© Hendrik van den Berg
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With the US currency currently being a reserve currency, do you expect the Dollar to maintain its status for years to come or there is a potential that the IMF's Special Drawing Rights may become an international reserve asset?
The reserve currency will be whatever currency governments, central bankers, corporations, financial firms, and wealth holders prefer to denominate their wealth in. Also, we should ask: If not the dollar, then what? The Euro region may be split in half, the Chinese Yuan is not yet freely convertible, the Swiss Franc has a very small economy behind it, and Japanese Yen assets are not very widely held outside of Japan.
Yes, technically Special Drawing Rights (SDRs) could become the international reserve currency, as some countries indeed wanted back in the 1960s. But I do not see this happening soon, largely because I do not think the US would agree to it. The US enjoys having its currency serve as the world's reserve currency because it lets its government borrow in its own currency and thus avoid the danger of default on its loans. SDRs evenly allocated across the world's economies would also deprive the US of the considerable seignorage it earns from being able to emit Dollars, spend them overseas for goods, assets, and wars, and then never having those Dollars come back to demand US goods and services.
Eventually, perhaps, the Chinese Yuan will become the reserve currency, just as the Dollar took over from the British Pound. However, in the meantime, the Dollar enjoys a great deal of momentum. It is not easy to change financial practices, redenominate assets, change units of account for countless transactions, etc. Chances are that there will not be a change until there is some major shift in international power and politics, as when World War I triggered the decline of the Pound and World War II (and Bretton Woods) then finally led to the Dollar as the reserve currency.
A number of currencies have been pegged to the US Dollar. What advantages and disadvantages do you see in floating and fixed exchange rates?
There are advantages and disadvantages from letting a currency float freely. With a floating currency, it is easier to deal with payments imbalances. Look at the difficulties Greece, Ireland, and Portugal face trying to become more competitive without being able to devalue their national currency; compared to letting the exchange rate do all the work of making national firms more competitive, price deflation is very costly in terms of unemployment and production losses. The counter-example is Iceland, which used a huge depreciation to quickly restore international balance, and thus enable the government to use expansionary fiscal policy to reverse its financial and economic collapse. Floating exchange rates are not the solution to everything, however. Floating exchange rates can become unstable and cause needless shifts in relative prices, creating imbalances where there were none to begin with. Also, if a large portion of a country's public and private debt is denominated in foreign currencies, then a sudden shift in exchange rates can trigger widespread defaults and financial crises.
In analyzing the advantages of floating exchange rates, it can be useful to examine the so-called "trilemma." This term refers to the basic principle that a country cannot simultaneously maintain completely independent economic policies, open trade and finance, and a fixed exchange rate. Only two of those policy goals can be pursued at the same time. For example, if a country wants to join the global economy while its government adjusts its economic policies in response to shifting domestic political pressures, as is to be expected in a democracy, then attempts to maintain a fixed exchange rate will, sooner or later, fail.
This is effectively the problem that European countries face: the Euro countries effectively have a permanently fixed exchange rate, while these vibrant democracies have also liberalized trade and finance across European borders. Hence, the fixed exchange rate, the Euro in this case, is under pressure. This is not to say the Euro is a bad idea; there are very good reasons for greater European unity, as 70 years of peace attest. (As the son of a family that lived through the German occupation of Holland, I fully appreciate how the European Union has completely eliminated the possibility of a repetition of such an event!) But, the trilemma should, perhaps, have been brought up before Europe rushed into the single currency without establishing the necessary mechanisms to control policy variations, economic divergences, and institutional inconsistencies across the very diverse participating economies.
I do think it is worthwhile to ask whether it really makes sense for the Greek population to suffer through a decade or more off austerity, when examples such as Iceland and Argentina make it clear that breaking the fixed exchange rate greatly accelerates the adjustment and recovery process. Temporarily losing a member of the Euro area need not be fatal; the EU is sufficiently strong to withstand such a modest setback. Greek citizens would be much better off, and the Euro might actually be less threatened. But this does not appear to be a possibility at this time.
China's Yuan has been pegged to the US Dollar. However, as you point out, fixed exchange rate regimes may lead to severe financial crises, since a peg is difficult to maintain in the long term. Do you think it is reasonable for China to peg its currency to the U.S. Dollar?
Actually, the fact that China pegs the Yuan to the Dollar does not mean the Yuan is a fixed currency. Actually, by fixing to the Dollar, China effectively lets the Yuan float vis-a-vis all other currencies. Technically, the Yuan floats in concert with the Dollar. Furthermore, the Chinese government has also made some modest changes in the Yuan-Dollar rate. The fixed Yuan-Dollar rate is not an immediate problem, however, unless you are an American firm competing with Chinese imports. For the global financial system, there is no danger of the fixed rate causing a financial crisis in China, since China is such a large net creditor. The Chinese central bank has more than enough Dollar assets, to the tune of trillions of dollars, to defeat any attack on the fixed exchange rate.
I do expect that the Yuan will be gradually eased into becoming a fully convertible currency with a more flexible, albeit still manipulated, exchange rate. Many countries manipulate their currencies' exchange rates, so I do not see why China would stop doing that, at least as long as its economy is dependent on cheap exports. Furthermore, I see no indication that China wants to move towards a fully open and unregulated financial system. China also wants to protect the international purchasing power of its huge stock of foreign assets. In short, I do not see a shift to a freely floating Yuan in the near future.
Given its economic size, China knows that the world financial system will have to adjust to its wishes, even as China also adjusts to the global financial system of which it is an integral participant. One important question is whether the US and the rest of the world are really prepared to accept China's financial power. If not, the global financial system could be in for considerable instability.