Monday, September 7, 2009

The single reserve currency pipe dream

Here we go again with the calls for a new reserve currency (or a new world currency). From Reuters:
A U.N. panel will next week recommend that the world ditch the dollar as its reserve currency in favor of a shared basket of currencies, a member of the panel said on Wednesday, adding to pressure on the dollar.

It's a strange proposal because central banks are free to create their own baskets of currencies and nobody is requiring them to hold dollars. And most of them do just that. It just so happens that the dollar tends to be a large part of those baskets because most nations have significant trade with the US and want to control their currency strength against the dollar (particularly the exporters). It is also because the US has the deepest government paper market (and getting deeper), which gives these central banks tremendous liquidity.

What's interesting is that the UN is convinced that this new global currency, which would be an equivalent of the ECU, would achieve more stable exchange rates.

Currency specialist Avinash Persaud, a member of the panel of experts, told a Reuters Funds Summit in Luxembourg that the proposal was to create something like the old Ecu, or European currency unit, that was a hard-traded, weighted basket. (Reuters)

ECU however did not reduce volatility among the member currencies. The only way exchange rate stability was achieved in Europe was for central banks to cede control of their monetary policy to a single central bank with the creation of the Euro. And there is no chance of countries such as the BRIC nations giving up control of their monetary policy to some central body. Simply having a basket currency out there will not introduce any additional exchange rate stability.

The UN is actually suggesting having an international body "manage" exchange rates. From Bloomberg:

“There’s a much better chance of achieving a stable pattern of exchange rates in a multilaterally-agreed framework for exchange-rate management,” Heiner Flassbeck, co-author of the report and a UNCTAD director, said in an interview from Geneva. “An initiative equivalent to Bretton Woods or the European Monetary System is needed.”

Flassbeck suggests that the exchange rate mechanism should not rely on the free markets, because financial-market participants don't know how to "price risk".

“The most important lesson of the global crisis is that financial markets don’t get prices right,” Flassbeck said. “Governments are being tempted by the resulting confidence game catering to financial-market participants who have shown they’re inept at assessing risk.

..."Today the Americans complain that when the world wants to save, it means a deficit. A shared (reserve) would reduce the possibility of global imbalances."”

Of course a body set up by the UN or the IMF will be able to price risk better and deficits will not impact exchange rates in the new world. Right.

In practice the way this mechanism would work is that every country contributes a pro rata share of their currency in exchange for this new currency. The problem however is that if this basket includes a relatively small amount of dollars (which seems to be the goal here), exporter nations will still need to hold dollars to control their currency value against the dollar. And with some constituent currencies tightly controlled by the various nations, while a UN body controls the basket, it's difficult to envision significant liquidity in this new world currency.

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