EDWARD HADAS: Why the next financial crisis will be about forex
'A flight from a reserve currency would throw the global trading system into disarray'
For centuries, cross-border trade has come with a currency problem. The expansion of globalisation has not made it any less pressing. The dilemma identified by the economist Robert Triffin is a powerful – and alarmingly current – reminder that a worldwide foreign exchange crisis is only one big mood change away.
The Scottish philosopher and economist David Hume identified the fundamental issue in 1752. While the sum of global exports always equals global imports, countries can run persistent trade deficits. In Hume’s time, the deficit country shipped gold to pay for overseas goods. Today, creditors have to accept large quantities of deficit countries’ currency.
Hume thought the free market would correct these imbalances, through what we now call currency devaluations. Exports would rise, imports would fall, and the gold would return. But it turns out that the economic patterns which lead to trade deficits are remarkably stubborn. They persist as long as importers can find a way to pay for their lifestyles.
When the gold runs out or the lenders finally give up, default is almost unavoidable. Usually, such national financial failures cause only small ripples in the world economy. But that is not always the case. As Triffin pointed out in 1960 the effects would be much more serious if creditors lose faith in the global reserve currency - the unit which is readily accepted for trade and commonly used for savings pretty much everywhere.
A flight from a reserve currency would throw the global trading system into disarray. As in Triffin’s day, the currency in question is the U.S. dollar. As the Belgian-American economist understood, the dollar will remain solid until the day of reckoning. Foreigners will be willing to accumulate more greenbacks because holdings of the global reserve currency help trade run smoothly. So they are more than happy to finance America’s trade deficit.
But the more the United States spreads dollars around the world, the more likely holders are to question America’s creditworthiness. Economists named the simultaneous desire for dollars and the danger involved in holding them the Triffin dilemma. Valéry Giscard d’Estaing, then the French finance minister, called it America’s “exorbitant privilege”.
The United States has exercised its privilege abundantly ever since. As the chart shows:
the net U.S. international investment position – basically the market value of dollars invested from America minus the value of dollars lent to it – first turned negative in 1988. After some gyrations, a firm trend has set in. By 2016, the deficit had reached around 11 percent of global GDP.
That is an awful lot of dollar value at risk. But the development is not surprising. Cross-border trade has increased from 17 percent of world GDP in 1960 to 45 percent today, according to the World Bank. The first horn of the Triffin dilemma explains that this growth leads to more expatriate dollars. The other horn points out that a currency crisis now would be very disruptive.
Suppose some American irresponsibility or arrogance exhausts the patience of the Chinese government, prompting it to sell some of its vast stock of dollar-denominated assets. Others would follow, rushing to currencies still perceived as relatively safe. That creates political discontent in countries such as Japan and Switzerland. Capital controls would come and cross-border trade would go.
Meanwhile, the U.S. Federal Reserve would probably raise interest rates to defend the dollar. Leveraged investors would be forced to sell, creating market mayhem. Big banks could topple over. Though they are better capitalised than a decade ago, they still rely extensively on the ready global availability of supposedly risk-free U.S. government debt.
No one wants that sort of meltdown, especially as there is currently no credible alternative to the dollar. Decades of debate about a possible global currency has produced nothing useful. China’s push to internationalise the yuan has recently gone into reverse.
Fortunately, there has been a strong global political-economic consensus to prevent a meltdown. Witness the coordinated and relatively fast response of global central banks, politicians and regulators to the 2008 financial crisis.
The unity of that global quasi-government is fraying, though. Central bankers have tested politicians’ patience with years of ultra-low rates. And global politics are troubled. President Donald Trump does not generally behave like a believer in cross-border solidarity. The euro zone has become more inward looking. China has become larger but also more nationalistic. Japan has become smaller.
Ultimately, all profound financial problems must have political solutions, because only governments have enough authority to allocate damage and restore confidence. This explains why cross-border financial problems are especially hard to solve – there is no international government to intervene.
The U.S. dollar’s reserve status has withstood numerous shocks and a succession of profligate presidents. If the Triffin dilemma turns into a crisis, though, everyone will wonder why the dollar was allowed to underpin the global economy in a political near-vacuum.