New Reserve Currency In The Making (?)

After the World Bank made the case for a new reserve currency, more than a month ago, these voices were repeated from the IMF’s managing director Dominique Strauss-Kahn who on February 10, 2011, also called for a new world currency, because he is worried about volatility in the foreign exchange markets – see here . The same thoughts were again repeated by Mr. Strauss-Kahn on February 26, 2011 (see here). He envisions an asset the could be similar but distinct from the IMF’s SDRs. He said that having other alternatives to the dollar “would limit the extent to which the international monetary system as a whole depends on the policies and conditions of a single, albeit dominant, country.” Countries that have called for an alternative to the dollar as a reserve currency include Russia and China, and other European countries have voiced concerns about the role of dollar, like France’s president, Sarkozy.

Enhancing the role of alternative to dollar currency assets is not a new discussion but it goes back to the creation of the SDRs as a substitute of the dollar-gold exchange rate in 1969. The current discussion though has been active the last few years, especially after the global debt crisis and the monetary policies of key player countries which arguably cause debasing of global currencies, bring new inflation fears and volatility in the currency markets. In an attempt to stabilize currency markets the IMF issued new international money worth of $250 billion, in 2009 (see here).

All these bring us to renewed concerns about the difficulty to maintain reserve currency status for the dollar by Prof. Michael Kuczynski from Cambridge University, as it is expressed in his comment in FT today, and also on the G20 meeting in Paris where IMF’s Strauss-Khan wants the Renminbi in SDR.

What Are Special Drawing Rights (SDRs)?

“The SDR is an international reserve asset, created by the IMF in 1969 to supplement its member countries’ official reserves. Its value is based on a basket of four key international currencies, and SDRs can be exchanged for freely usable currencies. With a general SDR allocation that took effect on August 28 and a special allocation on September 9, 2009, the amount of SDRs increased from SDR 21.4 billion to SDR 204 billion (equivalent to about $308 billion, converted using the rate of August 31, 2010).”

Here is the official factsheet of SDRs at the IMF’s website.

Reserve Currencies

Even though dethroning the dollar from its current status as the primary reserve currency is not something that can happen in the current setup, there is discussion about what being a reserve currency means and what are the alternatives to a dollar reserve currency.

FT published an article on the subject and can be found here. It considers a few alternatives like (a) the renminbi, (b) the euro, (c) SDRs (Special Drawing Rights), (d) pegging to gold price. A lot of research has been done on these issues and some thoughts are presented in this article about the pros and cons of being a reserve currency or having one of the alternatives as reserve currency. Bellow are some passages taken from the article together with some of my own thoughts on the matters. The parts taken from the article are in quotation marks.

One reserve currency?

“In truth, the benefits to the US, in terms of support for its currency and its financial assets, are uncertain. Also unproved is the wider case that having just one reserve currency is inherently unstable, contributing to the global current account imbalances that are widening again as the world economy recovers from recession.”

Is one reserve currency an unstable structure because it leads to the currency’s devaluation according to the Triffin’s dilemma?

“On the face of it, a modern version of the Triffin critique explains recent persistent American current account deficits; they have been funded largely by foreign governments buying dollar bonds. But the causation is not straightforward. Under a floating exchange rate system, as long as countries accumulate only moderate amounts of currency reserves allowing them to intervene in any future crisis, the demand for dollar-denominated assets should be limited.”

Are SDRs a good alternative to one reserve currency?

“The SDR is closer to an accounting unit than a currency.”

“In order for the SDR to work as a proper global currency, Prof Eichengreen says, some organisation – probably the IMF – would need systematically to control its issuance beyond the current system of ad hoc one-off distributions. Any such proposal to globalise monetary policy would provoke explosions of disbelief in legislatures worldwide. As Prof Eichengreen concludes: “No global government, which means no global central bank, means no global currency. Full stop.”

Linking currencies to the price of gold?

“An even less likely option is linking currencies to the price of gold, recreating one of the models of international gold standard used in the past few centuries. Following the rapid rise of the gold price in recent years, a phenomenon some investors claim is driven by fears about fiat currencies (those not backed by a physical commodity) being debased by inflation, interest in the subject was revived last year by Robert Zoellick. The World Bank president raised the eyebrows of economic policymakers – before rushing to clarify that he was not in favour of a strict gold standard – by arguing that the metal had become an “alternative monetary asset” and that governments should consider using its price as an “international reference point of market expectations” for inflation and currency values.”

“However, economists have long argued that linking currencies and price levels to the value of a fixed or nearly fixed stock of precious metal means forcing real variables such as growth and employment to bear the brunt of economic shocks – a socially and politically unacceptable outcome. Prof Eichengreen, in response to Mr Zoellick’s speech, pointed out that targeting the domestic price of gold would have caused the Federal Reserve, the European Central Bank, the Bank of Japan and the Bank of England to have tightened monetary policy sharply in recent years. “It is lunacy to suggest that in circumstances of weak growth and deflation risk, key central banks should simultaneously tighten [policy],”

How about the Euro or the Renminbi?

For these two currencies to be used as reserve currencies they need to strengthen. By that is meant, to strengthen their institutions. For the Euro, Europe has to overcome its current debt crisis, and to emerge from it stronger. In this case Euro may gain some power as a reserve currency.

As far as the Renminbi is concerned, this is a more remote possibility. Perhaps in 30 or more years Renminbi could play a role as one of the reserve currencies. Until then, the Chinese institutions should have to strengthen and be accepted from the rest of the world. It is not just the size of the market that matters but also the stability of its institutions and the trust of the rest of world on them. This is by far the most important determinant of a currency in order to gain its reserve status. 

A Changing Attitude

I do not like to bring up politics but this is an exception for a lot of reasons. First, because I am concerned about the path Greece is on and second, because I want to bring to your attention opinions of foreign officials as they are described by Mr. Michalis Ignatiou, an – according to the Greek media – informed and objective Greek journalist in the U.S. capital.

Mr. Michalis Ignatiou,  the permanent correspondent of several Greek media in Washington and a person with a lot of connections in the US capital, writes an article on the recent reactions in Greece after the announcement by Troika of the 50 Billion Euros privatization plan the government agreed with its foreign lenders. It is important when a person like Mr. Ignatiou, who spends all his time in Washington, describes how the Greek ministers and prime minister are perceived by their foreign counterparts, after 10 months of common life with Troika. The article is in Greek and can be found here, however, I attempt to translate a few key observations of Mr. Ignatiou.

Mr. Ignatiou states, that a source of his reassures him, that the decision to announce the privatization plan of 50 billion Euros was taken at the highest level, i.e. between Mr. Strauss Kahn the head of the IMF  and Mr. Papandreou, the Greek prime minister.  This point is coming together with the opinions of foreign officials about the deterioration of the economic conditions in Greece since Greece entered into the IMF program. Mr. Ignatiou again states that according to foreign officials – his sources – prime minister Papandreou is now seen as the reason of this deterioration. He says that the same person that in the beginning of the IMF involvement in Greece, was considered as the person who can push Greece forward, now is seen as the source of the problem. After a year of interacting with him, they realize that his objectives have changed, and he has become more concerned about prolonging his political career in Greece, rather than pushing forward hard reforms. On the other hand, they view the minister of economy, Mr. Papaconstantinou, as the one who strongly believes that without this program Greece will not survive, and as the only one in the Greek government who firmly pushes for the necessary actions.

Mr. Ignatiou, towards the end of his article, in an attempt to decipher the changed attitude of the prime minister, reminds the Greek people and the prime minister, that if Greece does not pay back the debts it has created with the IMF-EE-ECB consortium, its lenders have rights over the public property. A note that a lot seem to forget in Greece and which can bring Greece in a much more difficult position than the one it was before the IMF involvement.

Why Does The Economy Fall To Pieces After A Financial Crisis?

Here is Robert Hall’s paper published in the Journal of Economic Perspectives.

Inflation and TIPS 101

I am very concerned about inflation and this is a theme that I plan to be coming back to it regularly. Here, I want to first give, for those who are not familiar with, some definitions of inflation and then to introduce a class of assets that provide (perhaps) a hedge against inflation, the Treasury Inflation-Protected Securities (TIPS). The reason is to clarify some differences among different inflation measures and where perhaps each of them is used and also to dispel the misunderstanding that exists with respect to which measure of inflation do TIPS use and more specifically whether food and energy prices are included in it.

Unfortunately, there are many inflation measures and they differ on the composition of the asset basket for which prices are used in order to find the level of the Price Index, which then will result to the corresponding inflation measure. Inflation is the rate of change of the Price Index of each corresponding basket. Usually inflation is measured in a monthly frequency, as it is not feasible and perhaps it is not necessary to measure at a higher frequency.

The two inflation measures that matter for us are the Core Inflation and the Headline Inflation (CPI-U). What matters for us, as consumers, is the Headline Inflation because it incorporates the prices of more consumption goods – and goods that are broadly used – than the Core Inflation. Notably, the Core Inflation does not include food and energy prices. This is done because their prices are more volatile and they are more susceptible to short term supply shocks that can make a measure that includes them deviate substantially in the short term from a long term trend. Economists, and especially FED macro-economists, who want to gauge inflation dynamics in order to form monetary policy, need to base their policies on stable price trends and not on transitory effects, filter out these deviations – or “noise” around the trend – by focusing on the Core Inflation measure.

Why does the FED focus on Core CPI?

Different websites and even popular press takes this wrong hinting on negligence or conspiracy. The truth is far from that. The answer is that transitory deviations from the true CPI trend would give a lot of false signals to the monetary authorities and this would result to a huge distraction of value in the economy. This can be understood better with the help of the following example that I borrow from an anonymous source.

Suppose that the Federal Reserve had a mandate to stabilize the full Consumer Price Index, and that food prices suddenly doubled. To keep the CPI at a stable level, other prices would need to decrease. The problem, however, is that many prices are sticky, meaning that they do not instantaneously respond to changes in monetary and macroeconomic conditions. This is especially true in the service industry (which comprises the bulk of both GDP and the CPI).

To create these compensating price changes within a relatively short timespan, the Fed would have to impose extremely tight monetary policy, with sky-high nominal interest rates. And as we saw in the early 1980s, a large increase in nominal interest rates is extremely destructive to the real economy, leading to a massive increase in unemployment. Given our already weak economic conditions, such a policy would be even more damaging today.

Core CPI is a way to prevent this kind of needless suffering and unemployment. By targeting a more stable set of prices, the Fed avoids the wild swings in monetary policy that would inevitably arise from targeting an index that includes commodity prices. In other words, the demagogues who assail core CPI have it all wrong: the average American would be much, much worse off if the Fed targeted a volatile measure like headline CPI.

For more on CPI’s and their performance see here, here, here and here.

What are TIPS?

TIPS are Treasury Inflation-Protected Securities. They are bonds that have a fixed interest rate (coupon rate) which is determined at their auction, but they differ from Treasury bonds, in that their face value fluctuates positively one-to-one with the CPI. What I want to clarify here that is confusing to a lot of people is what is the CPI measure that is used for the face value. Several people spread around that this is the core CPI which is not correct. It is the CPI-U or Headline CPI that is used – that includes food and energy – in order to compute the TIPS face value. This is stated explicitly on the Treasury’s website. A question one may have is how does the Treasury come up with the future face values since they announce ahead of time the Daily Index Ratio for the next month. The answer to that is that they do a three month rolling average, extrapolating for the next one month period. The interesting remaining question is, how do they come up with daily CPI-U? I will respond to that when I find the answer.

To conclude, there is no cheating in the way TIPS have been constructed, as the belief that TIPSs face values do not reflect real inflation is not correct.

Roubini On Risks

Euro Under Attack

A video about the crisis in the Eurozone. The inside story of important events during the Eurozone crisis. Appear, Jean-Claude Trichet, George Papaconstantinou, Jean-Claude Juncker, George Soros, Christine Lagarde, Olli Rehn, and others. It is in French, with Greek subtitles.

Oil Prices And Recessions. Double Dip?

I take some facts, about the role of oil prices in the economy, from the article of Roubini on FT found here.

“About two-thirds of the world’s proven oil reserves and almost half of its gas reserves are in the Middle East.”

“Three out of the past five global recessions have followed a Middle East geopolitical shock that led to a spike in oil prices. In the other two global recessions, oil prices also played a role.  The Yom Kippur war of 1973 triggered a sharp increase that led to the global stagflation – recession cum inflation – of 1974-75. The Iranian revolution in 1979 led to a similar stagflationary rise in oil prices that triggered the 1980 recession (a double-dip recession for the US in 1980 and 1982). The Iraqi invasion of Kuwait in August 1990 led to a spike in oil prices at the time when the savings and loan crisis was already tipping the US into a recession; the US and most advanced economies then entered a short recession that lasted until the spring of 1991, when the war against Iraq was won. Even in the 2001 global recession – triggered by the bursting of the technology bubble – oil played a modest role as the second Palestinian intifada and broader Middle East tensions led to a modest but significant increase in prices.”

“Oil prices were also significant in the most recent global recession. The US entered a recession in December 2007 following the subprime bust, but this became global only in the autumn of 2008. This global recession was not triggered only by the collateral damage of Lehman’s bankruptcy. By the summer of 2008, oil prices had doubled in about 12 months, reaching a peak of $148 a barrel. That was a massive negative terms of trade and real income shock not just for the US, most of Europe and Japan but also for China and all the other net oil/energy-importing emerging markets. An already fragile global economy was tipped into an outright global recession.”

“This rise – and the related increase in other commodity prices, especially food – pushes up inflation in already overheating emerging market economies where oil and food prices represent up to two-thirds of the consumption basket.”

“But if oil prices were to rise much further, these economies would slow down sharply and some might even experience a double-dip recession. Finally, rising commodity prices increase investors’ risk aversion and may lead to a reduction in consumer and business confidence that is both negative for financial markets and the real economy.”

Credit Crisis Explained

Those At The Nucleus May Not Have The Best View

A really great article, full of truths about different things. The article is here, written by John Kay of FT. Here are some quotes from the article that I find worth mentioning .

“I was disappointed to find that the most distinguished of my lecturers, the economist Sir John Hicks, had never mastered how to hold the attention of a class. But clarity of thought and clarity of expression tend to go together. The best textbooks are often written by the best researchers: Richard Feynman could not only do physics brilliantly but also brought it alive with words.”

“… few people are as irritating as those whose combination of ignorance and arrogance is so profound that they claim to understand things they do not even know they do not know. The world of business and finance, which values confidence and certainty, is full of such people. “It isn’t really like that,” they will say; and when you ask what it is really like, they will tell you it is too complicated for you to apprehend. What they really mean, but do not recognize, is that it is too complicated for them to apprehend.

The bad financier, or businessman, like the bad scientist, pursues complexity almost willfully because he believes such complexity demonstrates his knowledge and sophistication. So the blind lead the blind through the mysteries of structured financial products and the jargon-ridden thickets of corporate strategy. People sell securities whose properties they only dimly appreciate to people who do not understand them at all. Consultants describe the business world in language – and, of course, PowerPoint presentations – whose elaboration disguises the banality of the thought.”

“Perhaps Henry Ford and Bill Gates were the men who really understood the automobile and computer industries, or perhaps they were just the people whose opinions turned out to be right, which is not the same at all.”