Harvard’s Emmanuel Farhi on a New Monetary System – IMF F&D
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Bibliographic details
- Authors: EMMANUEL FARHI
- Published: June 1, 2019
Overview
- Author: EMMANUEL FARHI, Robert C. Waggoner Professor of Economics at Harvard University.
- Publication: F&D Magazine; June 2019.
- Core message: We must prepare for a possibly turbulent transition to a new international monetary system as new competitors to the dollar—principally the euro and the renminbi—emerge.
Historical context and long-run patterns
- The international monetary system has moved from the gold standard to flexible exchange rates over the past two centuries.
- A constant feature: the system was almost always dominated by a single currency (pound sterling until World War I; dollar after World War II).
- The dollar’s predominance survived: the end of the Bretton Woods dollar exchange standard and the global financial crisis.
Dollar dominance — mechanisms and consequences
- The United States functions as the world’s banker, enjoying “exorbitant privileges” and bearing “exorbitant duties.”
- Attributes of dollar dominance:
- Preeminent supplier of safe and liquid assets to the rest of the world.
- Issuer of the dominant currency of trade invoicing.
- Strongest force in global monetary policy.
- Main lender of last resort.
- Reinforcing feedbacks:
- Dollar invoicing makes borrowing in dollars attractive; borrowing in dollars makes dollar invoicing more desirable.
- US role as lender of last resort makes dollar borrowing safer; safety increases US responsibilities in crises.
- Global effects of dollar dominance:
- Growing global demand for safe assets has reduced interest rates on relatively risk-free investments to historically low levels.
- This shortage of safe assets increases the probability of hitting the zero lower bound (macroeconomic instability).
- It pushes investors to lever up and take risks to reach for yield (financial stability risks).
The new Triffin dilemma and systemic risk
- A new so-called Triffin dilemma: to satisfy growing global demand for safe assets, the United States must stretch fiscal and financial capacities, potentially straining investor trust in the dollar and triggering volatility and self-fulfilling crises.
- Historical parallel: Robert Triffin’s mechanism that contributed to the fall of Bretton Woods and the dollar going off gold.
- Emergence of the euro and the renminbi could, in the long run, alleviate the safe-asset shortage and the Triffin dilemma by providing competing currency supplies.
Transition dynamics and instability risks
- A truly multipolar international monetary system will not emerge quickly.
- Reputation and institutions underpinning international currencies are built over time; existing coordination on the status quo can be persistent.
- Historical lesson from interwar years (pound and dollar coexistence): investor rebalancing between currencies can cause instability.
- As competitors emerge, international investors will have alternative assets to move into, which could exacerbate destabilizing speculation and lead to self-fulfilling confidence crises.
- Expectation: a potentially disorderly and turbulent transition period before the benefits of monetary competition materialize.
Concrete policy measures and recommendations
- Priority: strengthen the global financial safety net to:
- Make the global financial system more resilient.
- Alleviate the global safe asset shortage and mitigate destabilizing consequences.
- Measures to preserve lender-of-last-resort capacity:
- Preserve the ability of central banks and governments to act as lenders of last resort in their own countries.
- Measures to encourage decentralized cooperation:
- Reserve-sharing agreements: countries pool reserves to economize.
- Bilateral swap line agreements: central banks borrow another’s currency against collateral.
- Measures to strengthen multilateral capacity (IMF-centric):
- Bolster existing facilities and expand the financial capacity of the IMF.
- Strengthen IMF support to decentralized arrangements.
Possible IMF roles and more radical options
- Adapt and modernize aspects of Keynes-Triffin proposals:
- IMF could centralize reserve-sharing by administering a global deposit facility built on the existing special drawing right.
- IMF could multilateralize the decentralized, sparse, and discretionary network of bilateral central bank swap lines and enhance it with a star-shaped structure by:
- Acting as a central counterparty clearinghouse and underwriter of bilateral swap lines, or
- Offering short-term swap facilities of its own.
- Rationale: such steps would help economize reserves, stabilize expectations, and reduce the likelihood of abrupt, disorderly shifts in currency preferences.
Closing insight
- Quotation framing preparedness: Rudiger Dornbusch’s observation that “in economics, things take longer to happen than you think they will, and then they happen faster than you thought they could.” The piece stresses that now is an opportune time to prepare.
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