International Liquidity:
The Fiscal Dimension
Keynote Speech by Maurice Obstfeld

All schemes to enhance global liquidity require a higher level of fiscal
support and coordination from the international community. Loans totroubled sovereigns or financial institutions imply a credit risk that
ultimately must be lodged somewhere. Expanded international lending
facilities, including an expanded International Monetary Fund, require
an expanded level of fiscal backup. The same point obviously applies tothe European framework for managing internal sovereign debt problems,
including proposals for a jointly guaranteed euro zone sovereign bond.
Even attainment of a significant role for the Special Drawing Rightdepends upon enhanced fiscal resources and burden sharing at theinternational level.
Keywords: International liquidity; Sovereign debt; Euro zone crisis;
Fiscal union; International Monetary Fund; Special Drawing
RightsJEL Classification: F33, F34, F36, H87

University of California, Berkeley (E-mail: obstfeld@econ.berkeley.edu)
This paper was prepared for the 2011 International Conference, “Real and Financial Linkage andMonetary Policy,” held by the Institute for Monetary and Economic Studies, Bank of Japan inTokyo on June 1–2, 2011.
MONETARY AND ECONOMIC STUDIES/NOVEMBER 2011
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I. Introduction
The ultimate origin of the 2007–09 financial crisis, in particular the causal role of theinternational monetary and financial system, remains a topic of heated debate. Whatis undeniable, however, is that the development of the crisis, as well as its aftermath,revealed numerous weaknesses in the infrastructure of global monetary and financial
relations. These weaknesses, which plainly influenced the cross-border transmission of
the crisis and the official policy responses, are the focus of ongoing reform efforts.
While these efforts encompass several closely related areas—ranging from thesurveillance of global imbalances and exchange rates to coordination of financial
supervision—my main focus here will be on the nature and adequacy of internationalliquidity. The topic is a time-honored one, but the challenge of liquidity provision has
evolved in form and become more urgent as world finance has evolved.
Because liquidity crises typically are generated by solvency concerns and, in extremis, can generate solvency concerns themselves, the burden of crisis prevention andmanagement ultimately falls at the door of the fiscal authority, as forcefully stressed by
Goodhart (1999). In an international context, moreover, this fact inevitably raises questions of international cost sharing by fiscal authorities and private market participants—
as the 2010–11 sovereign debt crises in Europe have made painfully clear. Indeed,
the problem of allocating fiscal burden ramifies into every facet of the debate overinternational liquidity.

II. International Liquidity: Then
The adequacy of international liquidity was a major factor in Bretton Woods era debates over reforming the international monetary system. But four main features of theperiod—the U.S. dollar’s link to gold, the par value exchange rate system, the tighter
regulation of domestic and especially international financial transactions, and the more
limited development of financial markets in general—made the terms of debate quite
different from what they are today.
Through the demise of fixed exchange rates in the early 1970s, gross foreign exchange reserves constituted the most important source of international liquidity. Subject to policy conditionality, reserves could be supplemented by International Monetary
Fund (IMF) resources, and for a subset of richer countries, by foreign exchange swap
lines that were developed during the 1960s to counter speculation against fixed exchange parities. Defense of fixed exchange rates furnished the main motivation forholding reserves, and in an environment of limited private international credit, suchdefense was correlated with the need to finance imports when export earnings proved
inadequate. In a rapidly growing world economy, feasible increases in monetary gold
could not possibly meet countries’ demands for international reserves. Holdings ofdollars therefore fulfilled marginal global reserve demands, implying that the supply
of world liquidity would be tied to ongoing U.S. balance of payments deficits.
This system, however, contained an inherently self-destroying dynamic, summarizedby Triffin’s famous dilemma: either the world supply of liquidity would be inadequate,

34 MONETARY AND ECONOMIC STUDIES/NOVEMBER 2011

International Liquidity: The Fiscal Dimension

or foreign monetary authorities’ U.S. dollar holdings would expand beyond the amountthe United States could redeem in gold at the statutory dollar peg of US$35 per ounce.
Triffin’s tipping point—the point at which global reserves exceeded the value of U.S.
gold holdings at the US$35 per ounce price—was in fact reached as early as 1960(see Eichengreen [2011]). The subsequent history of the Bretton Woods system wascharacterized by increasingly desperate attempts to stave off dollar devaluation.
At its root, the Triffin problem was fiscal. As late as 1970, the world’s reserve
holdings of U.S. dollars implied a claim on U.S. gold equal to 4.2 percent of U.S.
GDP, at a time when the gross U.S. federal debt stood at only 28 percent of GDP.
While this fiscal burden was not insuperable if the US$35 per ounce gold price could bemaintained, the United States would have had to buy more than all the world’s monetary
gold to redeem global dollar reserves, thereby driving the world price to infinity anditself into state bankruptcy.
The most innovative attempt to solve this dilemma was the Special Drawing Right(SDR), which has received renewed attention recently as a possible linchpin of areformed international monetary system (for example, Zhou [2009]). The SDR was
launched on January 1, 1970 following passage of the First Amendment to the IMF
Articles of Agreement the year before. The SDR provided an unconditional supplement
to other financial resources that might be obtained through the IMF—unconditional
because, unlike in standby arrangements, a country’s use of its SDRs is not generally
subject to IMF policy conditionality (only to the payment of interest to the IMF). SDRs
were to be distributed (“allocated”) to Fund members in proportion to their IMF quotas,
and they could be exchanged with other Fund members for needed currency reserves.
SDRs thus would supplement liquidity by allowing for more efficient reserve poolingby IMF members. The hope was that SDRs would supplement and eventually evendisplace U.S. dollars in reserves, allowing global reserves to grow at an adequate pace
without as much need for U.S. payments deficits.

III. International Liquidity: Now
Since the 1970s, dramatic changes in the international monetary and financial landscape have changed the factors motivating global liquidity demand, both qualitatively
and quantitatively. The gold–U.S. dollar link is long gone, exchange rates are much
more flexible throughout much of the world, domestic finance has been widely and extensively liberalized, and cross-border financial transactions have grown dramatically.
For the industrial economies that were the major holders of U.S. dollar reservesin the 1960s and 1970s, easier credit market access and floating exchange rates madeSDRs largely irrelevant. Between 1981 and 2009, the (unheeded) calls for further SDR
allocation came from the developing world. But the events of 2007–09 and after haveshown that the need for international liquidity remains acute, even for the rich countries.
The sources of this need differ from those of the Bretton Woods years—but they arefamiliar from the experience of emerging market economies (EMEs).
For the richer countries, immersion in global capital markets has generated international liquidity needs in two main areas of vulnerability: the support of financial

35

institutions and the funding of sovereign debt. The two are closely related, as supportof the private financial system can swell government debt, while a fiscally strained
government may face difficulty in credibly underwriting financial stability. Both factors
played big roles in past EME crises, as just noted, but their appearance as a threat foradvanced economies is related to the latter group’s much more extensive degree offinancial liberalization and development.
A prime indicator of that development is the rapid growth of the gross foreign asset
and liability positions of advanced economies. Potentially at least, this process carries
an ever-increasing risk of balance-sheet crises. Figure 1 shows data for the three largest
high-income currency areas. In both the United States and the euro zone (panels [1]and [2]), external gross asset and liability positions roughly doubled in relation to GDP
after the late 1990s, with the euro zone’s levels of both being higher (even after nettingout the extensive intra-European positions of the individual member countries). For
both regions, a negative net international position has grown much more gradually andremains moderate. Japan’s case (panel [3]) shows considerably slower growth of grossliabilities. Over 1999–2009, less than half of Japan’s increase in gross foreign assets
is matched by increased gross liabilities. Japan’s net international investment positionstood at more than half of its GDP in 2009.
The acceleration of gross position growth for the euro zone over 2004–07 represents in part a dynamic process through which Europeans added U.S. asset-backed
securities (ABSs) and corporate bonds to their portfolios, financing these purchases(in the aggregate) via sovereign debt issuance and interbank borrowing (see Bernanke
et al. [2011]). The resulting positions led to substantial turmoil in 2007–09 in European
U.S. dollar funding markets, turmoil that well illustrates the first area of global financial
vulnerability mentioned earlier.
European banks, lacking a base of retail U.S. dollar deposits, financed dollar
ABS purchases through short-term wholesale dollar borrowing, but in the crisis foundthemselves unable to roll over the dollar loans or to swap euros into dollars on reasonable terms (McGuire and von Peter [2009]). The banks’ toxic assets were illiquid;
selling them would have forced realized losses and contributed to the general fire-saledynamics under way at the time. On the other hand, even more sales of euros (suppliedby the European Central Bank [ECB]) for dollars would have accentuated the safehaven dynamics driving the dollar upward. We now know that the Federal Reserve lentdollars extensively and directly to European banks that had access to its discount window; but the extension of swap lines to foreign central banks was a major supplement tothat process. As a result, the ECB and other central banks assumed the credit risk of theemergency loans—thus shifting part of the potential fiscal burden as a global last-resort
lender off of the Fed’s shoulders. Had the ECB, for example, made large losses on its
lending, some consortium of euro zone fiscal authorities would have had to assume theultimate liability to the Fed, as well as any cost to or recapitalizing of the ECB.
Different channels through which capital inflows can generate sovereign debt
problems—the second vulnerability area mentioned earlier—are illustrated by the recent experiences of some smaller euro zone countries. The data in Figure 2 extend only
through 2007, and are drawn from the updated database of Lane and Milesi-Ferretti(2007). Panel [1] of Figure 2 shows that the Greek case follows a pattern familiar to36 MONETARY AND ECONOMIC STUDIES/NOVEMBER 2011

International Liquidity: The Fiscal Dimension

Figure 1 Gross and Net International Positions, Large Currency Areas[1] United States[2] Euro 17[3] Japan

Sources: For the United States: http://www.bea.gov, accessed May 2, 2011. For the Euro 17:
http://sdw.ecb.europa.eu, accessed April 29, 2011. For Japan: http://www.boj.or.jp/en/
statistics/br/bop/index.htm/, accessed April 29, 2011 and http://www.esri.cao.go.jp/en/
sna/kakuhou/kekka/h21_kaku/23annual_report_e.html, accessed April 29, 2011.

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Figure 2 Gross and Net International Positions, Euro Zone Crisis Countries[1] Greece[2] Ireland[3] Portugal

Source: http://www.philiplane.org/EWN.html, accessed May 2, 2011.

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International Liquidity: The Fiscal Dimension

past sovereign debt crises in EMEs. Although there is financial deepening after accession to the euro zone, the main story is the rapid buildup of net external liabilities—
mostly intertemporal trade as opposed to intratemporal trade, in the terminology usedin Obstfeld (2004). Large current account deficits have mirrored large fiscal deficits,
and these have brought net external liabilities as well as government debt to high levels
relative to GDP, much higher than the levels EMEs have been able to tolerate withoutcrises in the past (Reinhart, Rogoff, and Savastano [2003]). The run-up in liabilities is
all the more surprising because, in common with EMEs that must borrow in foreign
currency, individual members of the euro zone have no inflation or devaluation option
to reduce the real value of debts, only some form of default. The eruption of a crisis is
no surprise; what is more surprising is that it did not occur earlier, and the delay must
be ascribed in part to the expectation of support from European partner countries.
Ireland points up the perils of having a large, internationally exposed banking sector(panel [2] of Figure 2). The exorbitant ratios of external assets and liabilities to GDP—
both as high as 13 in 2007!—overstate the risks to the Irish fisc, as much borrowing
was done by international banks located in Ireland, but with minimal connection to
the Irish economy. Yet the liabilities of those banks of direct systemic importance to
Ireland, once assumed by the Irish government in a bid to stem the domestic banking
crisis, were sufficient to spark a sovereign debt crisis, notwithstanding Ireland’s moderate level of net external liabilities. The lesson is clear: gross liabilities, especiallythose at short term, are what matter. Even those offsetting assets that happen to beowned by the debtors may well be illiquid, and saleable only at impaired values.
Portugal (panel [3] of Figure 2) shows a picture combining the most worrisomecharacteristics of both Greece and Ireland: higher gross assets and liabilities relative to
GDP than Greece, and thus higher liquidity risk, but a comparable level of net foreign
liabilities, roughly equal to GDP already in 2007.1
The policy response to the sovereign debt crises of these three countries has followed the model used many times in EMEs, including IMF involvement, with the added
twist that European Union institutions—the ECB, the euro zone countries throughthe European Financial Stability Facility, and the European Commission—have also
stepped in with financial support and their own demands on the borrowers. These include (at least so far) a rejection of outright sovereign debt restructuring outside of
Greece, in part because widespread restructuring might imperil banks elsewhere inEurope as well as the capital of the ECB, which has heavily underwritten the banking systems of the crisis countries and made direct support purchases of distressedsovereign debt.2 The future institutionalization of such European support, including theimplied pooling of fiscal resources, remains a work in progress.
Among high-income countries, sovereign debt problems have been most dramaticin the euro zone, but non-euro countries such as Iceland have also encountered difficulties. Governments that issue debt and whose financial institutions borrow primarily in
1. Banco de Portugal reported the country’s net international investment position to be 108 percent of GDP at
the end of 2010.
2. In the euro zone’s current crisis, both aspects of financial vulnerability described above are in play: financial
institutions in the debtor countries are dependent on the ECB’s last-resort support, while their governments are
dependent on official loans to avoid default.

39the currency that the domestic central bank prints would not require foreign currency
liquidity in order to make debt payments. Such countries could still encounter sharp
inflation and depreciation pressures in the face of big fiscal imbalances, and might
desire access to foreign exchange for intervention purposes, as the United Kingdom
did when it negotiated IMF standby arrangements in the mid-1970s.
The euro zone’s problems are singular in that members share a central bank andcannot individually use devaluation to aid adjustment. Instead, a stricken euro zone
member must rely on internal deflation. But internal deflation raises the real value ofdebts, itself a destabilizing trend. To make matters worse in the current situation, the redistribution to creditors from debtors is more severe when gross liabilities are higher—
and the expansion of leverage has been one consequence of the financial liberalization
within Europe (and globally) both before and after the euro’s introduction. I believe,
however, that the euro zone crisis is at heart a crisis of globalized finance, and thatbroadly similar crises are possible in the future on a grander scale.
All the preceding considerations point to high future international liquidity needs.
Given the extent of financial integration in the developed world, any realistic forecast
must consider the possibility of large-scale support for advanced countries. In addition,
more demand will continue to come from countries currently classified as EMEs, which
are growing more rapidly than richer countries and already account for more than half
the world’s output, measured at purchasing power parity (PPP). EME gross financial
flows—private and official alike—account for a significant and growing share of global
financial activity, though these flows are not yet near the levels of gross flows among
advanced countries. Thus, the growth of the EMEs will add increasingly to the need forinternational liquidity, and, as I now discuss, in ways likely to strain the world financial
system unless reforms are put into place.

IV. Meeting Future Liquidity Needs
After the widespread financial crises of the late 1990s, developing countries and especially EMEs embarked on a path of rapid foreign reserve accumulation. In part, reserve
growth reflected export-oriented growth strategies, but another motivation was to build
precautionary liquid hard-currency balances that could be deployed in the event of aninternal or external financial crisis. Accordingly, as the EMEs’ financial sectors grew,
so did their holdings of reserves (Obstfeld, Shambaugh, and Taylor [2010]). Figure 3
depicts the evolution of reserves since 1990. Advanced country reserves have risen
moderately over two decades, but the reserves of emerging and developing countries
have grown explosively and now stand at around one-third of the holders’ group GDP.
This means, of course, that poorer countries’ reserve holdings constitute a large fraction of the GDP of the advanced countries—large enough to affect materially the lattercountries’ capital markets.
For the holders, the great attraction of reserves is that they provide instantaneousand unconditional liquidity. But even at the level of the individual holder, there aredownsides: reserves may come at a high quasi-fiscal cost (costs also incurred if reserves
should depreciate against domestic currency), and these costs may be incurred even if

40 MONETARY AND ECONOMIC STUDIES/NOVEMBER 2011

International Liquidity: The Fiscal Dimension

Figure 3 Foreign Exchange Reserves of Emerging/Developing and Advanced Countries

Note: The “advanced” group excludes Hong Kong, South Korea, Singapore, and Taiwan but
includes the Czech Republic, Estonia, Slovenia, and the Slovak Republic.
Sources: International Financial Statistics (May 2011) for reserve data (which include gold
valued using national methods); World Economic Outlook (April 2011) for GDP data.

the marginal liquidity value of the reserves is illusory (because the process of reserveacquisition generated an equal short-term private foreign-currency debt as an offsetting
counterpart on the national balance sheet).
Beyond these individual costs, however, national self-insurance through holdingsof gross foreign reserves carries significant potential systemic costs. Reserve accumulation may influence interest rates in reserve centers—helping to fuel international
resentments about “exorbitant privilege” that often fail to recognize the root of the
problem in systemic congestion. Similarly, official portfolio shifts between different
currencies, or between asset classes within currency areas (think of Chinese purchasesof euro zone sovereign debt), can alter exchange rates and bond prices, possibly indestabilizing ways. Individual countries’ reserve gains may be strategic complements,
in the sense that one country’s gains lower the relative perceived financial stability of
its neighbors, in turn raising their marginal benefit from reserve accumulation. In thiscase, a non-cooperative equilibrium will entail excessive accumulation by all. A further
coordination problem arises when countries compete to keep their currencies weak andlimit domestic demand, so as to generate current account surpluses. Finally, in a global
crisis, a country may exacerbate problems elsewhere when it draws on its reserves.
For example, withdrawals of bank deposits in a foreign center may worsen liquidity

41

problems there. The basic point is that actions that enhance the apparent financial
resilience of the individual country may well, at the same time, undermine that of theinternational financial system as a whole.
Another drawback of a system based on gross reserve holdings is the potentiallylimited supply of suitable reserve assets. The possibility has been emphasized by Farhi,
Gourinchas, and Rey (2011), and is reminiscent of the Triffin dynamic, in that the very
logic of reserve accumulation implies an ineluctable process of destabilization for thesystem of self-insurance. Emerging and developing countries have historically faced
more limited credit market access than the richer countries, hence their greater demand
for reserves, yet their economies are growing more rapidly and likely will continue todo so for some time. The relatively low-risk assets in which they hold reserves, however, are limited in supply. For example, eligible reserve assets could be direct central
government liabilities, or other assets such as bank deposits that implicitly come undera government guarantee. What makes these assets “safe” is the creditworthiness of theirguarantor, including its predictable (and preferably low) propensity to try to inflate away
the assets’ real values.3 But no government can assume the corresponding liabilities
to an unlimited extent. A government willing increasingly to issue safe liabilities andinvest in risky assets eventually becomes more likely to encounter fiscal problems in asystemic crisis—precisely the moment its creditor will wish to liquidate its supposedly
safe claims. Thus, it appears infeasible for the emerging and developing countries tosatisfy their long-term reserve demands on the basis of a few rich and creditworthy
reserve issuers whose economies are shrinking as a fraction of world GDP.4 , 5These considerations help explain why some central banks are seeking to increase
their holdings of gold, reversing a decades-long trend, although the resulting likely
effect on the metal’s price illustrates the systemic dangers that result. As central banks
move into riskier asset classes, the chances grow that these assets’ prices will at somepoint come under pressure, eliciting destabilizing official asset sales.
The preceding problems of self-insurance could be overcome through reforms creating more low-conditionality international liquidity through a central institution suchas the IMF. The Fund’s recent development of the Flexible and Precautionary Credit
Lines are limited steps in this direction.
Such new facilities enhance the IMF’s traditional role of lending to governments
facing balance of payments pressures. The Fund’s recent participation in loan programsfor Greece, Ireland, and Portugal is something of a new departure, not only becauseof the close cooperation with European authorities, but because the programs have no
explicit balance of payments dimension. The IMF is lending euros to countries that use
the euro but cannot print it, assuming parts of fiscal and enforcement burdens that its
co-lenders would rather not shoulder in full.
3. Safe assets should be informationally insensitive assets, in the sense of Gorton and Pennacchi (1990). But as therecent crisis showed, putatively informationally insensitive assets (such as AAA tranches of mortgage pools)
may become sensitized to information, and therefore unsafe. The same might happen to agency debt or largebank deposits were government guarantees to become doubtful.
4. Of course, assets that are safe for one reserve holder may not be for another. Syria, to take an extreme example,
currently has fewer safe reserve options than most other countries.
5. In a related vein, Alan Greenspan reportedly worried around 2000–01 that if U.S. government surpluses
eliminated the federal debt, the Fed would be forced to invest the domestic portion of its portfolio in risky
private-sector assets.

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International Liquidity: The Fiscal Dimension

Alongside the IMF, however, there is also a need for facilities that provide direct,
multiple-currency support to financial institutions, as central bank swap lines did starting in 2007. National central banks are unlikely to provide facilities such as these except
on an ad hoc, discretionary basis. But if this is the case, then the resulting uncertainty
would make such potential credit lines a poor substitute for the liquidity offered bygross reserves. A more predictable architecture might have central banks provide credit
lines in their currencies to the IMF or the Bank for International Settlements (BIS),
for on-lending directly to national central banks.6 Under such a system, the central
banks of reserve centers would create outside liquidity during crises, denominated insuch currencies as the borrowing central banks needed. Of course, in setting up sucha system, measures to mitigate the resulting moral hazards are critical. As a partial
safeguard, the IMF or BIS could extend the facilities only to national central banks
meeting specified standards of supervisory diligence and independence from politicalinterference. Further discussion of similar ideas can be found in Truman (2008, 2010),
Obstfeld (2009), and Farhi, Gourinchas, and Rey (2011), among others.
A complementary but more limited step would enhance the allocation of liquidity
through reserve pooling. Under such a scheme, Chinese reserves, for example, could be
deployed quickly in aid of countries the IMF or some other gatekeeper deemed worthyof liquidity support.
All of these schemes to enhance global liquidity require a higher level of fiscal support and coordination from the international community. Loans to troubled sovereigns
or financial institutions imply a credit risk that ultimately must be lodged somewhere.
Expanded lending facilities, including an expanded IMF, require an expanded level offiscal backup. The same is obviously the case—and has been contentious—in the designof the future European Stability Mechanism. Proposals for a shared euro zone sovereign
bond (Juncker and Tremonti [2010]) likewise place fiscal demands on the financiallystrong countries that would be the ultimate guarantors of the jointly issued debt.
Through the resulting guarantees, the more creditworthy countries subsidize theothers, at some actual fiscal cost to themselves, and an even greater potential costin the event a member government gets into trouble. Globalized finance leads to an
inherent interdependence of stability risks, which in turn justifies an internationally
coordinated response. This response includes the joint provision of necessary fiscal
resources, as well as political mechanisms for allocating fiscal burdens in ways that
discourage free-riding.

V. Possibilities for the SDR
Article VIII of the IMF Articles of Agreement enjoins member countries to promote
the goal of making the SDR “the principal reserve asset in the international monetarysystem.” Recent proposals by current and former international policymakers likewise
have suggested that a reserve currency system should somehow be based on the SDR,
one objective being to dislodge the U.S. dollar from its privileged reserve currency role,
6. Central bankers would prefer the BIS. It has some experience in this area, and is more distant from politicalpressures than the IMF.

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Figure 4 SDR Holdings in Relation to Total International Reserves: Advanced
Countries, Emerging/Developing Countries, and the World

Source: International Financial Statistics (March 2011).

which is alleged to be potentially destabilizing as well as unfair. Would such a system besuperior to the current one, and in particular, provide more effectively for internationalliquidity needs? The question is difficult to answer in the absence of a specific blueprint
for achieving the end to which Article VIII aspires.
In the event, SDRs have never been more than 6 percent of global reserves, andeven the large allocations of April and September 2009 restored them only to a share
below 4 percent (Figure 4). Several factors prevent a much larger role for SDRs in thecurrent international monetary system, with fiscal obstacles among the primary ones.
That does not mean the SDR’s role could not be marginally larger, and perhaps even
usefully so.
At present the SDR mechanism functions largely as a reserve-pooling arrangement,
useful in reallocating global liquidity from countries with ample liquidity to those withmore urgent needs. A country holding SDRs can trade them to other Fund members,
or to prescribed SDR holders such as the BIS, for hard currencies.7 But the mechanism
does not create new liquidity, in the form of higher supplies of high-powered reserve
7. SDR transactions between countries usually are voluntary, but from time to time the IMF may “designate”
certain countries with strong external positions to accept SDRs.

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International Liquidity: The Fiscal Dimension

currencies, as might be needed during a global crisis. When countries sell SDRs to
the U.S. Treasury for U.S. dollars, for example, the Fed creates the dollars, accepting
in return SDR Certificates issued by the Treasury. The latter are dollar-denominated,so that the Treasury bears any currency risk. However, the high-powered dollars so
issued are (normally) automatically sterilized, and in any case the quantities involved
are typically small. For example, on May 4, 2011, the Fed held only US$5.2 billion in
SDR Certificates. SDR purchases of dollars from the United Kingdom would, likewise,not create new dollar liquidity.
The SDR’s value is linked to that of a basket of the four principal reserve currencies,
to stabilize the value of IMF members’ claims on the reserve pool. But the SDR is notitself a currency that can be bought and sold in private markets. This is a critical point,
because it implies that SDRs cannot be used directly in market operations. The obstacles
to creating a private SDR market are large—see Eichengreen (2011) for a discussion—and though the IMF could perhaps begin to promote this end by issuing SDR bonds inprivate markets, large-scale IMF borrowing would greatly increase the need for fiscal
backstopping by member countries.
If countries held more SDRs and fewer reserve currencies, some of the problemsof large-scale gross foreign reserve holdings, discussed above, might be mitigated. The
main proposal for large-scale replacement of currency reserves with SDRs is through a
substitution account, under which countries deposit currency reserves with the IMF in
return for SDRs (for example, Kenen [2010]). This scheme, however, merely transfers
any financial burden to the IMF, which itself could earn low returns on its currency
balances (in cases of exorbitant privilege) and bear the risk of exchange rate changes.
In other words, someone still must pay the cost of the reserve system, even if the threatof official runs on one or more reserve currencies is reduced.
How can IMF members share this cost? Plans for a substitution account founderedon this rock in 1979–80; the scale of the problem is even greater now. As has been truein the euro zone, absence of a centralized fiscal power hobbles the provision of public
goods that might enhance systemic financial stability. (Of course, individual countries
are free now to choose reserve portfolios that reproduce the SDR basket, though on
average they hold a higher weight of U.S. dollars.)
If SDRs can be created only through the allocation process and not through substitution, then under current arrangements, the extent to which they can replace currency
reserves is inherently self-limiting. This Triffinesque problem sharply circumscribes thepotential for realizing the lofty goal of the IMF’s Article VIII. Roughly speaking, because SDRs are merely claims on hard-currency reserves and cannot be used in private
markets, their emission has no further value once the value of outstanding SDR claims
is sufficient to purchase the outstanding stock of gross currency reserves.8
The situation would be different if SDR claims could be presented directly to central banks in return for their own currencies, as Truman (2008, 2010) has proposed,
because this change would make the outside supply of reserve currencies elastic ina crisis. Such a system would reproduce the stabilizing properties of the network
8. I am taking it for granted that, for example, the U.S. Treasury and the Fed would not willingly agree to thelarge-scale creation of SDR Certificates under current law.

45

of central bank swap facilities set up during the recent global financial crisis, but itwould be predictable rather than ad hoc and all countries, not just a select few, would
have access.
An equivalent mechanism could be set up without reference to the SDR at all,simply by instituting lines of credit from central banks and administered by the IMF
or BIS, as suggested above. Such credit lines would complement expanded flexible
IMF loan facilities for sovereigns. The advantage of working through the SDR as
Truman suggests is that SDRs already exist—the sunk cost of negotiation and national
ratification was paid long ago. However, even under Truman’s plan, existing national
legislation would probably need to be amended. And the implications for treasuries andcentral banks of potentially large foreign exchange losses and gains would need to besorted out.
Likewise, even the current SDR-based reserve-pooling arrangements could be accomplished, perhaps in a more flexible and need-based way, by explicit reserve pooling.
Pooling would allow relaxation of the current quota-based SDR allocation formula. Another advantage of this approach is that countries would not need to offset the currency
risk taken on through SDR transactions with opposite, possibly costly, forward-market
transactions. The costs of these could become significant were SDRs to become more
important as a reserve category.

VI. Conclusion
While I have focused on the international liquidity system and the fiscal requirements
for improving it, its redesign cannot be accomplished in a vacuum and indeed would
require challenging complementary reforms.
An enhanced international liquidity safety net, whether based on the SDR or onsome system of credit lines centered on the IMF, would enhance the IMF’s power. It
therefore calls for complementary reforms in governance structure. These would beaimed at increasing the voice of emerging and developing countries, in line with theirgrowing weight in the world economy. As part of a reformed international monetarysystem, the IMF’s macroeconomic and financial surveillance powers would have to be
upgraded. This change would add greatly to the need for reformed IMF governance.
Recent experience shows the potential for banking problems quickly to morph into
big fiscal problems with externalities for financial institutions abroad. This is a problem
for any globalized financial system, not just the euro zone with its common currency.
Thus, internationally coordinated lender of last resort support, with the coordinatedfiscal backup that is implied, requires some sort of common framework of financial
supervision and regulatory enforcement. The international supervisory system must
provide a strong brake to the several forms of moral hazard, and to be effective, supervision must be closely coordinated internationally, with the support of clear guidelines
for resolving cross-border financial institutions and sharing the resulting costs. The eurozone’s failed (but largely continuing) attempt to leave national supervisory regimes
in place offers a vivid example. Limitation of moral hazard also demands some sort

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International Liquidity: The Fiscal Dimensionof predictable system for orderly sovereign debt restructuring in cases of insolvency,
including potential cases of high-income countries.
The trilemma described by Schoenmaker (2011) applies quite broadly: if one
wishes to enjoy financial integration, one must give up national autonomy in financial regulation or give up financial stability. Even more generally, to function effectively, globalized markets require the support of globalized institutions of governance,
including institutions of fiscal coordination.

47

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