THE INTERNATIONAL DIMENSIONS OF CURRENCY AUTONOMY

By Brett Fiebiger, Ph.D

Modern economies operate on fiat monetary systems with an accent on plural. Anyone who takes a look at policymaking decisions around the global economy will soon observe that there seems to be substantial differences in the ability of policymakers to determine macro policies… why? In this post I will seek to provide some answers. The gist of it is that there are differing currency regimes in the global economy and macro policy autonomy exists on a spectrum of heterogeneous experiences.

The Currency Autonomy Spectrum

The term autonomous currency issuer is defined here as the degree of independence to which national policymakers can determine macro policies and development strategies. The concept is not a binary schema where a nation either operates on a wholly “autonomous currency” or on a wholly “non-autonomous currency”; instead, it exists on a scale of heterogeneous experiences where the extent to which a nation’s currency is used as international money plays some part in proceedings. Table 1 identifies seven distinct regions on the basis of four differing aspects of currency autonomy. The key points are that international currency status matters to currency autonomy along with domestic institutional practices especially in the peculiar and illogical case of Euroland.

Historically, prior to the adoption of fiat monetary systems, the ability of national policymakers and private agents to mobilise domestic resources was constrained by the amount of ‘precious’ metals that could be dug out of the ground. John Maynard Keynes decried ‘gold as barbarous relic’ in respect to its use as an underlying monetary asset because of the impetus to deflation. If you know or happen to meet any of the “gold bugs” still agitating for a return to the gold standard please remind them of the deflationary morass that was the Great Depressions of the 1890s and 1930s.

So while all nations now have fiat money only a few select nations can use their domestic currency to make international payments. Unsuccessful attempts to defend fixed exchange rate pegs have played some part in the more serious external financial crises such as the 1997/98 East Asian crisis. There is plentiful evidence that it is difficult to defend formal or informal pegs without ‘war chests’ of reserves. However, for developing countries, the adoption of a floating currency may not expand policy space that much. This is due to the burden of “original sin” and also because global capital is so dysfunctional at present (with the global investors tending to demand macro policy austerity from developing countries experiencing balance-of-payment difficulties).

While the adoption of freely or managed floating exchange rates can offer flexibility the real issue when it comes to currency autonomy is the currency denomination of external liabilities. Both the 1980s Majority World debt crisis and the 1997/98 East Asian crisis pivoted much less on matters relating to the ‘fixed versus floating’ debate and much, much more on the currency denomination of external debts. These nations suffered immense economic and social costs because their debts were contracted in a currency that domestic policymakers could not freely print. Indeed, when a nation has a majority of its external debts and import bills payable in foreign-currencies, exchange-rate depreciation actually worsens their plight by increasing the value of external liabilities relative to the domestic currency unit. The currency denomination of external liabilities is more decisive to the subject an of autonomous currency issuer than whether the exchange rate is pegged or floating.

The “original sin” hypothesis of Hausmann and Panizza (2010) refers to two domestic situations: (1) an inability to borrow abroad in the local currency; and, (2) a relative inability to issue long-term, fixed-rate debt, even domestically. These two aspects of currency autonomy are labelled in Table 1 respectively as international and domestic. From the late 1990s there was progress on overcoming domestic original sin at least for the major emerging market economies (EMEs). Domestically-issued local currency debt could provide a more stable funding source for EMEs than debt issued externally in foreign currencies. Further, a major advantage of local currency debt is that it does not increase in value when the currency depreciates, unlike debt issued in foreign currencies. There is reason not to overstate these developments as progress on overcoming international original sin remains modest.

In 2008 just over 60% of the outstanding external debt of developing economies was denominated in US dollars, 23% in euros and another 10% in yen. A major pitfall of foreign-currency debt is that it exposes the economy to the possibility that the central bank may have insufficient reserves to settle the debt along with any import bills payable in foreign currencies. Hausmann and Panizza (2010) report that currency mismatches for developing economies declined significantly during 2000-2008 due primarily to reductions in external debt levels and growth of reserve holdings. Attenuation in international original sin accounted for one-tenth of the decrease in aggregate currency mismatches (measured in simple or weighted averages). Thus, the authors concluded that lower mismatches reflected abstinence from financial globalisation, not redemption from international original sin.

Neoliberals neglect to discuss “original sin” altogether or attribute it to ‘faulty’ domestic policies. Financial Times columnist, Martin Wolf, is an example of the latter. The international original sin burden is not only about the difficulties that governments have in issuing local-currency debt in external markets but also the private sector. The example of Australia is instructive. Australia ticks all the boxes that neoliberals like Wolf would recognise as a well-managed economy (e.g. sophisticated investor base, established record of macro stability, ‘private’ central bank and a government with a low debt-to-GDP ratio). Over 2000-2010 the share of Australia’s gross external debt contracted in foreign currencies averaged around 60%. Why did Australia not issue a majority of its external debt (let alone an overwhelming majority) in the local currency? International origin sin appears to be more a product of ‘path dependency’ than domestic policies. Advanced economies that do not issue five major international currencies (US dollar, euro, yen, pound and Swiss franc) are also subject to international origin sin though to a lesser extent than developing economies. These factors suggest that the practice of contracting external debts in only the “strong” currencies was the product of little thought with the advantages of incumbency favouring a select group of advanced economies.

So what can be done about the burdens of domestic and international origin sin? In respect to overcoming the former the development of the financial sector is vital. The transition from a developing economy to a developed economy requires deep domestic credit markets so that economic growth can be driven ever more by domestic demand rather than export dependency.

(Most of the categorisation in Table 1 should be self-evident. One aspect that requires clarification is the ‘ability to monetarise debt’. I use the term monetarise in respect to public debt and private debt. Consider that the capability of the central bank to directly monetarise local-currency debt via outright purchases is limited for the Euroland member governments and also for economies subject to domestic and international origin sin but for different reasons. In Euroland the limitations are ‘self-imposed’ whereas the constraints on developing-country policymakers are imposed more by external factors (i.e. the threat of capital flight and comparatively high proportion of debt stocks denominated in foreign currencies). Also, unlike Euroland, countries subject to international origin sin cannot monetarise external liabilities either directly or indirectly. For these countries increases in domestic liquidity do not augment the supply, or directly alter the price, of money that can be used to meet foreign-currency external obligations. This means that even if countercyclical macro policies are able to be implemented they are likely to less expansionary in such economies by comparison).

The Special Status of the Issuer of the “Key” Currency

The circuit of international money begins when the centre country runs a balance-of-payments deficit (Costabile; 2010). This means that the USA has a special status in the global economy due to its role as the issuer of the “key” currency. It is for this reason that the USA sits atop the hierarchy of currency autonomy in Table 1. The macro policy constraints on the centre country are quite different to those on all other nations that cannot ‘benignly neglect’ the external position (Ocampo; 2007).

There is growing appreciation that the dollar’s global role and persistently large trade deficits run by the centre country are interconnected. When foreign central banks recycle dollar receipts gained from trade back into US Treasury debt this impedes exchange rate movements that would otherwise help to correct the imbalance of trade. The foreign sector is not the “source” of US dollar receipts though it can recycle these receipts back into the United States. Indeed, contrary to the concerns often reported in the mainstream media and espoused by neoliberal orthodoxy, the centre country’s external deficits do not “absorb” foreign savings that exist independently of US external demand. That foreign agents do provide considerable financing for US federal budget deficits does not ‘in and of itself’ mean dependence on foreign saving: the Fed can always buy T-bonds with new money.

A remarkable feature of the persistently large external deficits run by the United States beginning in the 1980s is the large disconnect between the flow and stock measures of US external borrowing especially during the period 2003-2007 (see Figure 1). The sum of current account balances from the beginning of 2003 through to year-end 2010 denotes, as an accounting identity, that the world’s richest nation received a net flow of foreign savings equal to $4.93 trillion (which is around one-third of US GDP in 2011). It follows then that the US net international investment position should have deteriorated by a comparable degree; yet, it deteriorated by only $0.44 trillion from -$2.41 trillion at the start 2003 to -$2.85 trillion at year-end 2010. In a puzzlingly way, the official statistics indicate that there is a large $4.49 trillion discrepancy between the flow and stock measures of the US external balance sheet. Stated differently, the US net international investment position at year-end of 2010 was 91.1% less than the amount of savings received by the USA since 2003, which points to a disquieting observation that the centre country can ‘borrow without liabilities’ on a colossal scale. This ‘borrowing without liabilities’ puzzle is sometimes called the “exorbitant privilege” and can be attributed to the following unique set of conditions enjoyed by the centre country:

1)      Receives a liquidity discount (interest rate premium) on external borrowings due to foreign nations amassing its currency (and government debt) for trade invoicing, anchor peg and reserve assets;

2)      Enjoys preferential treatment from international investors due to the ‘self-reinforcing’ perception that its government debt is the “safest” asset;

3)      Receives a ‘price subsidy’ on import purchases and foreign asset acquisition due to the ‘artificial’ inflation of its exchange rate (related to points (1) and (2));

4)      Runs balance-of-payment deficits without depleting its reserves of international money (i.e. the central country issues international money);

5)      Runs balance-of-payment deficits without necessarily experiencing a reduction in domestic liquidity due to the ‘automatic sterilisation’ of currency outflows by foreign central banks;

6)      Enjoys countercyclical wealth effects on the external balance sheet due to the currency mismatch in its foreign liabilities (denominated nearly exclusively in the domestic currency) and foreign assets (denominated mainly in foreign currencies) such that domestic currency devaluation generates net capital gains (thus shifting some of the brunt for external adjustment onto creditor nations).

7)      Is able to ‘lever up’ the external balance with high-yielding (valuation-friendly) investment categories (i.e. portfolio equity and direct investment) because it has no need to accumulate foreign currencies merely to participate in the global economy (or to safeguard against the Global Casino and the IMF) whereas other countries do (especially those subject to the burden of international ‘origin sin’).

What should one make of the ‘borrowing without liabilities’ discrepancy? It suggests that US external deficits are more sustainable than traditional approaches to external sustainability which assume symmetric returns on gross foreign assets and liabilities and, hence, that the centre country has an asymmetric capability to incur external deficits relative to other economies. (Curcuru, Dvorak and Warnock (2008) argue that the total return differential received by the centre country on its international portfolio is overstated due to the treatment of the ‘other’ valuation channel as implied capital gains when this channel is more likely to reflect statistical errors. Their position centres on the ‘other’ valuation channel which declined substantially in importance during 2003-2010. It is also the case that the US external balance sheet has become progressively more leveraged after 1980 (e.g. the rising weight of portfolio equity and direct investment relative to debt in US foreign assets) and that the prospect for a prolonged relatively low global interest rate environment will benefit the centre country given its large negative net position in the interest rate sensitive ‘debt’ category).

America’s trade deficits are a motor of global demand though they also generate internal distortions by depressing export and import-competing industries. A trade deficit represents a leakage of aggregate demand and if sustained over a prolonged period can undermine (i.e. “hollow out”) export and import-competing industries. Yes, the USA has its so-called “exorbitant privilege” from issuing the “key” currency, but the lifeblood of an economy is its productive capabilities and not consumption excesses. The persistently large trade deficits run by the United States was a factor in the ‘distorted’ expansion after the 2001 recession. As Nicholas Kaldor (1971) observed on what at the time was a burgeoning global dependency on US trade deficits: “If continued long enough it would involve transforming a nation of creative producers into a community of rentiers increasingly living on others, seeking gratification in ever more useless consumption, with all the debilitating effects of the bread and circuses of Imperial Rome [quoted in D’Arista, 2009]

The crisis suggests that the centre country is exhausted and that alternative sources of demand in the global economy are duly needed. Evidently, there is some merit to the idea that America’s external deficits sponsor growth and export-orientated industrialisation elsewhere, though it makes little sense to speak of surplus developing countries taking a “free ride” on the centre country’s external demand when: (1) the international payment system is dollar-centric (such that amassing dollar reserves is not voluntary but a prerequisite merely to participate in the global economy); (2) the global financial system is dysfunctional compelling “self-insurance / neo-mercantilist” policies in the periphery in order to regain macro policy autonomy; and, (3) there are no well-functioning collective insurance mechanisms (i.e. ‘war chests’ of reserves are needed to preclude a resort to IMF-bailouts attached to exploitative neoliberal structuring and self-defeating macro austerity).

There are also inequitable dimensions from the centre country being able to inject external demand by issuing international money ex nihilio when most other countries cannot. The centre country make ‘loans’ or pay for things by issuing international money while most other nations must instead earn or borrow money of a type they do not freely issue just to participate in the global economy. The not insignificant total return differential (i.e. the income and valuation gains on gross assets expressed as a percent of the totals outstanding minus that on gross liabilities) received by the centre country on its international portfolio went into overdrive during 2003-2010 (Figure 2).

In order for the richest country to enjoy an “exorbitant privilege” other countries (typically poorer) must be paying the bill. Consider the somewhat paradoxical instance of global capital flocking to the United States after the collapse of Lehman Brothers in 2008 when it was clear only that Wall Street was in serious trouble. For one nation to be perceived by financial markets as a global “safe haven” others must be at the receiving end enduring a self-defeating ‘flight to safety’ for reasons that bear little if any relation to the underlying economic “fundamentals”. That seems a little unfair… and the ‘borrow without liabilities’ puzzle… well that might be a reason why Washington policymakers are less-than-enthusiastic about the recommendation in the 2009 ‘Report of the Commission of Experts of the President of the United Nations General Assembly on Reforms of the International Monetary and Financial System’ (headed by Joseph Stiglitz) to have the IMF issue Special Drawing Rights more frequently in order to provide a supplementary reserve asset (and a truly international one at that).

The Peculiar and Illogical Case of Euroland…

Developing economies do not, of course, choose the burden of international original sin. When it comes to explaining why Euroland sits near the bottom of the hierarchy of currency autonomy the most peculiar thing is that policymakers have chosen that path. When the founding fathers designed the euro system they did so in accord with the neoliberal “wisdom” that ‘big’ crises do not happen and that fiscal policy is all but irrelevant. Some of the structural problems in Euroland are: (1) the Maastricht Treaty restrictions that aim to limit budget deficits to 3% of GDP and public debt volumes to 60% of GDP; (2) the so-called “excessive deficit” procedures; and, (3) the prohibitions on the European Central Bank buying the debt of member governments in the open market.  The latter is particularly important in the ongoing Euroland tragedy where the death of economy is occurring in slow-motion and by a million cuts. Financial markets believe and have good reason to believe that the US Federal Reserve will always be there ready and willing do whatever it takes to stand behind the US Treasury when/if needed: there is no such confidence about Euroland.

Making matters worse is that Euroland policymakers are drawing the wrong conclusions that the rules tying the hands of fiscal policy are not tight enough. It is very difficult to foresee the long-term survival of the euro currency unless the European Central Bank is given a mandate to act as the government’s banker and buy public debt in the open market. There is also a need for an agreement on a collective fiscal authority/mechanism to transfer funds between surplus and deficit members (especially since a single currency entails that changes in exchange rates are not an option to facilitate internal rebalancing). One can only hope that Washington policymakers do not foolishly tie their own hands on the fiscal front: Euroland is pursuing that miserly path and it is not working.

References

Costabile, L., ‘The International Circuit of Key Currencies and the Global Crisis’, Workingpaper Series No. 220, Political Economy Research Institute, University of Massachusetts Amherst, March 2010.

S. Curcuru, T. Dvorak and F. Warnock, ‘Current Account Sustainability and Relative Reliability’, International Finance Discussion Papers No. 947, Board of Governors of the Federal Reserve System, 2008.

D’Arista, J., ‘The evolving international monetary system’, Cambridge Journal of Economics, vol. 33, 2009, 633-52.

Hausmann, R., and Panizza, U., ‘Redemption or Abstinence?’, CID Working Paper No. 194, Harvard University, February 2010.

Ocampo, J., ‘The Instability and Inequities of the Global Reserve System’, United Nations DESA Working Paper No. 59, November 2007.

United Nations, ‘Report of the Commission of Experts of the President of the United Nations General Assembly on Reforms of the International Monetary and Financial System’, Final Report, United Nations, New York,  September 2009.

Wolf, M., Fixing Global Finance, John Hopkins University Press, Baltimore, 2008.

Brett Fiebiger

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