18 March 2007

Digital gold and a flawed global order

By Benn Steil

It is remarkable how the world's short history of floating exchange rates has affected popular thinking about what is eternally normal and proper in the economic system. Recently, China-bashing US Senators Charles Schumer and Lindsey Graham wrote matter-of-factly that: "One of the fundamental tenets of free trade is that currencies should float."

Such a "tenet" would have been considered monstrous by most of the economics profession up until the last three decades of the 20th century, prior to which money accepted across borders had generally been gold, or claims on gold, for about 2,500 years. Even John Maynard Keynes, the arch-slayer of the last remnants of commodity money, was an adamant supporter of fixed exchange rates.

Floating exchange rates have proved a source of tremendous periodic instability, yielding repeated currency crises in countries whose currencies are not acceptable for international transactions, but which build up imbalances in their national balance sheets through their imports of dollar capital. The fundamental difference between capital flows under indelibly fixed and flexible exchange rates was well known generations ago, decades before the modern era of globalisation. As Friedrich Hayek noted in a 1937 lecture, under fixed rates "the effect of short-term capital movements will be on the whole to reduce the amplitude of the actual fluctuations . . . If exchanges, however, are variable, the capital movements will tend to work in the same direction as the original cause and thereby to intensify it." This logic was mirrored precisely by the radical change in capital flow behaviour that accompanied the crumbling of a credible international monetary anchor, gold, between the first and second world wars.

Monetary nationalists, who believe it natural that every country should have its own paper currency and not waste resources hoarding gold or hard currency reserves, must eventually demand capital controls - as the most noted economist critic of globalisation, Joseph Stiglitz, has done - in order to stop the people from disturbing the government's control of national credit conditions. But the government cannot stop there, Hayek reasoned, as "exchange control designed to prevent effectively the outflow of capital would really have to involve a complete control of foreign trade, since of course any variation in the terms of credit on exports or imports means an international capital movement".

Indeed, this is precisely the path the Argentine government has been following since abandoning its dollar currency board in 2002. Since writing off $80bn worth, or 75 per cent in nominal terms, of its debts, the government has been resorting to ever-more intrusive means in order to counteract the ability of its citizens to protect what remains of their savings and to buy from or sell to foreigners.

In 2003, the Argentine government introduced capital and domestic price controls, the aim being to keep the exchange rate down while simultaneously containing the inflation that policy was giving rise to. In 2004, energy sector controls were extended to include export taxes and partial export bans on oil and gas. In 2005, rules were imposed forcing companies to convert most foreign proceeds into pesos and limiting the amount of foreign currency that individuals could acquire to invest abroad. In 2006, in an effort to stop the rise of inflation beyond 1 per cent per month, President Nestor Kirchner demanded "voluntary" price freezes on about 300 products, targeting component products of the official consumer price index, and extended export bans to beef and other products.

Argentina could not be a more fitting fulfilment of Hayek's fears, that the spread of monetary nationalism could only lead to ever greater international economic and political conflict. Since the 2002 devaluation, the Argentine government has been in continuous conflict with its European counterparts over the expropriations imposed on the latter's bondholders and corporate direct investors; and the population has turned viscerally anti-American, anti-International Monetary Fund and anti-globalisation.

It was well understood before the Bretton Woods era that monetary nationalism would fundamentally change the way capital flows naturally operate, making of a benign economic force one that would necessarily wreak havoc with flexible exchange rates. The global monetary order that has emerged since the 1970s is now globalisation's greatest source of vulnerability.

What is to be done? Realistically, sauve qui peut must be the message for nations whose currencies are not wanted by foreigners. Dollarisation - abandonment of parochial currencies in favour of the dollar, euro or other internationally accepted money - is, in a world of fiat currencies, unsupported by gold or silver, the only way to globalise safely.

Of course, the status of internationally accepted money is not heaven-bestowed and there is no way effectively to insure against the unwinding of "global imbalances" should China, with nearly $1,000bn (£509bn) of reserves, and other reserve-rich central banks come to fear the unbearable lightness of their fiat holdings. Digitised commodity money may then be in store for us. Gold banks already exist that allow clients to make and receive digital gold payments - a form of electronic money, backed by gold in storage - around the globe. The business has grown significantly in recent years, in tandem with the dollar's decline.

As radical and implausible as it may sound, digitising the earth's 2,500-year experiment with commodity money may ultimately prove far more sustainable than our recent 35-year experiment with monetary sovereignty.

The writer is director of international economics at the Council on Foreign Relations and co-author of Financial Statecraft

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