Justin Yifu Lin

P-Gold: A Proposal for a Brave New International Monetary System

[1]

The media report about the upcoming review of the SDR composition at the IMF once again attracts the attention about the need to reform the existing international monetary system. The 2008–09 global economic and financial crisis highlighted major deficiencies in the international monetary system. And while the system appears to have weathered the initial shock, it remains fragile. The global imbalances, which triggered the Great Recession, arising from the excess liquidity created by financial deregulation and monetary policy in the United Sates, were so large and lasted so long because of the reserve currency status of the U.S. dollar.

The dollar became the reserve currency in the Bretton Woods system after WWII. For nearly two decades, the dollar maintained fixed exchange rates tied to gold. Then, in the mid-1970s, the tie to gold was broken but the dollar remained as the predominant international reserve currency.

The world is now moving toward a more diversified set of reserve currencies, including dollar, euro and likely Chinese yuan as well after being accepted as a component in the SDR basket. Either gradually (as the U.S. economy’s share in the world economy shrinks) or through a sudden debilitating shock, the dollar’s central role is expected to diminish. Two key questions arise. First, how will this evolution toward a multi-reserve currency system affect global monetary and economic stability? Will it be more or less stable than the current system? Second, is there an alternative system, such as the creation of a new international reserve currency that might be more favorable to the global economy? A new international reserve currency will be acceptable only if it is a win-win for both developed and developing countries.

Some economists advocate that a multi-reserve currency system would be more stable because competition among major reserve currencies could become a discipline mechanism for resolving the incentive incompatibility between national and global interests of the reserve currency country in the current system. If a reserve currency country conducts its monetary policy in support of domestic interests at the expense of global interests, for example using quantitative easing as a counter-cyclical measure, reserve holders can switch out of that reserve currency and into others.

This argument has merit if all the major reserve currency countries have strong and healthy economies. It is more likely that the governments in the US and Eurozone may not be able to carry out necessary structural reforms in the coming years to return their economies to the pre-crisis normal, just like what happened in Japan after the crisis in 1991. Even though China is the largest trading country and the second largest economy in the world, its financial system is shallow because China is a developing country. That is, all the reserve currency countries have severe structural weaknesses. When these weaknesses become apparent in a reserve currency country, they can trigger the flight of short-term funds to other reserve currencies, causing them to appreciate sharply. The currency appreciation then weakens the real economy and worsens its structural weaknesses, inducing short-term funds to move yet again to another reserve currency. As a result, such a multi-reserve currency system is likely to be highly unstable. It is a lose-lose situation for both reserve currency countries and other countries.

Stability could be restored—and the conflict of national and global interests inherent in using national currencies as international reserve currencies resolved—if all countries adopt a single supranational reserve currency. I propose replacing the system of using national currencies as reserves with a global reserve currency called paper gold (p-gold).

Appropriately designed, an international currency can avoid the conflicts inherent in using national currencies as international reserve currencies, and it can have some of the desirable properties of precious metals used for that purpose while avoiding the imitations that precious metals’ inadequate supply growth imposes on global liquidity.

P-gold, as I propose, has the flexibility of paper money, in that it could support liquidity growth as the global economy expands, but that—similar to a commodity like gold—would be “outside” the system of national currencies. This offers stable exchange rates without the deflationary tendency of the gold standard. In addition, it would eliminate the inherent conflict of interest between a reserve currency country’s domestic policy concerns and the global public good of economic stability. This new currency would have the advantages of fiat paper money plus the stability of gold and so could be called p-gold (paper gold).

While the political process for agreeing on a governance structure for a new international currency would likely be complex, the economic structure of such a system is fairly straightforward:

  • P-gold would be an international reserve currency, issued by an international central bank, according to the provisions of an international treaty. Countries would agree that p-gold could be used to settle all international transactions for goods and services, commodities, and securities. P-gold would serve as a store of value, medium of exchange, and unit of account for international transaction.
  • At the outset, current reserve-issuing countries would turn over a combination of existing foreign currency reserves, gold, SDRs, and a predetermined amount of their national currency to the new international monetary authority. In exchange, these countries would hold equivalent p-gold reserves in a deposit reserve account at the international monetary authority. Other countries would place their existing foreign reserves—currency and securities—at the international central bank in exchange for a p-gold–denominated account. Countries would still have access to these funds—now denominated in p-gold—to finance their balance of payments.
  • The supply of new p-gold would follow Friedman’s k percent rule [2] (or a modified Taylor rule [3]) based on a projected measure of global economic and asset transaction growth. The precise value of k would be determined by an independent expert council created by the foundational international treaty.
  • Again to be determined by an international treaty, the seigniorage created by issuing p-gold could be used to pay for the operations of the international issuer and for producing international public goods, perhaps through international development institutions.
  • Countries could retain their national currencies but would have to fix their exchange rate to p-gold. Parity adjustments would require the permission of the international monetary authority and could be granted only in cases of severe balance of payments imbalances (when p-gold reserves have reached critical levels—either too high or too low relative to an agreed norm). The possibility for a member country to adjust exchange rate can avoid Euro countries’ troubles in the current crisis.

Setting up the new international monetary system and creating p-gold would require a credible treaty—especially if p-gold is to serve as a store of value. The k percent rule (discussed below) will work only if economic agents believe that the rule will not be tinkered with in politically motivated ways. Finally, any governance issues concerning the decision to allow the use of p-gold-denominated emergency liquidity support could be managed with a set of rules about the size of imbalances.

Providing adequate global liquidity and avoiding inflation would require a fixed rule governing monetary policy. The initial p-gold issuance could be based on an estimate of the current liquidity provided by international currencies and the value of trade and financial transactions. The agreement to use p-gold for all currencies would create instant demand for the new currency.

Thereafter, a simple rule of thumb could be devised along the lines of Friedman’s k percent rule. The value of k could be tied to growth in world GDP and world trade. An expert commission, using selection criteria laid out in the foundational international treaty, could periodically review the value of k and suggest any needed adjustments.

P-gold would enter the international monetary system through purchases and expenditures related to the operations of the international central bank and the production of global public goods. This would be a way of broadly sharing the seigniorage from the new currency across the international community. The foundational international treaty could specify what types of global public goods were eligible for p-gold seigniorage. Examples might be purchases of carbon credits, creation of internationally valuable environmental reserves, and basic research related to mitigating and adapting to the effects of climate change.

Total world currency in circulation is a small fraction of world GDP of $75 trillion, and only a small fraction of that is now used for international rather than national transactions. For example, there is about $1 trillion in U.S. currency in circulation, representing about 6 percent of the U.S. economy; only about half is held inside the United States. Extrapolating these figures internationally suggests that a stock of about $2 trillion (times an international multiplier) would be needed to support international transactions. If the k percent is 3, the annual seigniorage flow would be about $60 billion.

As part of the international treaty, countries would agree to fix the parity of their national currency to the new global currency. With a fixed exchange rate countries would have less control over their monetary policy. A country’s degree of capital account liberalization would have to be chosen carefully, based on the degree of monetary policy independence that makes sense for the country’s structure, trade patterns, and level of development. Current reserve currency countries follow a broadly flexible exchange rate and hold relatively low levels of international reserves (other than their own currencies). To support a fixed exchange rate system, these economies would now require international reserves to finance temporary balance of payments deficits. An adequate initial level of reserves could be estimated for each current reserve currency country, based on standard measures such as the ratio of reserves to short-term external debt and months of imports or some combination of measures.

In this new international monetary system, national central banks and regulators could retain the bank regulation, supervision, and lender of last resort functions domestically. In addition, as part of the foundational international treaty, all countries would undergo annual surveillance and consultations in the spirit of IMF Article IV surveillance to avoid a drift toward unsustainable fiscal and monetary policies and maintain macro stability in each country. The international monetary authority could also set up a facility for emergency liquidity support, according to a pre-agreed rule.

If a multiple reserve currency system is as volatile as predicted, countries might be able to successfully negotiate an international treaty to create p-gold and a new international monetary system within the medium term—for two main reasons. First, for reserve currency countries, the seigniorage in the current system is small, but the benefits from avoiding harmful speculative flows could be large. Second, for nonreserve currency countries, the harmful effects of using national currencies as international reserves will worsen. As financial globalization deepens, unstable blocs could form around key reserve currencies as the nonreserve currency countries fix their exchange rate against a particular reserve currency. Meanwhile, exchange rates among reserve currencies would fluctuate widely against each other in response to shifts in macroeconomic policies, external shocks, and currency wars to gain global market share at the expense of other countries. The resulting volatility of capital flows and financial prices (exchange rates, interest rate, and equity prices) could slow growth and triggering crises in both advanced and emerging market economies.

P-gold is an improved version of Keynes’ proposal for a new international currency called the bancor, which linked to a basket of commodities. That proposal never took off because countries had confidence in the U.S. dollar; the U.S. economy was strong, had the largest gold reserve, and dominated the global economy (at more than 50 percent of global GDP in the wake of WWII). Today, the U.S economy’s share of global GDP is around 20 percent, and the international monetary system is wobbly. The proposed p-gold, by reducing volatility and transaction costs, would be more conducive to long-term growth and stability. The move to an international reserve currency would be a win-win for both sets of reserve currencies and non-reserve currencies countries. The global community should consider it now.

[1] This article draws on Justin Yifu Lin, 2013. Against the Consensus: Reflections on the Great Recession, Cambridge, UK: Cambridge University Press.

[2] Milton Friedman, 1960. A Program for Monetary Stability. New York: Fordham University Press.

[3] John Taylor, 1993. “Discretion versus Policy Rules in Practice.” Carnegie-Rochester Conference Series on Public Policy 39: 195–214.

Justin Yifu Lin

Justin Yifu Lin was Chief Economist and Senior Vice President of the World Bank. His main academic theory is called New structural Economics.


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