The Science of Moral Hazard
By JC Collins
BANG. The world just ended.
Not really. But let’s consider the broader ramifications of using the SDR as either a reserve asset, or a method of diversifying foreign exchange reserves through the substitution accounts of the International Monetary Fund.
While poking the doom and gloom analysts with the stump end of a stick, I’d also like to give them kudos for understanding the human nature aspect of the multilateral transition. It will all end in madness once again. This I cannot disagree with, as I’ve stated many times myself that any new system will corrupt again in a matter of years.
But how will this corruption happen? And how long will it take for it to begin?
Let’s explore one method by which things could deteriorate at a pace which may surprise even the most hardened gold bug and judgement day juggler.
First, let’s review the broad strokes of what we mean by a multilateral transition.
Most readers by now understand the balance of payments challenges which have caused systemic instability and risk in the international monetary system. In a nutshell, there are countries with large trade deficits and countries with large trade surpluses. The United States is the largest deficit country, and China is the largest surplus country.
Everyone else is somewhere between those two giants.
Being that the USD is the primary reserve currency of choice, it has accumulated in ever increasing amounts in the foreign exchange reserve accounts of the central banks of the world. China obviously holds the most outside of the Federal Reserve itself.
The mass accumulation of the domestic currency of one country has caused major problems, but has given the US the ability to fund their budget deficits and put sanctions on other countries.
When the US dollar appreciates like it recently has, it puts tremendous pressure on the currencies of other countries, as they have to depreciate their own currencies in order to maintain the disequilibria which acts as the dysfunctional framework of the existing system.
The first order of the day is to diversify the amount of USD held as reserves, and secondly the overall demand for reserves in the first place needs to be reduced.
One method of achieving this is by making available alternative reserve assets, such as the euro and yuan, as well as regional reserve pooling mechanisms, regional currency units, and enhance the lending capabilities of the IMF (as well as other multilateral institutions, like the BRICS Bank and AIIB).
Any diversification of USD reserves and reduction of demand for reserves will act as a method of redistributing the exorbitant privilege which the United States has held because of the status of the dollar. Limiting the US as the primary provider of reserve currency will do much to help rebalance the monetary system.
Creating an environment where there are competing reserve currencies will help reduce the imbalances, both surpluses and deficits, of countries which have accumulated large amounts of USD.
In the coming months, and into next year, we will see the beginning stages of a diversification of reserves as the euro and yuan are more widely used as competing currencies to the dollar. But this will still leave some challenges of what to do with the larger volume of USD which has accumulated.
And how do we address further accumulation of not just the dollar, but the euro and yuan as well?
As an alternative reserve asset, the Special Drawing Right (SDR) offers an intriguing possibility. It would eliminate the exorbitant privilege of any one country holding the reserve currency status, as the US has since the end of WW2. And like the competing multi-reserve system defined above, it would help diversify and reduce balance of payments deficits.
There is no real reason that the SDR cannot be modified to act as a single global currency, and that may in fact be the long-term plan. The only real challenge with such a scenario, and it’s one we’ve touched on in regards to regional currency units, is that there is no real optimum currency area.
That is not to say that one cannot emerge from the various trade agreements which are in development around the world. We could eventually see the evolution of all regional trade agreements merging into one single global agreement. This would create and environment conducive to the free mobility of labor, goods, and capital, while building the framework for a true global optimum currency area.
Utopian faults aside, the initial use of the SDR will likely first appear as the tool which will help transition the international monetary system to a more stable and sustainable framework. It will do this by facilitating the diversification of reserves.
The substitution accounts of the IMF will allow large amounts of USD reserves to be exchanged for SDR denominated securities. The challenge with such an exchange will mean the IMF has to underwrite any loss from a change in US dollar exchange rate, which will in fact change in the coming months.
As such, there is likely to be some form of risk-sharing between the IMF members based on the amount of USD reserves exchanged.
Here’s where we encounter the possibility of human deficiency and further erosion of monetary sustainability. The nature of the substitution accounts will create a moral hazard as central banks will be tempted to accumulate even more reserves after the substitution exchange has taken place.
It would serve to create a further expansion of the global money supply and potential lead to even deeper financial challenges down the road.
Based on what we have learned from the past, it is probable that central banks and other financial institutions may not agree to the enhanced substitution exchange if restrictions are placed on the future accumulation of reserves, whether they be USD, euro, or yuan.
One of the methods of reducing the risk of further accumulation is creating a more flexible floating exchange rate arrangement which could be structured within any substitution process. These exchange rates would reflect the fundamental changes which we have discussed previously, namely that countries with trade deficits will see their currencies depreciate to facilitate an increase in exports, like with America, and countries with trade surpluses will see their currencies appreciate to facilitate the reduction, and sustainable substitution, of surpluses.
In the coming months we will hear much news about the IMF and potential role of the SDR. We will also be given additional information on the UN and G20 financial reform agenda, as well as a broader reporting standard from the Financial Stability Board (FSB).
The world may not end tomorrow, or even next year, but the coming macro-prudential policies and multilateral framework will allow for real exchange rates to adjust and slowly work towards rebalancing the international monetary system. But how long can this last if self-limiting binders are not built within the expanding solutions. – JC