By Mohamed El-Erian and Ramin Toloui
It has become fashionable to speculate on the future of the U.S. dollar as the world’s reserve currency. Amid an average 10% decline in the past six months, analysts have tended to favor one of two conclusions. Some argue that, since you cannot replace something with nothing, the dollar’s global role is secured. Others feel that America’s medium-term prospects are now inconsistent with such a role.
As with many post-crisis issues, the reality is much more complex. This is not just because the dollar will be caught between these two extremes in the muddled middle for the foreseeable future, but also because the dollar is part of a bigger picture that concerns the evolving role of the U.S. as the sole provider of a range of global public goods. At a time when the global system needs such anchors, this uncertainty raises a set of important policy issues.
A couple of decades ago, Charles Kindleberger, the economist best known today as the author of Manias, Panics and Crashes, identified five public goods that support a growth-oriented global economy: (1) acting as a consumer of last resort, (2) coordinating macroeconomic policies, (3) supporting a stable system of exchange rates, (4) acting as a lender of last resort and (5) providing counter-cyclical long-term lending.
In today’s globalized financial world, we would add two more goods to this list: providing the risk-less – a true AAA – asset to benchmark other instruments and activities, and supplying deep and predictable financial markets, which other countries can use to improve their financial intermediation processes.
On the eve of the crisis, the U.S. was the unquestioned provider of all these public goods. But, with the crisis having originated at the core of the global system rather than the periphery, almost every one of them is weaker. As a result, there are two policy questions that need to be addressed: first, which of the public goods can be restored, which can be jointly provided and which need to be replaced; and, second, how will this take place.
On the question of what can be restored, re-establishing the credibility and predictability of U.S. financial markets requires well-designed reform of financial supervision and a credible medium-term program to rein in the budget deficit and limit the growth of U.S. government debt.
On the question of what can be jointly provided, the expanded new role for the G-20 and reform agenda for the International Monetary Fund underscore the extent to which the management of global macroeconomic policy aspires to become more inclusive. This is positive. However, the jury is still out on whether these fora have sufficient teeth to resolve policy differences and convince governments to assume shared responsibilities.
We should also expect to see more discussion in the next few years on new types of reserve assets. While the discussion will include supranational vehicles (like an expanded role for the special drawing rights), the more interesting question is the broader use of currencies like the Chinese yuan. These options will not replace the central role of the U.S. dollar, but supplement it at the margin.
There is one public good that needs to be replaced: the key role that the U.S. has played as the engine of global growth. This role is now constrained by the debt of U.S. households. A sustainable global economy needs other major sources of internal demand, particularly among economies such as China that have historically been focused on export-led growth.
The manner in which these transitions take place is critical. One risk is that key actors will resist these secular changes and seek to reconstitute an outmoded system that no longer fits post-crisis realities. At the other extreme is the risk that major powers go their own way, forsaking effective coordination of policies in favor of more nationalistic moves, such as aggressive currency management or trade and financial protectionism.
The best defense against these outcomes is early recognition and coordinated action. Key economic powers must shape their expectations and policy strategies to the changed contours of the global economy. They must also actively manage policy changes at the national and multilateral level in a way that broadens the provision of global public goods.