Was China’s call for a world currency a sign of weakness?

A couple of economists have weighed in on the Chinese proposal for a world reserve currency. They are both worth reading in full, as I think it highlights a perhaps overlooked aspect of the current crisis.Stephen Flanders at the BBC is impressed, giving the Chinese kudos for global leadership for a proposal that

    ….would have made it quite difficult for economies like China to exist. If there had been a Keynes-style global currency system, China would have had to rein in exports and cut domestic saving a long time ago. There would have been no wall of cash looking for safe, or pseudo-safe, assets in countries like the US. And we wouldn’t be where we are today.

She adds

    Maybe Governor Zhou is making mischief at America’s expense. Maybe he hasn’t gone back to the Keynesian roots of his idea to see where, exactly it would lead (though I would find that very surprising).

I suspect Paul Krugman would not find it all that surprising, though:

    But there’s both less and more here than meets the eye. S.D.R.’s aren’t real money. They’re accounting units whose value is set by a basket of dollars, euros, Japanese yen and British pounds. And there’s nothing to keep China from diversifying its reserves away from the dollar, indeed from holding a reserve basket matching the composition of the S.D.R.’s — nothing, that is, except for the fact that China now owns so many dollars that it can’t sell them off without driving the dollar down and triggering the very capital loss its leaders fear.

    So what Mr. Zhou’s proposal actually amounts to is a plea that someone rescue China from the consequences of its own investment mistakes. That’s not going to happen.

I think this is a key point. It is very easy to berate the US, UK and similar economies for running deficits and going on a spending spree. It fits with our intuition. Spending bad, saving good. We should have been like China, Japan and Germany, saving heavily and runnign surpluses. But it is worth bearing in mind that those sprees essentially financed world growth over the last decade, and that they had to financed from somewhere. The finance came from those countries that were running huge trade surpluses, particularly China. That too played its role in the present mess.

In order to truly fix the world economy, those countries that were running huge deficits need to become more restrained. But those countries that were running huge surpluses need to begin to start adding a significant contribution to global demand, and reduce their savings. This does not fit with our intuition. If they do not, it will be difficult to find something to fill the gap left by the busting of the booms in the housing and financial sectors. Even if we could get past that problem, it would lead to a glut of cheap money looking for a home: exactly what put us into the mess in the first place. As Krugman puts it

    And the call for some magical solution to the problem of China’s excess of dollars suggests something else: that China’s leaders haven’t come to grips with the fact that the rules of the game have changed in a fundamental way….

    The bottom line is that China hasn’t yet faced up to the wrenching changes that will be needed to deal with this global crisis. The same could, of course, be said of the Japanese, the Europeans — and us.

  • Mack

    I don’t know Kensei, Anglo-American economies went crazy borrowing money to invest in a pyramid scheme, and as a side-effect purchase Asian goods built with German machinery. Had we not done so, our deficits wouldn’t be as bad, and their surpluses not as large.

    How this winds up being their fault, or why they’d want to repeat our mistakes, is beyond me…

    Peter Schiff descibes this effect well. We have 10 men on an island, 9 Asians and an Americans. So the 10 decide to divy up the labour, a couple of Asians set up a farm, another couple head of fishing another few start building huts and shelters – the American decides his role is going to be to sleep in the huts and eat the food. So, the common wisdom goes, the American appears to be the critical engine of this economy – without him to eat all the food and sleep all day in the huts the Asians would be all out of a job!

  • Kensei

    Mack

    How this winds up being their fault, or why they’d want to repeat our mistakes, is beyond me…

    Who was assigning blame? We need out of this “It’s X’s fault” mentality, it’s damaging.

    The surpluses would not be as large, true, but China would have had much less growth and both Japan and Germany would likely have either been stagnant or in recession. Those economies to a great deal have proposered due to our irresponsibility.

    That’s ok; it was a sensible thing to do at the time. But it is not sustainable, and it isn’t coming back. Success will require change beyond the prolifragte economies. I just want to throw in a counterpoint to the hairshirts constantly getting chucked about. It isn’t a good idea either. What is needed is a balanced economies and a balanced world economy. Export and imports should ideally match, and huge surpluses cannot be sustyained any miore than huge deficits.

    This is not a new problem. A spointed out the Chinese idea originates from Keynes.

  • abucs

    I am a bit confused over this new world currency.
    Doesn’t the currency have to actually be backed by something ?
    I know we used to have the gold standard, and then paper money was backed by the GNP of each country but what will the new currency be backed by ?

    It won’t be a natural resource and it won’t be by a single juristiction, it will have to be backed by a conglomerate of nations.

    But that new money will have to, at some stage be invested, even if it is in simple interest paying deposits. And those investments will ultimately be backed by somebody else. So what is the use of having a world currency when it is going to be backed ultimately by much the same people as it is now ?

    The only way i see it happening is that some international body will build up their own assets in this new currency and trade against that. But who would be this new body and why would we give them our money ?

    Something smells fishy here to me.

  • Kensei
  • abucs

    Thanks for the links Kensei.

    With the first proposal in the first link i still see someone ?? building up wealth in this new currency.

    For the second link suggestion i’m not really sure why it needs a new currency. It seems to have its main focus on keeping countries current accounts in balance and using a basket of currencies as the marker.

    Wealth in this new currency could be built up again i suppose (by someone imposing the tax ??) if countries were willing to pay the tax.

    If the whole focus is to balance trade though you’d probably want a high tax. Countries would aviod paying the tax (and taxing their own exporters i guess) by either :

    reducing exports which might not be too good for world trade. If this happened it would mean a lot of jobs and the new currency reserves will not be built up because they would not be receiving the tax.

    or probably just recalibrating their currencies which mean more countries might want to control their currency values (like the Chinese). Not sure what that would do for world trade, but the new currency reserves would definitely not be built up then and so it would not be used as a ‘default currency’ but more of a marker between ‘real’ currencies ??

    i think countries like China/Ireland who are export focussed might suffer quite badly in the medium term.

    I’d like to hear your thoughts though.

    I’m still confused. :o)

  • Mack

    abucs –

    Currencies today are all FIAT currencies. From the Latin – “It will be done”, that is to say they are backed by nothing other than the will of the government issuing the currency.

    Now that the USA is debasing the dollar, the Chinese have real concerns about their huge dollar reserves. So they’d like to replace the dollar as the world’s reserve currency with something not under the control of a single nation.

    The proposal is not for a currency like the Euro, that would actually be used for day to day trade, but rather a currency that would be used by nations for their currency reserves, ultimately national currencies would be valued against the reserve currency and would be free to float against it. What this would mean for the Chinese is that if the USA decided to print dollars the dollar would collapse but their foreign reserves would hold their value.

    There is a difference between money and wealth. Money is a store of value and means of exchange, and as such it can have completely arbitrary values. You could theoretically just issue the new currency (simply by printing notes & minting coins, or by entering a number in a database) – this would be another Fiat currency. If the amount of currency in existence is finite the value of each unit could be ascertained by an open market auction. The Chinese proposal is slightly more complex as I believe that the SDR’s themselves would be funded from a basket of Fiat currencies.

  • Kensei

    Also this is important from the linka bove:

    Nations that imported more than they exported — debtor nations — would pay a small interest charge to the Clearing Union on their overdrawn account. This would encourage those nations to promote exports by a range of domestic policies as well as marginal currency devaluation. Equally, nations that ran an aggressive trade policy and exported more than they imported would also be charged by the Clearing Union for their surplus account. This would encourage those nations to find ways to spend their excess Bancors back in debtor nations — or gradually lose that surplus.

    Large surpluses become a cost, rather than a vehicle for getting a return.