became a footnote in history is because the second half of the policy solution -- reducing the dollar glut -- never happened. The US made some gestures toward capping dollar outflow in the mid-sixties, and then under Nixon we just stopped trying, in part because we liked the short term gains. So SDRs were the solution to a problem that never happened. Instead, in a very short time, just as was predicated, we got the opposite problem, the one this whole complex policy scheme was designed to ward off: the dollar collapsed. The US decided to do nothing (a policy of benign neglect, they called it, although malign neglect would probably be closer to the mark); the dollar glut kept growing; there was a run on it; and Nixon had to devalue it. It took less than three years of benign neglect to bring it all crashing down.
As far I can understand, we're in exactly the same position now, if not yet at the same point in time. We have the problem of a dollar glut. The amount of reserves outstanding are sufficient that they could theoretically at any moment collapse the dollar. The US has to substantially reduce its current account deficit in order to prevent that from happening. But that would have a contractionary effect on the rest of the world. In the short term, its fixable, or stave-offable. But in the long run, it's not fixable without changing the system.
The theoretical solution, once again, would be some kind of SDR equivalent -- a new reserve currency. Although of course this time it would be nice if had some of the elements of multilateral democracy, and a bias towards development, things which have in recent years been most prominently discussed by Joseph Stiglitz and his colleagues.
One of the most interesting things this parallel brings out is how short the time frames have been of global monetary systems. We have a tendency to think of the dollar-reserve currency system as something that has been around since WWII, which to most of us means basically forever. But in fact, there have already been two very different dollar reserve systems -- and the first one, for all its magnificent success, didn't actually last that long. The dollar-gold system ran perfectly for about 12 years, from 1948-1960. At that point, it started developing the dollar glut problem. There was a twilight period of 10 years while people discussed the problem, and came up with theoretical solutions and stop gap measures. What really kept it going was that non-US countries that had recently benefited most from the system continued to prop it up at their cost. And then the reserve currency system collapsed.
The 70s were a complete mess monetarily and economically. It wasn't oil that caused the mess -- it was arguably the mess that caused the oil problems. (It was OPEC's precipitous loss of income when the dollar collapsed that they were out to restore.)
The savage Volcker recession restored the value of the dollar and initiated a completely new dollar reserve system, where now dollars would be supplied to the rest of the world through a current account deficit. It was the evolution of a new system rather than the conscious creation of one. But it immediately created a new crisis to go with it -- the debt crisis, which was caused precisely by the dollar having its value restored. The world spent the next 8 years wresting with that crisis in multilateral negotiations. It was eventually solved by serially and incrementally writing down a lot of the debt through defaults, work-outs and the Brady bond system.
After that kink was worked out, the new dollar reserve system seemed to work just as well as the original dollar gold system did for world economic growth -- for about a dozen years, depending on where you want to date it from. And it now it seems clear we're in the grip of another dollar glut, and another version of Triffin's paradox, where a US deficit once again must be reduced to safeguard the value of the reserve currency, and it can't be done without contractionary effects, at least not over the long term. And once again, we seem to be in a twilight period where the non-US countries that have recently most benefited -- or which have evolved in such a way that their economies can't survive in a low dollar environment without a terrifyingly complete and unpredictable overhaul -- are propping up the value of the dollar at their cost.
Of course history never exactly repeats itself. I don't think we really have any idea what a second collapse of the dollar would really look like. Before the collapse in 1971, people were terrified of the idea because they thought a world of universal floating rates couldn't possibly be stable or economically healthy. The floating rate system that evolved has many of exactly the problems they feared -- huge, unpredictable changes in currency values that sink countries into depression overnight -- but over all it it's been a lot stabler -- and certainly a lot freer of inflation -- than almost anyone pre-1971 ever thought possible. And this has probably contributed to making us a lot more sanguine about another possible collapse of the dollar, along the lines of Heck, last time they said it would be the end of the world, and it wasn't. It has also probably made US officials especially complacent, since the collapse seems in retrospect to have turned out well for the US -- it looks like it played a key role in reversing the US's relative decline in productivity and GDP growth vis a vis its most important competitors. I think there is a deeply felt sense that, if monetary Chaos ever comes again, the US will do fine, because when its every country for itself, we will naturally do best, being stronger faster and more risk taking than any other.
Of course all this sanguinity rests on drawing a curve through one point. The last collapse ended with the dollar re-established as the world currency. That is not a given. And what happens to US relative fortunes if it doesn't is completely unknown.
But really, I think the main contributor to sanguinity is simply obliviousness. I think if you asked most people in government or media today about the last dollar collapse, they'd probably look at you blankly and ask What dollar collapse? They all took Econ 101. They all heard about the gold standard and it ending in 1971. It just that it seems like it never mattered, unlike, say the OPEC price hike, which is oddly still foremost in our national imaginaire.
And while prediction is impossible, I have to say, looking at it in the most general way, if you use this time frame -- where each dollar reserve system last a dozen years or so, and goes through transitional periods before and/or after -- it makes it look like a dollar collapse within the next decade would be the most normal thing in the world -- that it's staving it off longer than that that would be unusual.
And lastly, if the SDR, or something like it -- a global reserve currency that is not the dollar -- is the only solution to Triffin's dilemma -- the only thing that could prevent a dollar collapse -- I think we can agree that it's virtually impossible to conceive of it being implemented on Bush's watch. And that for that matter, it's not easy to imagine it being implemented on anyone's watch. Things were a lot more multilateral in the 60s, and we couldn't do it then.
Michael