Mervyn King: Do we need an international monetary system?
Speech by Mr Mervyn King, Governor of the Bank of England, at the 2011 Economic
Summit, Stanford Institute for Economic Policy Research (SIEPR), Stanford, California,
11 March 2011.
* * *
I am indebted to Charlie Bean, Martin Brooke, Oliver Bush, Ed Dew, Katie Farrant, Andrew Hauser, Jenny Scott,
Misa Tanaka and Iain de Weymarn who have worked closely with me in preparing this speech, and to Michelle
Wright and Rumman Khan for their excellent assistance in preparing the empirical and historical research.
No country, however large or small, is an economic island. Trade has always been the key to
faster economic growth and higher living standards. Some of the most successful examples
of economic development have followed the path of export-led growth, and some of the most
unsuccessful have not. South Korea, for example, exports the same amount of manufactures
in a day as Egypt exports in a month, and its GDP per head is now five times higher. And
trade is not restricted to goods. The days when trade was measured by weight or volume of
cargo through our ports have, by and large, gone. Services account for around a fifth of world
trade, a proportion that is growing.
The expansion of trade in services is related to the rise of technologies that make it easier to
transmit services around the world. Within a few miles of this conference room are
companies like Apple, Facebook and Google that have transformed the way in which
services can be provided worldwide. And even the older services have become tradable -
over the course of a century the All England Lawn Tennis Club Championships at
Wimbledon have grown from a small local tournament to the world's premier tennis event
driven by a global television audience of around 400 million people in 187 countries (as many
as are members of the IMF).
But international trade requires a monetary system to flourish - the rise of the successful
Asian economies would never have occurred if they had been restricted to barter. If flexible
exchange rates were allowed to determine the relative values of different currencies in
competitive markets, why should there be any need for "rules of the game" or an international
currency? Indeed, is the phrase "international monetary system" an oxymoron? That leads to
the question I want to discuss today: what is meant by the international monetary system and
do we need one?
Over the years, views on the need for "rules of the game" governing international payments
have ebbed and flowed. So it is not surprising that France has chosen the international
monetary system as a theme of its presidency of the G20 this year.
Why not leave these issues to market forces? What are the externalities in the international
monetary system which mean that one country's actions distort the choices open to others?
The main externalities in today's international monetary system are most visible in the
interaction between the advanced and emerging economies. The rising importance of the
emerging economies has perhaps been the most important development since the Bretton
Woods framework of fixed exchange rates was abandoned in the early 1970s. China and
India alone have brought 2 1⁄2 billion people into the world trading system, with many more in
other countries such as Brazil and Russia. And over the next five years, emerging economies
are expected to account for almost three quarters of total growth in world output.
Trade has promoted development in China and other emerging markets, and has benefited
the rest of the world as the costs of a range of traded goods and services, particularly
manufactured goods, have been driven down. But the emergence of the accompanying
imbalances in current accounts had huge effects on the global pattern of spending. Between
1998 and 2006, annual output in high-saving economies expanded by around $10 trillion -
$1trillion more than the growth in domestic demand in the same economies. The rise in
output relative to demand in the high-saving countries was only possible because there were
matching capital flows. Capital flowed "uphill" from many of the emerging markets to
advanced deficit economies, not an obvious sign of capital moving to exploit profitable
investment opportunities. The deficit countries - predominately the US, UK, Australia and
countries in the euro-area periphery - were borrowing almost $1trillion dollars more each
year
by 2006 than they had been in 1998. This created unsustainable paths for domestic
demand, net debt and long-term real interest rates.
Whether households or policymakers truly understood how unsustainable these paths were
is hard to know. But the extent of the resulting financial fragility became all too apparent in
late 2008. Credit supply in many of the advanced economies froze, confidence collapsed
around the world and private demand fell sharply. Output was cushioned only through an
unprecedented policy response around the world. That did bring an end to the sharp falls in
output, and allowed confidence to recover somewhat. And in many countries, particularly
those that did not suffer directly from banking crises, output has bounced back.
Yet this extraordinary policy response has simply postponed much of the required
adjustment in spending patterns around the world. And long-term real interest rates are
unsustainably low.
The challenges of sustainability are most evident in vulnerable euro-area periphery countries.
Unable to sustain domestic spending through further borrowing they are now struggling to
substitute external demand for domestic spending. They face a major challenge to raise
output by enough to allow them to service existing debt and to bring unemployment down.
This is particularly difficult within a currency union because, without a flexible exchange rate,
it is not easy for them to lower domestic prices relative to those overseas. And even if that
were possible, the burden of debt, denominated in nominal terms, would rise relative to
income. These countries, then, are heavily dependent on the pattern of spending elsewhere
and would benefit greatly from an expansion in domestic demand in countries with stronger
balance sheets.
The main lesson from the experience of the imbalances is that national policy frameworks
alone were unable to prevent domestic demand from growing at an unsustainable rate.
Intertemporal budget constraints do not exercise the same discipline as constraints that are
immediately binding. So unsustainable paths of spending and precarious stock positions
developed. As a result, abrupt, and costly, adjustment at some point in the future was always
likely.
Markets can enforce inter-temporal budget constraints only over a long-time horizon. As a
result, countries can pursue inconsistent policies for long periods, and a range of
imperfections in the financial system encourages them to do so. An example of those
imperfections is that opportunities to insure against exchange rate fluctuations are limited -
markets are incomplete. Exchange rates can move in surprising and unpredictable ways.
Over the past twenty years, the ratio of the highest to the lowest dollar-yen exchange rate
was almost 2 to 1, and the same was true of the dollar-euro rate. The difficulty in insuring
against such swings means that this volatility can induce large fluctuations in output with
unnecessary costs incurred in the relocation of resources and employment. Fixed, or
managed, exchange rate regimes may help to limit the real economic costs of "excessive"
volatility that reflects short-lived shifts in market sentiment, but if they impede desirable
adjustments of real exchange rates, they contribute to unsustainable patterns of spending.
There are other reasons why emerging economies, in particular, have managed their
exchange rates. Perhaps the most important is that pushing down on the exchange rate is a
means to pursue a strategy of export-led growth. Another motive, important in the wake of
the Asian financial crisis, was to build up large precautionary balances of foreign exchange
reserves as a way of insuring against sudden reversals in capital flows, especially of
shortterm bank lending, that proved so damaging in the 1990s.
Such policies distorted saving and exchange rates, and created large capital flows unrelated
to the distribution of profitable real investment opportunities. Given imperfections in financial
markets in both borrowing and lending countries, such capital flows can lead to a degree of
fragility, such that, when adjustment comes, there is a high probability that it will be abrupt.
For example, the distortion from a "too important to fail" implicit subsidy to the funding costs
of banks in the industrialised world led to excessive leverage in these countries. Creditors
were prepared to lend at lower rates and on a greater scale than they would have without the
implicit subsidy. In other countries, financial repression artificially raised saving rates by
making borrowing too costly. This highlights the need to focus reform efforts on the
international monetary and financial system (IMFS).
There are, therefore, both "good" and "bad" imbalances. On the one hand, the advantage of
globalisation is that it allows savings to flow to where the rate of return on new investment is
highest. On the other hand, imbalances can be a symptom of distortions to the price signals
in the economy, leading to unsustainable patterns of capital flows and spending that are
costly to correct. Distinguishing between them will never be easy, but is necessary when
setting monetary, fiscal and financial policy. But we should assess imbalances in terms of
whether their consequences are "good" or "bad" - that is, whether they are creating a
distorting externality.
So how should we reform the current system of monetary arrangements? If problems
abound, there is certainly no shortage of proposed solutions. Since Bretton Woods, there
have been regular suggestions for changing from fixed to flexible exchange rates, or the
other way round, returning to the gold standard, creating a new international currency,
changing the composition of the currency basket comprising Special Drawing Rights (SDRs),
abolishing or introducing controls on capital flows, and providing new ways of holding
currency reserves.
What is much less clear, however, is the problem to which these proposed solutions are
thought to be the answer. I have suggested that we need to analyse more carefully the
imperfections, or frictional costs, which make a regime of floating exchange rates an
insufficient answer in itself. The crucial frictional costs, it seems to me, are those associated
with a sharp fall in output and employment following an abrupt adjustment in the current
account, whether brought about by a sudden movement in exchange rates or the collapse of
a financial system. They reflect distortions of the price signals for inter-temporal saving and
financing decisions. Both the Asian and the recent financial crisis were vivid illustrations of
how large those costs can be. Central to any solution is a problem that has not been
resolved since the Bretton Woods conference in 1944, namely the asymmetric pressures on,
and responsibilities of, deficit and surplus countries to adjust their spending patterns.
In trying to deal with this central question, we should not get sidetracked by issues such as
changing the composition of the SDR basket. The SDR is a reserve asset, not a reserve
currency, and as such has rather little to do with the emergence of unsustainable levels of
spending and interest rates.
Our predecessors were well aware of the central issue. At Bretton Woods, both American
and British officials presented proposals for schemes to impose more symmetric obligations
on both surplus and deficit countries. For the United States, Harry Dexter White, an alumnus
of Stanford, put forward the idea of a "scarce currency" clause for the Articles of the IMF. And
his British counterpart, John Maynard Keynes, proposed an International Clearing Union with
penalties on large surpluses or deficits (his suggestion of a new currency, the bancor, was
included primarily because at the time national currencies were not convertible). His aim was
to ensure symmetric obligations. As he wrote in 1941,
"[T]he social strain of an adjustment downwards is much greater than that of an
adjustment upwards. And besides this, the process of adjustment is compulsory
for the debtor and voluntary for the creditor. If the creditor does not choose to
make, or allow, his share of the adjustment, he suffers no inconvenience. For
whilst a country's reserve cannot fall below zero, there is no ceiling which sets an
upper limit. The same is true if international loans are to be the means of
must
adjustment. The debtor borrow; the creditor is under no such compulsion".
And ever since then, the absence of an effective symmetric framework of obligations on both
debtor and creditor countries has led to periodic crises. The obstacle to the creation of a
binding framework is clear. Governments know whether they are debtors or creditors today.
So a framework that has economic and indeed moral force when seen from behind the "veil
of ignorance", as suggested by John Rawls, is unlikely to appeal to governments.
Should we conclude, therefore, that in the absence of a world government, the identification
of "new rules of the game" is likely to be no more than a theoretical exercise? Certainly, the
fate of Keynes' proposal for an International Clearing Union is not encouraging. But the
experience of the past twenty years shows that large imbalances mean that everyone suffers
when there is a sharp adjustment.
So there is scope, if not for formal international policy coordination, then for an international
conversation about how to improve a system that is fragile. Central banks were able to
ensure, for a while, that the paths of output were sustainable - consistent with low and stable
inflation. But the patterns of demand were far from sustainable. And when the sharp
adjustment to demand eventually came, it inevitably had implications for the level of output.
Reform of the IMFS, and of our domestic financial systems, is a necessary complement to
the domestic price stability oriented policy frameworks of central banks.
The immediate issue of how to move to a more sustainable position requires a resolution of
different countries' economic strategies for rebalancing. There can be only one path for
rebalancing - with rebalancing in the deficit economies, by definition, just a mirror of that in
the surplus countries. But the path that would be chosen by high-saving economies differs
from that which the more indebted industrialised economies would prefer. Their need to
deleverage and reduce borrowing means that if another abrupt adjustment is to be avoided,
they cannot risk taking too long to rebalance their economies. In contrast, many of the
emerging economies continue to require rapid economic growth and abundant employment
opportunities in their export industries to ensure adequate levels of employment for their vast
populations. As a result, policymakers in countries like China quite simply see limits to the
extent and speed at which they should expand the share of domestic demand in their
economies. They do not want to rebalance their economies too quickly. Of course, ex post
there must be consistency between these two strategies as demand in the world as a whole
must "add up".
The current pattern of demand in the world economy is unsustainable. The political tension
generated by the divergent preferences of surplus and deficit countries risks moves towards
protectionism, as happened in the 1930s. So there must be scope, in the short term, for a
"grand bargain" to adopt a set of policies that would support an agreed path of rebalancing
and avert a move towards protectionism.
Such a "grand bargain" should be the central objective of the G20's Framework for Strong,
Sustainable and Balanced Growth. It would require a shared analysis, seemingly absent at
present, of the relative importance of the "good" and "bad" aspects of the imbalances. And it
should comprise (i) an agreed path for the reduction or increase of net exports relative to
domestic demand; (ii) an agreed framework for allowing real exchange rates to support the
path for unwinding the imbalances; (iii) a set of rules governing the circumstances in which
countries would be able to limit short-term capital flows; (iv) macro-prudential policies to limit
the build-up of imbalances and add to the instruments available to pursue financial stability;
and (v) structural policies, including fiscal measures, to raise national savings in deficit
countries and to lower savings in surplus countries. Some combination of all of these
elements will be necessary in order to chart a path back to sustainability.
There are pitfalls to avoid. Too often the policy response to a sharp adjustment to an
unsustainable position starts and ends with the provision of liquidity. Rarely, however, is the
problem a temporary shortage of liquidity. As we have seen since 2007, and on many
occasions before that, most players - whether financial institutions or countries - would like
others to believe that greater provision of liquidity is the answer. Almost always the provision
of liquidity works only when it is the bridge to a more fundamental solution.
Once rebalancing has been achieved, there will be the longer-term question of how we
prevent a recurrence. There is no world government to impose "rules of the game" to
internalise the externalities. So the solution can be found only in cooperation between
nations. At present, the plethora of international meetings offers many chances to see the
world, if not actually to save it. Ultimately, only the Bretton Woods institutions themselves -
the IMF and the World Bank - have the legitimacy to represent all of their 187 member
countries. But their governance is outdated. At the height of the crisis, the G20 and the G7
provided strong leadership. But legitimacy and leadership should go together. One without
the other does not offer a sustainable vehicle for international cooperation. So allowing the
G20 to metamorphose into the governing body of the IMF makes a good deal of sense. Such
an evolution would, with a little commitment and imagination, create a single effective
framework for international economic cooperation. And in the long run a more powerful and
legitimate international body might be able to use its clout to deal with the imperfections and
frictions that I have discussed. It might even be the vehicle for a more rules-based framework
for the IMFS, based on a judgement about the sustainability of the pattern of world demand.
Although that seems a distant prospect today, there is a precedent for a system of
internalising cross-border externalities: the WTO already plays a similar role in international
trade. So far, these rules have stood the test of time. Indeed, it is now more likely that
protectionism would result from high unemployment, which the rules were not designed to
prevent, than the pressures from producers which have been resisted.
There is much to do. None of the underlying causes of the current crisis have been removed.
The problem of "too important to fail" banks is still with us. And even more intractable is the
challenge of how to reconcile free trade with a stable international monetary and financial
system.
Today, the most obvious problem at the global level is that the imbalances are growing
again. And continuing high debt levels, although in many ways a natural response to low
long-term interest rates, leave indebted countries particularly vulnerable to a rapid reversal of
high saving rates in surplus countries and a rise in long-term interest rates - surely inevitable
in the long run - which would drive down asset prices. It is clear that these vulnerabilities
affect us all. So recognising our common interest in moving to a more sustainable pattern of
world demand is in our self-interest.
The global community showed that it could work together when the world economy was
close to the abyss in 2008. The challenge now is to prove that we can also work together
when we are no longer in an immediate crisis, but still facing deep-seated problems. Will we
create a more stable IMFS? The next few years will provide the answer. And they will, as our
Chinese friends say, be interesting.