Annual income twenty pounds, annual expenditure nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pound ought and six, result misery.
-Charles Dickens

Economic forces help me keep my expenditures within my income over time. Companies that are not able to generate revenue greater than their expenditures over time are forced to close. Governments and countries must ultimately live within their means as well. Governments can spend more than they receive in taxes by borrowing, but purchasers of their debt will stop lending to any government whose debt they think is growing too large for the government to service. Governments can and have defaulted on their debts. Countries as a whole can ultimately only buy from the rest of the world what they pay for with what they sell to the rest of the world. The economic forces that operate, and that need to operate, to keep whole nations within their means take us to the heart of the current debate about the international monetary system and the role of the U.S. dollar in that system.

Like any other economy, the Cayman Islands must ultimately live within its means as well and the fact that its currency is exchangeable for U.S. dollars at a fixed exchange rate means that the behavior of the U.S. dollar is particularly important for Caymanians.

Introduction

A country (all of its people, companies, and government
taken together) must live within its means in the same way that individuals do.
Its expenditures abroad must not exceed its income from abroad in the long run.
Like individuals, countries can finance some foreign spending by borrowing but
only as long as their capacity to repay their foreign debts remains credible.
And, like prudent individuals, most countries also build up reserves (savings)
that can be drawn upon when their foreign income falls temporarily short of
foreign expenditures.

Virtually the only aspect of transacting abroad that sets it
apart from transaction at home is that most countries have their own currency.
Generally we expect to receive our own currency when we sell abroad and
foreigners expect to receive theirs when they sell to us. Thus a country’s
foreign reserves (usually owned by its central bank) must be held in a currency
acceptable abroad. Almost two thirds of the world’s official (government owned)
foreign exchange reserves of 6.7 trillion dollars are held in U.S. dollars
(predominantly U.S. Treasury securities). The only other important currency in foreign
exchange reserves is the Euro with 27% of the total.

A country’s expenditures abroad are largely for imports and
it generates foreign income by exporting and from the return on foreign
investments or gifts. When the outflow of money from importing exceeds the
inflow from exporting, the foreign trade deficit is financed from the country’s
foreign currency reserves (a currency that is accepted abroad) or by borrowing
foreign currency if it can.[1]  To build up foreign currency reserves
in the first place the country must export more than it imports (have a trade
or current account surplus).

The United States, as the reserve currency provider, is
unique among nations because it needs no reserve of foreign currency. The rest
of the world will accept the U.S. dollar. It needs only to print more of them
to satisfy any demand. When China or other countries want to increase their
reserves of dollars, they must export more than they import and the U.S. must
do the reverse. A key issue is how this system maintains the desired balance
between these flows and adjusts them when deficits and surpluses are excessive.
Related to that issue is whether the approximately $4 1/2 trillion U.S. dollars
held in official reserves are potentially destabilizing given serious concerns
about the future value of the dollar and dollar interest rates in the face of
huge prospective U.S. government deficits.  Would externally produced reserve assets, such as gold or the Special Drawing Rights (SDR) of the International Monetary Fund, be better or helpful?

Regulation by Markets

The Balance of Payments Adjustment Mechanism

When my budget is out of whack I can draw down my savings or
borrow for a while if the imbalance is temporary. Once I have used up my
savings and cannot borrow more, I am forced to either work harder to generate
more income in order to sustain the level of my consumption or cut back on my
expenditures. The same is true for countries. The counterparts to working
harder or reducing consumption for a nation as a whole are to export more
and/or import less.

The economic force that brings about the adjustment of
unsustainable trade imbalances is what economists call the terms of trade. The
terms of trade, or real exchange rate, is the price relevant for international
trade. The price to me of an IBM/Lenovo PC produced in China depends on its
price in Chinese renminbi and the exchange rate of renminbi for dollars (and
the price of American exports in China depend on their U.S. dollar prices and
the exchange rate). When the exchange rate of the dollar depreciates (buys less
of other currencies) imports into the U.S. become more expensive and exports
become cheaper to foreigners and thus more competitive.  Collectively the U.S. will import less and export more. But a change in the terms of trade can also result from
changes in the Chinese or American prices of traded goods. If the Chinese do
not want to accumulate more dollar reserves, economic pressure will change the
terms of trade so as to make Chinese goods more expensive in the U.S. and
American goods cheaper in China in order to reduce the trade deficit and thus
the need for China to accumulate as many dollars. The depreciation in the REAL
exchange rate needed to reduce the large U.S. trade deficit can result from a
depreciation of the renminbi/dollar exchange rate or from a deflation in the
U.S. or inflation in China (or, obviously, some combination of these). Focusing
on the nominal exchange rate only, can be misleading.

The market forces that produce the terms of trade adjustment
just described operate differently, but to the same effect, when countries have
fixed exchange rates, as they do if they use the same currency (as was the case
in effect with the gold standard), or freely floating, market determined
exchange rates. A trade deficit (actually the more comprehensive current
account deficit) in one country has its counterpart in surpluses in other
countries.[2]

When governments play by the rules of the gold standard or any other fixed
exchange rate regime, the gold or foreign exchange reserves of the deficit
country fall reducing its money supply (its importers sell their currency to
the central bank for foreign reserves/gold). The opposite happens in the
surplus countries. Foreign exporters sell the gold/foreign exchange to their
central banks for their national currency, the supply of which increases.
Prices fall in the deficit country and rise in the surplus countries. This
market process changes the real exchange rate (terms of trade) in the direction
that adjusts imports and exports so as to reduce trade deficits and surpluses.
With market determined exchange rates and (let’s assume) domestic inflation
targets for the national currencies, foreign exchange markets experience a
surplus of the deficit country’s currency and a shortage of the surplus
country’s currencies. The excess supply of the deficit currency results in the
depreciation of its exchange rate, which has the same effect on the real
exchange rate (terms of trade) described above for the gold standard.

This rule-based system has suffered two problems. Countries
often did not play by the rules (e.g., they might sterilize the market effects
on their money supplies). Even if they did, when an external asset like gold is
replaced by a national currency as the international system’s reserve asset,
the country that supplies it (the U.S. in the currency system) must run a
current account deficit in order to supply the dollars the rest of the world
wants. As it is supplying its own currency, it will never run out of “foreign
exchange reserves.” The U.S. can supply its dollars to the world as long as it
wants them. It is not forced to “adjust” to large deficits in the way other
countries are. The system rests on the rest of the world’s confidence in the
stability of the value of the dollar in all of its dimensions. Neglect of this
reality and responsibility by the United States could result in a catastrophic
flight from the dollar.[3]

World Demand for Dollars

For a variety of reasons, many countries in the last few
decades chose to keep their exchange rates low enough relative to the U.S.
dollar to facilitate the growth of their export sectors or to accumulate larger
foreign exchange reserves. Many developing countries following the earlier
example of Japan have adopted an export lead strategy for development. For some
this strategy took the healthy form of removing trade restrictions that allowed
the growth of both imports and exports subjecting their economies to greater
competition and promoting greater efficiency and productivity. But some, such
as China, promoted exports at the expense of imports as their strategy for
growth. These countries set their exchange rates (explicitly or via foreign
exchange market intervention by their central banks) below levels that would produce
balance between imports and exports. To prevent the resulting inflow of surplus
dollars from depreciating their currency’s exchange rate in the market, the
central banks of these countries intervened to buy the excess dollars (often
sterilizing the domestic monetary consequences of such intervention to prevent
inflation, thus violating the rules of the game). The result was an increase,
and often a very large increase, in their foreign exchange reserves (ownership
of U.S. dollar assets).

In some cases, countries wished to increase their foreign
exchange reserves for sound prudential reasons. Following the Asian financial
crisis of 1997, many Asian countries thought that the conditions imposed by the
IMF for its temporary balance of payments financial assistant were too harsh.
In order to avoid them in the future, they determined to increase their
reserves to levels that would avoid the need to borrow from the IMF when their
exchange rates were under attack.

For these and other reasons many countries ran international
trade surpluses that greatly increased their foreign exchange reserves. Their
surpluses were necessarily matched by the deficits of others, largely the
United States. 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. Thus the result of the build up of reserves in China and other surplus countries has been a huge inflow of capital into the deficit countries (largely investments in the United
States—largely U.S. government securities). [4]

Though this huge accumulation of dollar assets abroad was in
response to world demand for reserves, it has created a system that is
dependent on the stability of the American economy and the value of its
currency. The system is vulnerable to the successful conduct of American
monetary and fiscal policies. But the arrangement complicates American
macroeconomic policy. The desire of others to accumulate dollar reserves
flooded American financial markets with liquidity, which lowered interest
rates. If the Federal Reserve had tried to raise interest rates it would only
have attracted even more foreign inflows thus appreciating the dollar and
worsening the American current account deficit. These conditions (plus American
housing policy and other factors[5]) fed the housing price bubble in the U.S.[6]

The value of the dollar is now in doubt. Financing America’s
huge current and even larger prospective fiscal deficits will be difficult and
promises higher interest rate or higher inflation or both. Either of these
developments will reduce the value of foreign exchange reserves held in
dollars. Any slowdown in the accumulation of dollars abroad, much less any
effort to reduce them by diversifying out of the dollar, would greatly
accelerate the fall in the dollar’s exchange value. This poses a serious
dilemma for countries with large dollar reserves. Should they try to diversity
out of dollars and thus contribute to the further fall of dollar or should they
stick it out and suffer whatever losses are expected.

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).[7]^,[8] 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 dollar’s exchange rate in 1971, the need for SDRs became less pressing. The G20 heads of
state meeting in London in early April 2009 called for an additional $250 billion dollar allocation of SDRs, almost an eight-fold increase over the current stock of $32 billion. These were allocated August 28, 2009.

_______________________________________________________________________

[Side bar on the SDR]

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.

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. Prior to the
new allocation of SDRs in August 2009, the IMF had 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 over most of 2009 or the 250 billion U.S. dollar
allocation last August. 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. SDRs are
“allocated” to IMF members in proportion to their quotas in the IMF, which
roughly reflect their economic size and importance in world trade. Allocated
are credited to the SDR account with the IMF as additional SDRs owned and held
by each receiving member. At the same time the member’s SDR account with the
IMF will record a liability for the same amount. The member will earn interest
at the SDR interest rate on whatever SDRs it holds[9]
and must pay interest at the same rate on its SDR liabilities. If it continues
to hold the SDRs it was allocated, the member will earn the same interest
income that it pays on its allocation.[10]
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. The member will enjoy
larger foreign exchange reserves at no cost (but with no net interest return).
If the member uses 100 million of its SDRs, for example, 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, the member would then have a net charge to the
extent of its net use of its SDRs. This is the sense in which an SDR allocation
is like a line of credit (without the commitment fee or risk of cancelation).
Conversely, if the member 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 can 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 SDRs in payment for another country’s financial obligations or
to buy them (rather than dollars) for dollars. 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. Official SDRs
may also be lent, swapped, and sold forward.

[End of side bar]

______________________________________________________________________

A Future for the SDR?

The current system suffers from several weaknesses. a)
Currencies pegged to the U.S. dollar need to have reserves of dollar assets to
avoid the exchange rate risks associated with fluctuations in the dollar’s
exchange rate with other currencies. Thus the value of the approximately $4.5
trillion of official reserves held in dollars are exposed to whatever happens
to the value of the dollar and the U.S. has not always been a good steward of
the responsibilities that come with being the supplier of the world’s reserve
currency. b) Market discipline of America’s policies that affect its external
balance is weak because the United States, as the supplier of the reserve
currency, is not subject to the restraining power of a loss of reserves when
its monetary and fiscal policies are too lax. c) The ongoing growth in desired
reserves as the world’s output grows requires an American current account
deficit large enough to supply them and the accumulated stock of external
claims on the U.S. can and has grown very large. d) Changes in world demand for
dollars (e.g. because of easier IMF terms for balance of payment support that
reduce the need for reserves, or a loss of confidence in the dollar) may be
hard to absorb and if abrupt could produce wide swings in the external value of
the dollar.

The use of an externally supply reserve asset such as gold
overcomes the first three of these problems and reduces to the scope of the
forth one (a loss of confidence is unlikely). The pros and cons of and the
historical experience with the gold standard have been extensively written
about. The Special Drawing Rights (SDRs) of the IMF are more recent and less
widely known.

The SDR has a very important advantage over dollars or gold.
Its supply can grow (by allocation by the IMF on the basis of the decision of
an 85% weighted majority of its members) without the need for a balance of
payments deficit by the U.S. (or any other supplier of a currency used as
international reserves) or the mining and refining coats of gold (or any other
commodity that might be used). SDR allocations are distributed in proportion to
member countries’ quotas in the IMF and growth in members’ reserve demand is
not likely to exactly match such a distribution (though it is a reasonable
first approximation given the economic basis for members’ quotas). Thus some
marginal reallocations would occur that would have to involve balance of
payments deficits and surpluses. However, these would be much smaller than are
now required to supply the world with the dollars it demands.

An enhanced role for the SDR might be limited to providing
some or all of the future growth in foreign exchange reserve desired by countries
or might also replace some of the existing dollar reserves.[11]
If all further increases in international reserve assets were in SDRs, any
dollars purchased by the Peoples Bank, for example, to preserve its nominal
exchange rate and/or to expand its reserves (as with the gold standard or gold
exchange standard) would be sold to the U.S. for SDRs. It would add SDRs rather
than dollars to its reserves. The U.S. could no longer print dollars (issue
Treasury securities) to satisfy China’s demand for reserves. If the U.S.
holdings of SDR’s ran short, it would need to allow the upward pressure on its
interest rates that would naturally result from its purchases of dollars (thus
reducing the supply of dollars in the market) in order to increase the capital
inflows needed to provide it with the SDR’s demanded by China. The market
adjustment mechanism that now applies to the rest of the world would apply to
the U.S. as well.^[12] It would be more difficult for the U.S. to undermine the global balance
adjustment mechanism as it does now.

To replace some or all of existing dollar reserves with SDRs
would require much larger allocations of SDRs or the creation in the market of
significant quantities of private SDRs (SDR denominated bonds and other
financial claims). The SDR faces a unique challenge because of its current
official valuation as a basket of currencies. The official SDR allocated by the
IMF must currently be exchanged for dollars or other national currencies at the
official exchange rates calculated daily by the IMF on the basis of current
market exchange rates for these currencies. Thus it may not be the case that
China or some other holders of SDRs can find IMF member countries willing to
buy them at that price on any particular occasion. Dollar reserves can always
be sold because the price of dollar asset may fall if necessary until willing
buyers materialize.

All fiat monies gained acceptance initially by being
exchangeable for something else (such as gold). The U.S. dollar’s acceptance
internationally was bolstered by its convertibility into gold by the U.S.
Treasury until international claims on American gold so far exceeded America’s
holding of gold that President Nixon was forced to end the dollar’s
convertibility in 1971.[13] Yet the world’s demand for and use of dollars continued to grow based on its ultimate convertibility into American goods and services and reasonably
predictable prices.

While internationally traded commodities like oil, gold,
copper, silver, diamonds etc might well be priced in SDRs and wholesale
purchases settled in (private) SDRs, the official SDRs held in central bank
reserves would generally need to be converted into a national currency to be
fully usable, and as noted abovevwould need to be exchanged at the IMF’s
official rate for that day. To deal with this situation, IMF member countries
judged to be in a sufficiently strong balance of payment position are required
to accept SDRs when designated by the IMF to do so. This is not likely to be a
significant burden in normal times as the global growth in reserve demand would
produce sufficient opportunities to sell SDRs for those wishing to do so. In
unusual periods in which the global demand for reserves (including SDRs) falls,
the “burden” of being designated to accept them in exchange for dollar, Euros
or some other freely usable currency could be reduced by a cancelation of SDRs,
which like an allocation would fall on countries in proportion to their IMF
quotas.

Conclusion

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)^[14],
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 would 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.^[15]
This was the path followed by the Euro (and its predecessor the Ecu).^[16]

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 seigniorage profits from selling their currency to the citizens of the
rest of the world.

Bibliography

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.

While it will probably take a few years for the economy to fully recover from the recession of 2008-9, the financial crisis that deepened it and threatened another great depression has passed. With the benefit of hindsight we now have a clearer picture of its causes. Inappropriate government policies and regulations incented and permitted economic agents to undertake too much risk with borrowed money. Following is a big picture overview of what happened and how to “fix it”.

Macro Factors – Global Imbalances

For a variety of reasons, many countries chose to keep their exchange rates low enough relative to the U.S. dollar to facilitate the growth of their export sectors or to accumulate larger foreign exchange reserves (the foreign currency assets owned by central banks with which they can finance temporary external deficits and defend the external value of their currency[1]).

Many developing countries following the earlier example of Japan have adopted
an export lead strategy for development. For some this strategy took the
healthy form of removing trade restrictions that allowed the growth of both
imports and exports subjecting their economies to greater competition and
promoting greater efficiency and productivity. But some, such as China,
promoted exports at the expense of imports. These countries set their exchange
rates (explicitly or via foreign exchange market intervention by their central
banks) below levels that would produce balance between imports and exports.[2]
To prevent the resulting inflow of surplus dollars from depreciating their
currency’s exchange rate in the market, the central banks of these countries
intervened to buy the excess dollars (often sterilizing the domestic monetary
consequences of such intervention to prevent inflation). The result was an
increase, and often a very large increase, the foreign exchange reserves
(ownership of U.S. dollar assets) of these countries.

In some cases, countries wished to increase their foreign exchange reserves for sound prudential reasons. Following the Asian financial crisis of 1997, many Asian countries thought that the conditions imposed by the IMF for its temporary balance of payments financial assistant were too harsh. In order to avoid them, they determined to increase their reserves to levels that would avoid the need to borrow from the IMF when their exchange rates were under attack.

For these and other reasons many countries ran international trade surpluses that greatly increased their foreign exchange reserves. The surpluses of some countries must be matched by the deficits of others. Thus the result of the build up of reserves (largely investments in the United States—largely U.S. government securities) in China and other surplus countries has been an inflow of capital into the deficit countries (largely the U.S.). [3]

Under the gold standard, the international reserve asset was supplied by nature.[4] Under our current system the U.S. dollar is the dominant reserve currency and it is supplied at the discretion of the Federal Reserve, America’s central bank. For other countries to obtain dollars on net the U.S. must have a balance of payments deficit. Under the gold standard, increases in the world’s demand for reserve assets (gold) would increase the price of gold (as its supply is limited by nature) and would produce worldwide deflation.[5]

Under the current dollar standard, the world’s trade surpluses are invested
(largely) in the U.S. The U.S. money supply is not affected, but the demand for
U.S. securities is increased lowering interest rates in the U.S. If surplus
countries have fixed or targeted exchange rates, their central bank must buy
the surplus dollars thus increasing their domestic money supplies. Sterilized
intervention to defend exchange rates is very expensive.[6]

Large global trade imbalances of recent years have lowered interest rates in
deficit countries and when combined with the Federal Reserve’s policy of
domestic price stability in the U.S. (avoiding deflation as well as inflation)
have flooded the world with liquidity. Very low interest rates and excessive
liquidity fueled asset price bubbles, including the real estate bubbles in the
U.S., U.K., Spain, and a number of other countries.[7]

This is the macro environment that fueled other factors that facilitated
excessive risk taking by banks and other financial institutions.[8]

Micro Factors—Excessive Leverage

After centuries of little change, commercial banks have changed dramatically over the last three decades. Traditionally banks took deposits from the public, provided payment services for their depositors using those deposits, and made loans financed by those deposits. Over the last fewdecades, banks increasingly financed loans with borrowed funds, replaced liquid and safe government securities with riskier assets on their balance sheets, and undertook other speculative (trading) activities. They also moved their riskiest assets off their balance sheets into special purpose vehicles and other structured finance products. In short, banks enormously increased their leverage and significantly increased the riskiness of the assets and positionsthey held on and off their balance sheets. Why did this happen?

Several factors combined to shift the balance of risk and return sought by many but not all banks in the U.S. and in many other countries. Adrian Blundell-Wignall and Paul Atkinson, in a very insightful article in the Journal of Asian Economics[9] set out four primary factors: “(i) capital rules and tax wedges set up clear arbitrage opportunities for financial firms over an extended period—these were policy parameters that could not be competed away as they were exploited. Instead they could be levered indefinitely until the whole system collapsed;
(ii) regulatory change permitted leverage to accelerate explosively from 2004;
(iii) systemically important firms in banking with an equity culture emerged;
and (iv) cumbersome regulatory structures with a poor allocation of
responsibilities to oversee new activities in the financial sector were in
place.”

The complex and badly flawed U.S. tax code, with different rates for different people and circumstances, created the possibility to reduce taxation on a given underlying income stream (e.g. a mortgage) by shifting it to investors and/or forms that received more favorable tax treatment through the construction of complex financial derivatives. The tax saving was largely enjoyed by the financial engineers creating these complex financial instruments, with little to no gain for the economy. Modern computers significantly lowered the cost of constructing and monitoring these complex financial instruments, further increasing their attractiveness.

Basel II permitted reductions in capital for mortgage related investments while closing some regulatory holes created by off balance sheet activities of covered banks. Anticipating these changes many banks effectively reduced capital charges to their future Basel II levels by moving them off balance sheet starting in 2004. Some ill advised regulatory changes by the SEC in the U.S. allowed American banks to greatly increase leverage toward the more lax European levels. When combined with accelerating real estate prices in the U.S., and some other countries, some banks increased their leverage and the riskiness of the assets they held significantly. The question remains, why bank shareholders and management accepted to do so.

For the United States, a major factor was the increased dominance of the “equity culture” over the “credit culture” in banks, following the adoption of the Gramm-Leach-Bliley Act of 1999, which allowed the merging of investment banks with commercial banks.

Banks’ deposit customers want a safe place to keep their money and convenient ways to settle (pay) financial obligations with that money. Small savers want safe term deposits with modest, risk free interest rates that can be easily withdrawn when needed. Bank’s accommodated those preferences by lending modest amounts to its depositors or to credit worthy businesses with good track records or collateral. For centuries, bank owners understood the nature of the banking business in this way and expected modest but steady returns on their investment. Blundell-Wignall and Atkinson refer to this as the “credit culture.”

Investment banking has a very different culture. Investment banks earn fees for facilitating complex financial deals and for managing customer funds who generally have a much higher risk tolerance than do typical bank depositors. Investment banks also trade and invest their own fund. The risk preferences of investment banks and their customers tend to be high in pursuit of high returns. While the repeal of the depression era Glass-Steagall Act, removed some harmful restrictions, such as the prohibition against interstate banking, it also removed the barrier between investment banking, commercial banking and insurance. As the risk taking equity culture of investment banking mingled with the conservative credit culture of traditional bankers, risk preferences and standards in many banks shifted toward the equity culture. Conversations with Citibank employees confirm a dramatic change in the institution’s attitude toward risk taking over the last decade as its management was taken over by investment bankers.

The extensive use of bonuses in preference for higher salaries is also more typical of the equity-investment banking culture in which the risks and rewards of performance are shared with employees. From an investment banking perspective, the tax and regulatory arbitrage opportunities of poorly designed tax laws and regulations called for and justified as much leverage as they could get away with. The risks seemed small and the return large if highly leveraged as long as real estate prices kept rising.

Reliance on functional regulation, which certainly has its merits, left cross-functional risks uncovered. ‘‘Multiple specialized regulators bring critical skills to bear in their areas of expertise but have difficulty seeing the total risk exposure at large conglomerate firms or identifying and preemptively responding to risks that cross industry lines.’’[10] Market self-regulation was weakened by the lax enforcement of underwriting standards by agents and brokers who earn fees for concluding deals but have no skin in the game (no financial stake in the ultimate outcome – repayment—of deals). Compliance with already low underwriting standards was sometimes fraudulently ignored or misreported. But the combination of these weaknesses with the presumption of many players that because the government was promoting increased home ownership and the lower mortgage underwriting standards needed to qualify more marginal borrowers, the government would stand behind its policies and bailout participants if they incurred losses. The expectation of many that they could keep large profits from risk taking and pass on the losses to tax payers proved all to true in the end. Obviously, greater risks were logical in this environment.

The way forward

Economic fluctuations and bubbles have always existed and will continue to exist. However, greater central bank sensitivity to its contribution to asset price bubbles should be able to avoid bubbles as large as the recent real estate bubble. Beyond that, excessive risk taking can be reduced in the future by removing the tax and regulatory arbitrage opportunities that reward it[11] and by strengthening corporate governance so that bank owners have more control
over the salaries of and risks taken by management. Filling some of the
regulatory gaps will also help. The moral hazard impetus to excessive risk
taking exacerbated by government bailouts over the past two years will be difficult to overcome but extending the failing bank resolution powers the FDIC now has for banks (bank bankruptcy laws) to a broader range of financial institutions and requiring firms to develop resolution plans in advance will help. Similarly removing artificially low costs of funds to firms viewed as “too big to fail” with appropriately higher capital requirements will also help restore market discipline of excessive leverage and risk taking. Blundell-Wignall and Atkinson provide an excellent summary of an exit strategy and reformed system needed in the future. I want to focus, however, on the nature and scope of commercial banking itself.

The fractional reserve banking system, which allows banks to lend the money deposited with them, provides commercial banks with their great efficiency as well as fragility and potential instability via bank runs. It has long been the source of much discussion. Strangely perhaps, some strong free market advocates have proposed extreme regulation of commercial banks in the form
of drastically limiting what they may do with deposits. Narrow banking, for
example, would forbid banks to lend, limiting them to investing depositor’s
money in liquid and safe bonds or bills (e.g. marketable government debt). The
deposits of cash with mobile phone companies in Kenya and Afghanistan that can be transferred to other mobile phone customers as a convenient, low cast way to pay bills or transfer cash have a similar restriction. One hundred percent of the deposits with the phone company must be deposited by the phone company with banks. Credit Unions operate under somewhat less strict regulations that allow them to lend to their own, member depositors. Others have advocated what might be called mutual fund banking (as opposed to the “par value” banking we now have), in which depositors acquire a share in the bank’s assets rather than the right to withdraw the amount they deposited[12].
In that regard it is like a normal mutual fund against which checks may be
written for whatever the current value of the depositor’s share of the bank’s
assets are. Mutual funds can lose money but cannot go bankrupt (unless they are allowed to leverage investments). The severity of these regulatory restrictions is accepted by their advocates in the interest of clear, rule-based arrangements within which the banks could operate freely and safely.

While these proposals have some merit, they are extreme and in my opinion unnecessarily restrictive. A more moderate proposal is to restore some version of the separation between commercial banks and other forms of financial services contained in the Glass Steagall Act.

Mervyn King, Governor of the Bank of England, stated the
problem recently as follows: “Why were banks willing to take risks
that proved so damaging both to themselves and the rest of the economy? One of
the key reasons – mentioned by market participants in conversations before the
crisis hit – is that the incentives to manage risk and to increase leverage
were distorted by the implicit support or guarantee provided by government to creditors
of banks that were seen as “too important to fail”. Such banks could raise
funding more cheaply and expand faster than other institutions. They had less
incentive than others to guard against tail risk. Banks and their creditors
knew that if they were sufficiently important to the economy or the rest of the
financial system, and things went wrong, the government would always stand
behind them. And they were right…. It is hard to see how the existence of
institutions that are “too important to fail” is consistent with their being in
the private sector….

“The banking system provides two crucial services to the rest of the economy: providing companies and households a ready means by which they can make payments for goods and services and
intermediating flows of savings to finance investment. Those are the utility aspects of banking where we all have a common interest in ensuring continuity of service. And for this reason they are quite different in nature from some of the riskier financial activities that banks undertake, such as proprietary trading. In other industries we separate those functions that are utility in nature – and are regulated – from those that can safely be left to the discipline of the market….

“There are those who claim that such proposals are impractical. It is hard to see why. Anyone who proposed giving government guarantees to retail depositors and other creditors, and then suggested that such funding could be used to finance highly risky and speculative activities, would be thought rather unworldly. But that is where we now are.”[13]