Moreover, as argued earlier in this section, just like the US dollar, the euro’s economic base is bound to decline relative to the size of the world economy over the medium-term due to the slow growth projected for the region and a relatively rapid aging of its population, unless the euro zone continues to expands beyond its current borders, which is highly unlikely given the current problems with the functioning of the euro-centered monetary and fiscal system.

_A priori_ , this new, three-legged system could go a long way in dealing with the potential liquidity shortage at the global level by substantially increasing the supply of reserve assets to the world economy without resorting to over-expansionary macroeconomic policy. This, however, is based on an important (and possibly unrealistic, in view of recent research findings by the IMF) assumption that the reservecurrency countries would increase the supply of safe assets to match the existing demand, without any one country or group of countries resorting to unsound fiscal and monetary policies. Moreover, as long as the reserve-issuing country or countries follow prudent fiscal and monetary policies that also take into account the cross-border effects of the policy changes, they can maintain their reserve currency status and share the benefits of the “exorbitant privilege.” The macroeconomic policy competition among the reserve-issuing entities is thought to bring about greater policy discipline by the reserve-issuing countries that the current system lacks, though as indicated earlier, this is conditional on a tight policy coordination among the reserve-issuing countries, preferably within the G7 and G20 frameworks .<sup>81</sup> The lack of international policy coordination in the provision of adequate global liquidity, which is the sum of international liquidity and domestic liquidity in reserve issuing countries, has been a perennial problem under the various international monetary systems. Under the Bretton Woods I, the gold exchange standard was essentially abandoned due to the scarcity of gold. More recently, however, the problem has become much more complex since it now involves not only officially held liquidity, but also liquidity held by the private sector in countries with convertible currencies and open or quasi-open capital accounts. Global liquidity developments, which reflect the actions of regulated institutions and markets and the expansion of the shadow banking sector, can bear importantly on the risks posed by capital flows. 82 While the two components of global liquidity were roughly equal at the end of the 1990s, the liabilities of the shadow banking system have become more important, and correspond to the rapid increase in both global liquidity and gross cross-border flows prior to the crisis, a direct result of the financial deregulation in the 1980s and the 1990s. Shadow banks were an important source of instability during the 2008-09 crisis that fell outside of the regulatory perimeter.<sup>83</sup> Global banks in the reservecurrencies countries collect liquid funding globally and lend globally based on an overall global asset allocation strategy. When perceived risks are low, global banks increase their leverage, expand their balance sheets, often involving their related shadow banking entities, and generate a global liquidity expansion well beyond what may have been the intention of central bank authorities of the affected countries. Global banks also provide a mechanism to magnify and extend the effect of a reserve-issuing country’s monetary policy to non-serve currency advanced and emerging economies. When the reserveissuing country increases (reduces) its money supply, for example, by lowering (raising) its policy rate, a large capital outflow to the non-reserve currency countries (inflow from non-reserve currency countries) will occur through carry trades. The rise of global banks as a result of financial liberalization in the 1980s and 1990s and the loose monetary policy in the US in 2000s contributed to a large increase in cross border capital flows from the mid-1990s until the onset of the global crisis in 2008-09.

<mark>Given the slow pace of economic growth and high unemployment rate in the US, as well as the fears of possible deflation as consumers and homeowners pay down their unsustainably high debts, many</mark>

> 81 International Relations Committee of the European System of Central Banks (2010).

> 82 See IMF (2011e).

> 83 The role of global banks in the generation and distribution of global liquidity, and the linkage with capital flows, has been examined by Bruno and Shin (2011).

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