Illustration by Josh Cochran
Illustration by Josh Cochran

When the world economy heads into crisis, the international currency system often breaks down. This occurs either because debtors can’t meet their obligations, or because creditors fear they are not being repaid in sound money. The first condition exists today in the euro zone; the second is likely to emerge in the China-U.S. relationship.

So how might these conditions change the system? Much discussion concerns whether the U.S. dollar will be replaced as the global reserve currency by the Chinese yuan or whether it will simply be one of a number of reserve currencies that includes the euro, yuan and yen.

The global reserve currency is the one that forms the largest proportion of the holdings of central banks. More broadly, it is also the currency most likely to be accepted by merchants worldwide. In my view, the debate about whether the dollar will be replaced by the yuan is a bit of a red herring because such a shift will not occur quickly.

As of 2010, about 60 percent of all foreign-exchange reserves were denominated in dollars, giving the U.S. currency a critical mass. Investors are still comfortable with holding it; despite the country’s fiscal problems, in times of crisis, the dollar is regarded as a haven. It will take a long while for international investors to become confident that a Communist-led government will always respect their rights.

China’s Enormous Economy

By 2020, if current trends are realized, China will become the world’s largest economy. The nation’s foreign-exchange reserves already give it significant power as a creditor nation. But even if foreigners wanted to hold yuan instead of dollars, there would be constraints on their doing so. And removing the constraints would probably cause the yuan to soar, something that the Chinese are keen to avoid.

So it seems unlikely that the next 10 years will see a yuan standard replacing a dollar standard. But might the present crisis conditions lead to some other sort of change? Might countries, for example, be driven to enter a new arrangement comparable to the 1944 Bretton Woods pact, in which the world’s major industrial states agreed to adhere to a global gold standard to stabilize international currencies?

At this juncture, an agreement on this scale would be very difficult. Bretton Woods was made possible because of the limited number of participants and the urgency of wartime. Much of Europe was under Nazi occupation and could not take part; the Soviet Union had little intellectual input; and the developing world was consulted on a fairly cursory basis. The Americans were in charge, but listened to John Maynard Keynes out of respect for his intellect.

A modern agreement would have to get consensus from the U.S., China, the European Union, India, Brazil, and so on. This would be tricky. But perhaps there could be an arrangement less formal than Bretton Woods. In November 2010, Robert Zoellick, a former U.S. Treasury official who runs the World Bank, wrote of a concept in which countries would agree on structural reforms to boost growth, forswear currency intervention and build a “co-operative monetary system.” This system, he continued, “should also consider employing gold as an international reference point of market expectations about inflation, deflation and future currency values.”

Some saw this mild suggestion as a call for a return to the gold standard, which, barring desperate circumstances, is unlikely. But before we dismiss all ideas for reform, we should remember that the world operates under what some call a Bretton Woods II regime, with the Americans buying Chinese goods and the Chinese supplying the finance. The implications of this process are everlasting U.S. trade deficits and an ever-greater investment by the Chinese people in U.S. government debt.

Dollar Connection

The system may have suited the Chinese until now because they were eager to find manufacturing jobs for their rural population. At some point, however, the Chinese may feel the need to do something else with their trillions of dollars in reserves. Already they are looking to diversify by acquiring natural resources in the developing world. They have also criticized the U.S. for its economic policy, calling on the Americans to limit their budget deficit.

Despite the strength of this rhetoric, the Chinese will not abandon the dollar outright. They already own so much in the way of U.S. government debt that any indication of their intention to sell would cause a plunge in bond prices. The fates of creditor and debtor are locked together. So the answer might be some kind of managed deal, with the Chinese agreeing to let their currency strengthen and to limit their current account surplus while the Americans agree to tackle their budget deficit. The currencies would trade in a range while the deficit would have a target.

Timothy Geithner, the U.S. Treasury secretary, hinted at such a solution in October 2010, suggesting a limit on current account surpluses of about 4 percent of gross domestic product. A Group of 20 meeting of finance ministers nodded mildly in the direction of this proposal. But nothing will happen overnight. Neither the Chinese nor the Americans will want to accept constraints on their behavior.

The Chinese will change tack if they believe such a shift is in their own interest. This might be because they face losses on their government-bond holdings, or because they wish to shift to a consumption-based, rather than an export-led, model to court domestic popularity.

To some, the idea that the U.S. would accept constraints on the independence of its economic policy might seem a fantasy. It is hard enough for a president to get his own plans through Congress, let alone get approval for a set of policies dictated from abroad. As a result, one would expect a new system to arise only as part of a further crisis.

Savers and Spenders

In a speech in October 2010, Mervyn King, the governor of the Bank of England, called for a “grand bargain” among the major players in the world economy. “The risk,” he said, “is that, unless agreement on a common path of adjustment is reached, conflicting policies will result in an undesirably low level of world output, with all countries worse off as a result.”

The fundamental problem is the imbalance between the saving and the spending nations. In a sense, the situation resembles that of the late 1920s when the Americans and French owned a huge proportion of the world’s gold reserves; this time it is the Asian and OPEC countries that have too much squirreled away. What should naturally happen in such circumstances is for the exchange rates of the surplus nations to appreciate. But countries have been attempting to hold their currencies down, either by intervening in the markets or by imposing capital controls. All currencies, however, cannot fall; some must rise and risk deflation in the process.

Any target for exchange rates, or current-account surpluses, would have to be flexible. Fixed exchange rates require either subordination of monetary policy or capital controls to be effective. The Chinese, who already restrict investment, might favor capital controls, but it is hard to see the U.S., with its huge financial-services industry, agreeing to a worldwide restriction.

However, there is one factor that might persuade the U.S. government to change its mind: its debt burden. As has already been discussed, reducing debt via an austerity program is unpalatable, and outright default is almost unthinkable. But governments did manage to reduce their debt burdens after World War II, under the auspices of the Bretton Woods system.

Only with capital controls can government debt burdens be inflated away. Private savings can be more easily forced into public-sector debt.

How would a managed exchange-rate system work today? Even under Bretton Woods, after all, it eventually proved impossible to keep exchange rates pegged. But the system did work for a quarter of a century. And if an exchange-rate peg gives speculators a tempting target, the answer would be to curb the speculators. Again, if the Chinese set the rules, such a move would seem more likely. They regard Western governments as foolish for allowing their economic policies to be at the mercy of the markets.

If the U.K. set the terms of the gold standard, and the U.S. set those of Bretton Woods, then the terms of the next financial system are likely to be set by the world’s biggest creditor: China. And that system may look a lot different to the one we have become used to over the past 30 years.

(Philip Coggan is a columnist for the Economist. This is an excerpt from his book, “Paper Promises: Debt, Money and the New World Order,” to be published Feb. 7 by Perseus Books. The opinions expressed are his own.)

To contact the writer of this article: Philip Coggan at philipcoggan@economist.com

To contact the editor responsible for this article: Mary Duenwald at mduenwald@bloomberg.net