Is There Inflation Ahead?

In reaction to the financial and credit crisis that seized American and international financial markets last September, the Federal Reserve has pumped enormous quantities of credit into the market in an effort to unblock clogged credit flows. The Fed creates this credit out of thin air, or as Fed Chairman Bernanke put it, it is printing money. Knowing that inflation is ultimately the result of the central bank (the Federal Reserve) printing too much money, many people are concerned that the Federal Reserve’s recent and current policies doom the U.S. and the dollar to serious inflation in the next few years. This note reviews the historical relationship between the growth in the money supply and prices (inflation) and the recent behavior of the money supply, and presents my assessment of the prospects for inflation over the next few years.


The simplest analytical framework for understanding inflation is the quantity theory of money. This framework may be presented in two different ways. As economists prefer to think of price determination in terms of supply and demand, our preferred formulation of the theory says that the value (purchasing power) of money (“the price level” P) results from its supply (M) relative to its demand and that (as the simplest assumption) its demand is proportional (k) to real output (real GDP–q) or M = kqP. An increase in the supply of money (M) will cause prices to raise (P) until the demand for money (kqP) matches the increase in its supply. Both theory and evidence says that the money supply has no long run effect on real output (q), thus ultimately the entire effect of money growth is on the price level (CPI).


Thus inflation (which is the rate of change or growth rate of the price level) reflects the growth rate of the money supply or ΔM = Δq + ΔP (where k is constant, q is independently determined by growth in labor, capital and productivity, and Δ is the change from one period to the next in whatever it refers to). Hence inflation is determined by the economy’s real economic growth rate and the growth rate of the money supply:

ΔP = ΔM – Δq.[1] If the economy is growing at 3% per year and the money supply is growing at 5% per year, inflation will be approximately 2% per year. However, historical evidence reveals a lag of one to two years between changes in money growth rates and inflation. If money growth increases to say 10%, the impact on inflation would not materialize for another one to two years.


Instead of the demand for money formulation described above, the quantity theory of money is sometime presented in term of money’s velocity of circulation (V): MV = Pq. The two versions are equivalent (V = 1/k). The key point is that with a lag of a year or two increases in the rate of growth of the money supply cause a comparable increase in inflation.


These are long run relationships. In the short run other factors can dominate the behavior of inflation. In the long run a reduction in the economy’s growth rate (Δq) increases the inflation rate resulting from a given rate of growth of the money supply. However, in the short run if real income growth slows or even falls (with no change in its long run potential growth rate) it has the opposite effect on inflation. Economists refer to this as the output gap (between real output and potential or full employment output). When actual output falls below its potential, as occurs during recessions, inflation is reduced for a given rate of growth in the money supply (the demand for money—k—increases temporarily).


Our central bank–the system of Federal Reserve Banks–indirectly controls the money supply (currency held by the public and the public’s deposits with banks) and its rate of growth. There is a link between the money created by the Fed (called base money) and the broader money supply (M). The two are related by the so called the “money multiplier.” Usually the money supply grows at about the same rate as base money.


With these ideas in mind the huge injection of liquidity by the Fed is worrying many people. The Fed has increased base money as a result of large loans to banks and other financial institutions and as the result of buying government securities and mortgage backed securities from the market. By two measures the increase has been huge. Total Federal Reserve Credit has more than doubled over the last year from 0.90 trillion dollars on April 11, 2008 to 2.15 trillion on April 15, this year. Almost all of that increase occurred since September. As a result, base money almost doubled over the same period, rising from 874 billion Sept 10, 2008 to 1,726 billion March 25th of this year.


The Federal Reserve argues that this will not cause inflation for two reasons. First, the large increase in the provision of Federal Reserve Credit and base money was undertaken because of a large increase in the demand for liquidity by banks and other financial institutions in response to the subprime mortgage crisis. Thus doubling base money has not increased the money supply by nearly as much. Using a popular, relatively broad definition of money (MZM), the money supply rose from 8.6 trillion on April 7 2008 to 9.4 trillion on April 6, 2009. Stated in terms of growth rates, which can be directly related to inflation rates, the growth in MZM over the past year (year on year) was 9.7%. This is already significantly reduced from the year on year increase of 14.5% on January 19th of this year and only modestly above the 8.7% average annual rate of growth over the decade ending December 2008 during which inflation averaged 3.0% (the demand for money, k, grew about 2% per year on average over this period).


Secondly, the Fed estimates that over the past year the public’s demand for money has increased temporarily as the public “moved to safety” in the holding of its assets (currency and insured bank deposits). An increase in money demand (k) or equivalently a decrease in its velocity of circulation (V) means that the supply of money can grow more rapidly to that extent without increasing inflation. In addition, the recession with its increasing “output gap” further reduces inflation (temporarily).


Finally, the Fed intends to withdraw the extra liquidity it has injected (and thus reduce base money) as the credit crunch eases and the economy begins to recover. It remains committed to its target for inflation of around 2%. Thus the answer to the question of whether Fed policy will produce inflation in a year or two depends primarily on whether it successfully withdraws the large amounts of liquidity injected over the past six months. I have confidence that it will be able to do so more or less (but not exactly) at the right time and pace.


The real risk of inflation, however, is political. The Federal budget has unfunded liabilities (the difference between the cost of the benefits promised and the revenue now legislated to pay for them) that simply cannot be paid for. The Federal budget deficit expected over the next three or four years as a result of the financial crisis, recession and foreign wars of several trillion dollars is nothing compared to the present value of the government’s unfunded obligations to pay out Social Security benefits of about 13 trillion dollars. The present value of unfunded liabilities of Medicare commitments’ is six time (yes six times) that. It is not possible to raise taxes enough to cover these commitments. Promised benefits will have to be cut. Invariably tax rates will be raised as well and the slowing of economic growth resulting from all this will make the burden of these deficits even harder to carry. In addition, the rest of the world will not continue to finance as much of our annual deficits (and thus to own as much of the outstanding debt) as they have in the past, i.e. the market will force our external trade deficits to contract.


All of this adds up to higher, potentially significantly higher, interest rates in the years ahead (once we have recovered from the current recession) to enable the government to raise the money needed (sell its bonds) to finance its revenue shortfalls. Just how high interest rates will raise will depend on how much government spending can be cut and future entitlement promises reduced, how efficient and productive the economy will be and thus how high its growth rate will be, and how large a trade deficit the rest of the world lets us have.


“Economists have found that structural deficits raise long-run interest rates, complicating the Fed’s dual mandate to develop a monetary policy that promotes sustainable, noninflationary growth. The even more disturbing dark and dirty secret about deficits—especially when they careen out of control—is that they create political pressure on central bankers to adopt looser monetary policy down the road.”[2] The short run effect of monetary growth is the opposition of its long run effect. Increasing the Fed’s creation of money initially pushes down interest rates as it buys more government securities or increases its lending to banks. However, as the higher money growth rate increases inflation, higher expected inflation gets build into new borrowing and lending interest rates pushing rates up eventually.


Current monetary policy does not need to result in higher inflation down the road. But the higher interest rates we are in for risk generating misguided political pressure on the Fed to try to keep them low. If the Federal Reserve gives in to the pressure, inflation will be higher and as soon as the economy comes to expect that higher inflation nominal interest rates will end up being even higher still. Try to remember the inflation and high interest rates of the 1970s through 1981 and tell your congressman to resist the inflation solution.

[1] This is a simplification of the following ΔP/P = ΔM/M – Δk/k – Δq/q, more correctly reflects the percentage rate of change of each variable.


[2] Richard W. Fisher (President of the Federal Reserve Bank of Dallas), "Storms on the Horizon",  Remarks before the Commonwealth Club of California, San Francisco, California,  May 28, 2008.

What are SDRs?

The very large increase in world trade (globalization) over the last four decades has enormously reduced poverty and raised living standards for very large numbers of people. Government policies in the U.S., China and elsewhere have produced large, unsustainable trade imbalances (mismatch of imports and exports). Free trade on its own would not produces such imbalances.  New Global Studies has just published my article “Time for a New Global Currency?” The article explains what the IMF’s Special Drawing Rights (SDRs) are following the G 20s recommendation that the IMF allocate an additional 250 billion dollars worth of them, and how they might facilitate achieving and maintaining better global balance.

Living with Bias

One of the many factors that have contributed to America’s success is its ability to accommodate people with different religious beliefs and cultural practices. This has been an important factor in attracting the world’s best and brightest to our shores, thus keeping us ahead in an increasingly globalized and competitive world economy. To be sure, while accommodating diversity, we also require a broad consensus on the need to respect the rights of others and the separation between the private and public spheres. But within that broad consensus, people worship as they chose, celebrate the holidays and festivals of their choice, and abide by the behavioral norms of their choice. Debates have occurred throughout our history about where the boundary between the public and private spheres should be, but our success resides, in part, in our agreement to leave many very important issues to the private sphere. I have commented on this issue a number of times but there are several recent examples that bring to the fore again the debate over the proper dividing line between public and private spheres.

Our religious and cultural preferences are biases. They are beliefs we hold for whatever reason or choices that we make about values we chose to adopt because we believe them to be superior or at least the most appropriate for guiding our own actions. Muslims, Jews, and Catholics, chose to cluster together with their own kind on Fridays, Saturdays and Sundays respectively without the rest of us being much bothered. It would be foolish for Catholics to extend this clubiness to which restaurants and shops they patronize, but if that is their choice, what is the harm compared with the harm of restricting their freedom to choose? For better or worse a preference (bias) for “our own kind” is part of our human nature. The social costs of forcing a Catholic to shop in a Jewish or Muslim owned shop would be enormous and would strike American’s as ridiculous. Fortunately, the free market itself discourages such biased and economically irrational behavior because the indulgence in such biases comes with a cost. Limiting your shopping and dinning (or employment) to your own kind, limits choice (be definition) and competition and thus almost always increases the cost you must pay to indulge your biases.

Social acceptance of the right of people to indulge their personal biases in broad areas of our lives, allows people with different beliefs can live peaceably together. It is when we try to force our own beliefs and rules on others beyond the truly essential values needed to live together that series strains and social turmoil can result. Here are some recent examples.

Afghanistan just passed a law that moved the boundary between public and private spheres far too far in favor of public religion. “The law, which was approved by parliament and signed by President Hamid Karzai [in March], codifies proper behavior for Shiite couples and families in the most intimate detail. It requires women to seek their husband’s permission to leave home, except for "culturally legitimate" purposes such as work or weddings, and to submit to their sexual demands unless ill or menstruating.

“Initially seen as a political gesture to the country’s Shiites, who make up 20 percent of the population and have long sought legal recognition of their religious beliefs, the law has become a political nightmare for a government struggling to balance conflicting pressures from traditional and modernizing forces at home and abroad…. I could not keep silent any longer," said Foreign Minister Rangin Dadfar Spanta…. The Shiite law, he said, had a ‘totalitarian orientation that does not accept the difference between what is private and public. It identifies some Afghan citizens not as human beings but as slaves.’

“‘The law… was supposed to be an achievement: to recognize Shias’ legal rights so Hanafi [Sunni] laws would not be imposed on them,’ said Sima Samar, a Shiite woman who chairs the Afghan Independent Human Rights Commission. ‘But it was also used by a few leaders who want to put chains around half the population. It is good to have rules for marriage and divorce, but if I want my wife to wear pink lipstick and she wants to wear red, why should that be a matter of law?’”[1]

Islamic states or Islamic dominated states differ dramatically over the issue of whether to separate church and state. In Turkey and Indonesia they are separate and in Iran they are not. The Islamic Republics (Afghanistan, Iran, Mauritania, and Pakistan) may offer a purer choice for Muslims but are bound to pay the price of bias discussed above. Contrast Afghanistan’s approach to that taken by British Archbishop of Canterbury, Dr Rowan Williams, in which he argued that British law should accommodate Islamic practice for those wanting to adhere to it (rather than incorporating it into the law as was done in Afghanistan). His comment precipitated a laud public debate and illustrates how difficult it is to reconcile some of these issues.

As I mentioned in an earlier note American Muslims who could afford it are able to effectively achieve by contract the rights and obligations of second, third and fourth wives as permitted by Islam while observing the American limit to one wife (at a time). The observance of the practice in some Islamic countries of subordination of wives to the practices just adopted into law in Afghanistan would require the voluntary agreement of the wife in the U.S. Some conflicts in values and practices are simply not resolvable within America’s legal system, but the number of conflicts can and generally are minimized by leaving many things to custom and contract. Oxford University Islamic scholar Professor Tariq Ramadan stated that: “I really think we, as Muslims, need to come up with something that we abide by the common law and within these latitudes there are possibilities for us to be faithful to Islamic principles.”[2]

Our founding fathers did not come here to establish a religious state (at least the wiser of them did not). They came here to escape religious states that did not allow them to worship according to their own beliefs. They came here to be free to worship as they wished and that required that they allow others to worship as others wished. Thus they wrote the separation of church as state into our constitution leaving religion to the private sphere. Those who wish to brake down that barrier are doing a dangerous thing.

There are also some alarming recent examples in which private citizens are being forced by law to comply with preferences of others. Laws that command actions are generally more invasive and repulsive than those that prohibit them. A month ago it was reported that: “President Barack Obama will rescind a Bush Administration rule that granted protection to doctors, nurses, pharmacists, and other health care workers who refuse to perform or assist in abortions, sterilizations, and other contraceptive procedures on moral grounds. The rule was issued by the Department of Health and Human Services late in Bush’s term, and applied to any hospital or clinic receiving federal funds.”[3] This would be a bad move. "’I will do nothing against my conscience in the practice of medicine ever regardless of what any law is at any time,’ Sen. Tom Coburn told FOX News” and rightly so.[4]

The Washington Post recently reported a number of court cases in which the rights of individuals were violated for one or another “social interest:”

“– A Christian photographer was forced by the New Mexico Civil Rights Commission to pay $6,637 in attorney’s costs after she refused to photograph a gay couple’s commitment ceremony.

— A psychologist in Georgia was fired after she declined for religious reasons to counsel a lesbian about her relationship.

— Christian fertility doctors in California who refused to artificially inseminate a lesbian patient were barred by the state Supreme Court from invoking their religious beliefs in refusing treatment.

— A Christian student group was not recognized at a University of California law school because it denies membership to anyone practicing sex outside of traditional marriage.”[5]

These are dangerous (to public harmony) trends. Gay and Lesbian Americans deserve to have every right enjoyed by any other American (marriage, adoption, inheritance, etc.). But I don’t think I should have the right to demand that you work for me in whatever capacity whether you want to or not. Why in the world would a lesbian want to hire a psychologist to council her on her relationship whose unloving and misguided religion thought lesbians were evil? I can’t imagine that a reluctant shrink would be worth the money.

Let’s keep the public private boundary more in favor of the private sector. Let’s prohibit only that behavior that truly harms us (stealing our property, harming our person, etc) and not force others to do what we want them to do. Address “bad” behavior with education and the market cost of bias. There will always be difficult boundary issues but the less the state interferes in matters that can and should be left to individual briefs and customs the richer, healthier, and more peaceful we will all be.

[1] Pamela Constable, "Afghan Law Ignites Debate on Religion, Sex" , The Washington Post, April 11, 2009, Page A01.

[2] "Sharia law row: Archbishop is in Shock…" September 2, 2008, London Evening Standard.

[3] Mark Impomeni, "Obama Scraps Protections for Abortion Objectors" Political Machine, Feb 28th 2009.

[4] "Obama to Repeal Bush Abortion Regulation" Fox, March 3, 2009

[5] Jacqueline L. Salmon, "Faith Groups Increasingly Loss Gay Rights Fights" The Washington Post, April 10, 2009, Page A04.

Time for a New Global Currency?



The U.S. dollar is the world’s primary international reserve currency. Most international payments are made in dollars, many globally traded commodities (such as oil) are priced in dollars, and almost two thirds of the world’s official (government owned) foreign exchange reserves of 6.7 trillion dollars are held in dollars. The only other important currency in foreign exchange reserves is the Euro with 27% of the total.


When central banks want to increase the size of their foreign exchange reserves (as most did after the Asian financial crisis in the late 1990s) they will largely want to do so in dollars and this will result in (only be possible from) larger than otherwise U.S. trade deficits. The U.S. trade deficit is the means by which the rest of the world accumulates the dollars it wants. This arrangement and the global imbalances it sometime promotes has long been a source of concern.


Both the Governor of the Peoples Bank of China (China’s central bank) and the President of Russia have recently called for the ultimate replacement of the U.S. dollar as the world’s reserve currency with one issued by the IMF (the Special Drawing Right—SDR).[2],[3]  The SDR was created in 1969, just before the collapse of the Bretton Woods international currency system, precisely for this purpose. With the abandonment of the gold exchange standard and the floating of the dollars exchange rate in 1971, the need for SDRs became less pressing. The G20 heads of state meeting in London in early April called for an additional $250 billion dollar allocation of SDRs, almost an eight fold increase over the current stock of $32 billion.

Special Drawing Rights


Most people have forgotten what SDR’s are (if they ever knew). Like dollars or any other currency, the SDR is both a unit of account and a means of payment. The value of the SDR was originally defined as the market value of 0.888671 grams of fine gold, which in 1969 was equal to one U.S. dollar. Currently one SDR is the market value of a basket of 0.632 U.S. dollars, 0.41 Euros, 18.4 Japanese yen, and 0.0903 Pound sterling. At the time the current basket was adopted (January 1, 2006—its valuation basket or method of valuation is reviewed and adjusted every five years) these amounts reflected weights of 44 % for the U.S. dollar, 34% for the euro, and 11% each for the Japanese yen and pound sterling. Over time these weights vary with the exchange rates of the fixed currency amounts in the basket. The U.S. dollar values of the amounts of each currency in the valuation basket are determined in the market each day and added up to determined that day’s value of the SDR (see the table below).


All of the IMF’s financial activities, in particular its loans, are valued in SDRs. These SDR denominated loans are not SDRs proper any more than U.S. Treasury bonds are U.S. dollars proper. The SDR amount of credit due to the IMF varies over time as its lending activity varies. IMF loans are actually disbursed to borrowing central bank largely in member currencies (primarily U.S. dollars), but the obligations are denominated in SDRs.


Friday, April 03, 2009


Currency amount under Rule O-1

Exchange rate 1

U.S. dollar equivalent

Percent change in exchange rate against U.S. dollar from previous calculation






Japanese yen





Pound sterling





U.S. dollar







U.S.$1.00 = SDR

0.666621 2

-0.233 3

SDR1 = US$

1.50010 4






The exchange rate for the Japanese yen is expressed in terms of currency units per U.S. dollar; other rates are expressed as U.S. dollars per currency unit.



IMF Rule O-2(a) defines the value of the U.S. dollar in terms of the SDR as the reciprocal of the sum of the equivalents in U.S. dollars of the amounts of the currencies in the SDR basket, rounded to six significant digits. Each U.S. dollar equivalent is calculated on the basis of the middle rate between the buying and selling exchange rates at noon in the London market. If the exchange rate for any currency cannot be obtained from the London Market, the rate shall be the middle rate between the buying and selling exchange rates at noon in the New York market or, if not available there, the rate shall be determined on the basis of euro reference rates published by the European Central Bank.



Percent change in value of one U.S. dollar in terms of SDRs from previous calculation.



The reciprocal of the value of the U.S dollar in terms of the SDR, rounded to six significant digits.


Prepared by the IMF Finance Department



What we might call the SDR proper, the SDR denominated reserve asset allocated by the IMF—the SDR the Governor of the Peoples Bank of China was referring to, has played a very limited role to date. The IMF has only issued SDR 21.433 billion of them (the equivalent of about 32 billion U.S. dollars at current exchange rates). For perspective, this might be compared with the amount of credit directly created by the Federal Reserve (Federal Reserve Credit) of about $2 trillion dollars or the 250 billion U.S. dollar allocation (as the creation of SDRs is called) proposed by the G20. The new allocation, by raising the stock of SDRs from 21.4 billion to $271.4 billion, will provide a very big boost to the SDR.


An SDR allocation is similar to a line of credit. The 250 billion in new SDRs will be “allocated” to IMF members in proportion to their quotas in the IMF, which roughly reflect their economic size and importance in world trade. Bulgaria, for example, with a quota currently of 640.2 million SDRs, which is 0.29% of the total (financial) size of the IMF, would receive an allocation of 725 million SDRs (250 billion times 0.29%). These will be credited to Bulgaria’s SDR account with the IMF as additional SDRs owned and held by Bulgaria. At the same time Bulgaria’s SDR account with the IMF will record a liability for the same amount. Bulgaria will earn interest at the SDR interest rate on what ever SDRs it holds[4] and must pay interest at the same rate on its SDR liabilities. If it continues to hold the SDRs it was allocated, Bulgaria will earn the same interest income that it pays on its allocation.[5] In short, if it does not use any of its SDRs and does not acquire additional ones in payments from other IMF members or other holders or buy them, its interest income on its SDR holdings and payments on its net cumulative allocations will be equal and will thus cancel out. Bulgaria will enjoy larger foreign exchange reserves at no cost (but with no net interest return). If Bulgaria uses 100 million of its SDRs, its interest income will fall by that amount times the SDR interest rate, but its charges for its net cumulative allocation will remain unchanged (other than from changes in the SDR interest rate). In short, Bulgaria would then have a net charge to the extent of its use of its SDRs. This is the sense in which an SDR allocation is like a line of credit (without the commitment charge or risk of cancelation). Conversely, if Bulgaria acquires additional SDRs from other central banks so that its holdings of SDRs exceed its net cumulative allocation, it will enjoy net income to that extent at the SDR interest rate.


If the demand for SDRs equals or exceeds their supply, countries could use their SDRs directly. The Chinas of the world, with foreign exchange reserves of $2 trillion (mostly in U.S. dollars), would be happy to accept and hold them in payment for another country’s financial obligations or to buy them (rather than dollars) for dollars that the selling country could use to settle obligations with someone else unable or unwilling to accept SDRs. For the past twenty five years virtually all SDRs have been used in this way. Most countries using their SDRs first converted them into dollars by selling them for dollars to another central bank in so called “Transactions by Agreement.” However, the system also has a mechanism, so called “Transactions with Designation,” by which countries with a strong balance of payments can be designated to buy SDRs for dollars, or Euros (or another freely useable currency) when a holder wishing to sell them for currency cannot find a buyer in a Transaction by Agreement. With the huge allocation now being proposed, it is likely that some users will again need to resort to this obligatory purchase requirement for a while.


Global imbalances


Twenty years ago as the Berlin Wall came tumbling down the United States imported $580 billion worth of goods and services from the rest of the world (1989). This was about 11% of U.S. domestic production (GDP). The U.S. paid for most of that by exporting $487 billion worth of goods and services. The shortfall (trade deficit) of $93 billion was more than paid for by the net income received by American’s from their investments abroad. This modest trade deficit of 1.7% of GDP rose to an unsustainable 5.7% of GDP by 2006. The gradual depreciation of America’s overvalued dollar over the last few years has begun to correct this global imbalance and this last year (2008) saw a reduction in the U.S. trade deficit to the still very high level of 4.7% of GDP. Though American imports continued to grow (to almost 18% of GDP in 2008), its exports grew more rapidly over the last few years thus replacing some of the lost consumer spending as households starting to pay off excessive debt and to rebuild their savings. This desirable correction has been temporarily interrupted by a global recession and creeping protectionism in the U.S. and elsewhere.


These large global imbalances contributed significantly to the U.S. housing bubble and the financial crisis it created. Large U.S. trade deficits (the U.S. imported much more than it paid for with exports) financed largely by Chinese and Japanese trade surpluses invested in the U.S. (largely U.S. Treasury bills and bonds) kept interest rates in the U.S. low despite large U.S. government deficits and very low household savings rates. Excessive borrowing and housing demand in the U.S. resulted.


The rapid increase in world wide trade (globalization) over the last several decades benefited American consumers and workers world wide (including in the U.S. where unemployment reached historically low levels). But U.S. trade imbalances (the mismatch between imports and exports and the balancing capital flows to the U.S.) reached unsustainable levels and will have to contract. There are limits to the number of U.S Treasury bills the Peoples Bank of China is willing to hold (it still continues to add to that number but at a slower rate). There is also a limit to the amount of debt the U.S. Treasury can service (pay interest on) and financial markets have already begun to reflect a higher (though still low) probability of U.S. default on its huge and rapidly growing public debt.


The lowering of tariffs and other trade barriers (e.g. transportation costs) permitted this rapid growth in trade, which doubled the incomes of a third of the world’s population, something aid could never have accomplished. Why then didn’t markets operate to limit trade imbalances to sustainable levels? The failure reflects the failure of government policies in China and the U.S. and elsewhere to play by the rules of international finance and the accumulation of the U.S. dollar in international reserve holdings made this failure easier.


When a country buys more from the rest of the world (imports) than it sells to the rest of the world (exports), it must borrow from the rest of the world to pay the difference (or use its reserves of foreign currencies). If the rest of the world is not eager to lend or otherwise invest in the borrowing deficit country, exchange rates will adjust in international currency markets (or the “real exchange rate” will adjust via domestic inflation or deflation). The simple market reality is that consumers tend to buy where they get the best deal (price and quality mix). When comparing a product of comparable quality produced in China verses the same product produced in Indiana, the price to an American is the dollar cost of producing it in and shipping it from Indiana or the Chinese Renminbi cost of producing it in and shipping it from China times the exchange rate between the Renminbi and dollar. The exchange rate plays a critical role in determining the cost of American exports to the Chinese or of Chinese imports to Americans. Thus the statement that Chinese labor is cheap so of course they can sell it to Americans cheaper, is half (the exchange rate half) meaningless and totally wrong.


The rule of international finance with regard to exchange rates is that governments should not interfere with this price (exchange rate) adjustment process. The market process for maintaining the desired external balance can be illustrated with examples from two opposite exchange rate regimes. The gold standard, the most recent and most important global currency and a the time tested example of a fixed exchange rate regime, and a freely floating (market determined) exchange rate with a domestic inflation or monetary aggregate target.


If two countries (or the whole world) are on the gold standard, the exchange rate of their currencies for each other are determined and fixed by the prices (exchange rates) of each of their currencies for gold. The rules of a pure gold standard, like those of modern currency boards (e.g. Bosnia, Bulgaria, and Estonia), require that the monetary authority passively provides its currency for gold (at the officially fixed price of gold) or gold for its currency (buying it back) as demanded by the market. With open and free trade, this system insures that the market produces and maintains balanced trade between these two countries (or the whole world). Balanced trade here mains a trade surplus or deficit (exports minus imports) just sufficient to satisfy the net desire of residents to invest abroad (investment abroad minus foreign investment at home). Let’s leave this complication aside and assume that markets desire on net to invest in their own countries so that market forces produce a balance between imports and exports and let’s stick with the example of the U.S. and China representing the rest of the world. How does the gold standard produce balanced trade?


The mechanism can be most easily explained be starting with a balanced situation (equilibrium) and introducing a disturbance. If the value of American exports to China equals the value of America’s imports from China at the fixed exchange rate between their currencies (via the gold prices of each), the sudden discovery of oil in China (or an increase in the price of oil where the U.S. is an oil importer) would raise the value of American imports from China. This introduces an imbalance in their trading relationship (an American trade deficit). The U.S. is no longer able to pay for all of its imports with exports. If must pay for the more expensive oil with gold (any dollars sold by American importers for Renminbi that are not wanted by Chinese importers to pay for their imports will be sold to the American central bank for gold). This outflow of gold from the U.S. reduces the money supply in the U.S., which lowers the average price level in terms of dollars (the value of dollars and gold are increased relative to American goods and services). This process makes Chinese goods relatively more expensive to American’s, who will thus import less and American goods relatively cheaper to Chinese, who will thus buy more of them. Gold flows out and the U.S. money supply and dollar prices of American goods and services fall until balance is restored between imports and exports (with the higher price of oil).  No unsustainable global imbalance is possible (other than temporarily while the “real” exchange adjusts as described above) as long as neither country’s central bank interferes with this process.


Taking the same example of an oil price increase, but with a freely floating, market determined exchange rate, the adjustment in the real exchange rate that the market demands takes place via a depreciation in the nominal exchange rate of the dollar for the Renminbi (i.e. an appreciation of the Renminbi). In this case the surplus of dollars in the foreign exchange market described above cannot be sold to the American central bank as was the case with the gold standard. As a result the excess supply in the foreign exchange market drives down the price of the dollar relative to the Renminbi. Under both regimes the real exchange rate adjusts as required to restore trade balance. An unsustainable global imbalance is not possible unless one or the other central banks intervenes in the process.


Normally to import a country must sell its currency in the foreign exchange market for the currency of the country whose goods and services it wants to buy. Similarly when some of its companies export they will only accept payment in their own currency, which requires the country buying them to sell its currency in the foreign exchange market for the currency of the exporter. The U.S. is unique in this regard because it issues the reserve currency of the system. Other countries will accept and sometime hold dollars when they sell their goods and services to the U.S. or to other countries. If they do not use these dollars to import (from the U.S. or other countries) they will invest them in the U.S. buying U.S. securities (often government securities), U.S. companies or shares in companies or even real estate.


The U.S. and China (to continue with our two country example) have interfered in the market’s natural equilibrating tendency in two ways. China has not wanted to let its currency appreciate against the dollar because its rapid growth is largely driven by exporting (foreign demand) and an appreciation would reduce foreign demand for Chinese exports. Thus the Peoples Bank of China (its central bank) intervened in the foreign exchange market to buy up the excess dollars resulting from China’s trade surplus in order to keep the exchange rate of its currency constant (or to slow its appreciation). When the Peoples Bank buys dollars it does so with its own currency. Under the rules of the game, if the Peoples Bank wants to peg its nominal exchange rate it must allow the increase in the supply of Renminbi in China and the Renminbi inflation it would cause when it buys dollars in the foreign exchange market. However, the People’s bank has resisted this alternative means of appreciating the real exchange rate of its currency through what economists call sterilized intervention. The Peoples Bank prevents the increase in its money supply caused when it buys dollars by buying the Renminbi back through the use of other central bank policy instruments (such as selling Chinese government securities and retiring the Renminbi received for them)—hence the term “sterilized” intervention.


The U.S. for its part has kept interest rates higher than they otherwise would be by running large fiscal deficits and as a result of very low private sector savings rates. Such rates encourage China and other countries to invest more in the U.S. than they otherwise would. China points attention to this U.S. pull of foreign investments into the U.S. The U.S. points to the Peoples Bank’s sterilized intervention and undervalued exchange rate as pushing investment into the U.S. of its resulting increase in foreign exchange reserves. The fact that China’s exchange rate policy has resulted in rapid and large increases in its foreign exchange reserves (U.S. dollars) has pushed so much into U.S. investments that U.S. interest rates remained low despite low savings rates and fiscal deficits.[6]


A Future for the SDR?


In the above examples, if the SDR replaced the U.S. dollar as the international reserve asset, any dollars purchased by the Peoples Bank to preserve its nominal exchange rate (as in the gold standard example) would be sold to the U.S. for SDRs. It would hold SDRs rather than dollars in its reserves. The U.S. could no longer print dollars (issue Treasury securities) to satisfy China’s demand for reserves. If its holdings (reserves) of SDR’s ran short, it would need to allow the upward pressure on its interest rates in order to increase capital inflows to provide it with the SDR’s demanded by China. The market adjustment mechanism would work as described above.[7] It would be more difficult for the U.S. to undermine the global balance adjustment mechanism as it does now.


The key advantages of the SDR over the U.S. dollar (or any reserve currency issued by a national central bank) are that its value is more stable relative to currencies in general (being a currency basket)[8], its supply is determined by collective decision of the IMF’s member countries, it is added to each countries’ reserves (to the extend of each countries allocation) without cost (now countries must sell their goods and services to acquire additional net foreign reserves), and the global supply can be increased without the need for a current account (or trade) deficit by the issuing country. These are formidable advantages.


Getting from here to there will take more than additional allocations of SDRs, though that will be part of the evolution. Most central bank reserve transactions are not with other central banks. They are with the market. The Peoples Bank of China buys dollars in the foreign exchange market (i.e. from banks and other foreign exchange dealers) and uses them to buy U.S. government securities in American markets (not from the U.S. Treasury directly). Thus the acceptance and growth of the “official” SDR (those allocated to central banks by the IMF), will require the development of private ones (private SDR denominated financial instruments) and mechanisms for linkages between the private and the official ones.[9] This was the path followed by the Euro (and its predecessor the Ecu).[10]


The extent to which the world chooses to hold and deal in SDRs rather than dollars will reflect the extent to which individuals and governments are more confident in the valuation of the SDR than the dollar or other possible units and the convenience (cost) of dealing in the asset. The world has changed its reserve currencies from time to time to align with the dominant economic power of the time, but such changes have always been gradual. If the SDR catches on, its displacement of the dollar would also be gradual, taking place over many years of growing use.


An important advantage of an international currency like the SDR emphasized by People’s Bank Governor Xiaochuan is that the U.S. would be subject to much stronger market pressure (in the form of exchange rate adjustments) that would maintain better balance between imports and exports than is now the case. The U.S. would also face far less risk of the central banks of the world losing confidence in the dollar and sharply reducing their willingness to hold them. As the SDR does not and is not likely ever to exist in currency form, the U.S., and increasingly the E.U. are likely to continue to enjoy the seniorage profits from selling their currency to the citizens of rest of the world.




Warren Coats, "The SDR as a Means of Payment," IMF Staff Papers, Vol. 29, No. 3 (September 1982) (reprinted in Spanish in Centro de Estudios Monetarios Latinoamericanos Boletin, Vol. XXIX, Numero 4, Julio–Agosto de 1983).

            "SDRs and their Role in the International Financial System," International Banking and Global Financing, proceedings of a Conference held at Pace University, New York City, May 1983.

            With William J. Byrne, "The Special Drawing Right:  Composite Currencies: SDR, ECU, and Other Instruments," Euromoney, 1984.

            With Jacob Gons, Thomas Leddy, and Pierre van den Boogaerde, "A Comparative Analysis of the Functions of the ECU and the SDR," in The Role of the SDR in the International Monetary System, Occasional Paper No. 51 (Washington, D.C., IMF) (March 1987).

            "Enhancing the Attractiveness of the SDR," World Development, Vol. 18, No. 7 (July 1990).

            With Reinhard W. Furstenberg and Peter Isard, "The Use of the SDR System and the Issue of Resource Transfers?," Essays in International Economics, International Finance Section, Department of Economics, Princeton University, No. 180 (Dec. 1990).

            "Developing a Market for the Official SDR," Current Legal Issues Affecting Central Banks, Volume 1, International Monetary Fund (Washington, D.C.) May 1992.

            "In Search of a Monetary Anchor: Commodity Standards Reexamined," in Framework for Monetary Stability, ed. by T. J. Baliño and C. Cottarelli , (Washington: International Monetary Fund, 1994).

Dmitry A. Medvedev, "Building Russian–U.S. Bonds" The Washington Post, March 31, 2009, Page A17.

Zhou Xiaochuan, "Reform the International Monetary System", Website of the Peoples Bank of China, March 23, 2009.



[1] I was Chief of the SDR division of the Finance Department of the IMF from 1982 – 1986.

[2] Zhou Xiaochuan, "Reform the International Monetary System", Website of the Peoples Bank of China, March 23, 2009.

[3] Dmitry A. Medvedev, "Building Russian–U.S. Bonds" The Washington Post, March 31, 2009, Page A17.

[4] The SDR interest rate is also determined daily on the basis of three month government securities with the same weights as the currency basket.

[5] Each new allocation is added to all previous ones and the total is called the “net cumulative allocation.”

[6] I have often wondered whether those politicians demanding an appreciation of the Renminbi realized that it would raise interest rates in the U.S. when the Peoples Bank no longer had such large foreign exchange reserves to invest in the U.S..

[7] This describes a relative imbalance rather than a global shortage of reserves. If as now the world were in recession or suffering a global shortage of reserves (which would otherwise require a global deflation to overcome) the IMF’s members could authorize a further allocation of SDRs as the G20 has just recommended.

[8] The SDR’s value could also be fixed to gold, as it was initially, or to baskets of commodities or goods and services. See Coats, 1994.

[9] Coats, 1990.

[10] Coats, Gons, Leddy, and van den Boogaerde, 1987.

Relaxing Bank Accounting Standards—A Big Mistake

“The board that sets U.S. accounting rules voted yesterday to let financial firms report higher values for some troubled assets, a controversial step likely to increase some banks’ reported earnings but also heighten suspicions that the companies are concealing problems.”[1] The vote Thursday by the Financial Accounting Standards Board (FASB) is a very bad development for several reasons.

1. The FASB caved in to very ill advised pressure from Congress to rush through this dilution of accounting standards, thus undermining the independence and professionalism of the Board.

2. While we don’t know the details, because the new ruling has not actually been written yet, a key lesson from Japan’s lost decade and every other major banking crisis of the last century is that denying or hiding bank losses is a big mistake. “This behavior is corrosive: unhealthy banks either don’t lend (hoarding money to shore up reserves) or they make desperate gambles on high-risk loans and investments that could pay off big, but probably won’t pay off at all. In either case, the economy suffers further, and as it does, bank assets themselves continue to deteriorate—creating a highly destructive vicious cycle. To break this cycle, the government must force the banks to acknowledge the scale of their problems.”[2] Thus the FASB’s ruling is a step backward. It will undermine market confidence in banks further and make the resolution of the problem harder and slower.

3. If banks can record higher values for some of their assets (especially mortgages and Mortgage Banks Securities) it is much less likely that they will sell them to other investors under the Treasury’s new toxic asset purchase scheme, because they will then need to value them at the actual (lower) sale price. When assets are actually sold, mark to market accounting will still apply. One arm of government is undercutting the policies of another.

Arthur Levitt, a former chairman of the SEC said, "I was very disappointed in the process in that the independent agency buckled to the strong-armed tactics of Congress, This is a step toward the kind of opaqueness that created the economic problems that we’re enduring today."[3] “If investors believe banks are overpricing assets, "the capital markets will remain closed to major banks and other financial intermediaries for an extended period of time," the CFA Institute, an investor advisory organization, said in an analysis. The group, which opposed the change, said "investors will not be willing to commit capital to firms that hide the economic value of their assets and liabilities."[4]

This is a potentially dangerous mistake.

[1] Binyamin Appelbaum and Zachary A. Goldfarb, "Under New Accounting Rules, Toxic Assets May be Revalued", The Washington Post, April 3, 2009, Page A15.

[2] Simon Johnson, "The Quiet Coup–The Way Out", The Atlantic, May 2009.

[3] Op. cit., Appelbaum and Goldfard.

[4] Ibid.