Category Archives: Sustainable Finance

Global Imbalances: Equilibrating Exchange Rates vs Quantity Controls

Can we find an equilibrium exchange rate system (e.g. fixed or floating) that might reduce global imbalances or should we rely on penalties, caps or liquidity provisions to create sustainable balance of payments.

For example at the Oct. 22, 2010 G20 summit, Timothy Geithner argued that reducing current account imbalances would strengthen global growth and make it more likely to last. The U.S. pushed to commit each Group of 20 nations to keep its surplus or deficit to less than 4 percent of gross domestic product.  But the manner in which this was to be achieved offered little change from previous measures amounting to deflation in deficit countries and no change in surplus countries.

Criticisms of such policies hark back to the reforms of global imbalances put forth by luminaries such as John Maynard Keynes and Nicholas Kaldor.  Both economists were skeptical of the powers of flexible exchange rates to equilibrate imbalances.  In particular, Kaldor in 1977 found empirically that appreciations of the Japanese and German exchange rates, and even rising labor costs relative to their trading partners, did little to change their increasing share of world trade in 1960s and 70s, typically at the expense of the US and UK. Looking at the history of currency realignments, the success of devaluations in reducing surpluses is variable at best.

Kaldor’s instead proposed a solution that would focus on the terms of trade between manufactured goods and commodities – the raw materials essential to industry. Ordinarily, devaluation will raise a country’s cost of raw materials (if such inputs are primarily imported), create inflation and possibly lead to rising wages.  This would raise the cost of manufactured exports and lower competitiveness. During the period that Kaldor studied, he found that the appreciation of the Japanese and German currency compensated for rising prices of food, industrial materials and oil. This, along with Verdoorn’s law (increasing returns in production and the positive feedback in market share and labor productivity) allowed these countries’ trade surpluses to grow.

Consider today’s currency environment, if China was alone in maintaining a low exchange rate relative to the US dollar, then they would necessarily lower the price of their own manufactured goods (i.e. the price of the ‘value added’ by its processing activities) in terms of basic inputs (food and raw materials).  However this trade off between competitiveness and terms of trade is not occurring because there are many other emerging market nations that are also devaluing their currency, including those that primarily sell commodities, all are hoping to create a competitive edge and develop their manufacturing base through export-led growth.

Kaldor designed a trading system that would balance the manufacturing trade between the highly industrialized nations and prevent the industrially dominating ‘go-ahead’ countries from growing through unrequited exports, at the expense of other industrial countries, effectively stopping them from exploiting their own growth potential and ability to pursue policies of full employment.  Kaldor felt that only with cost push inflation pressures and/or a limited supply of labor (although this was rarely binding due to immigration) would an export-led country have an incentive to ever raise their exchange rate enough to counter their competitive advantage in manufactured exports.

Kaldor’s preferred solution was the institution of a new reserve currency, backed by a basket of commodities.  He called this commodity reserve currency (CRC) his ‘gadget’ and once instituted he believed that it would be an apolitical, automatic stabilizer that would resolve global imbalances, promote even growth and effective demand throughout the world (Kaldor initially took this idea from Benjamin Graham and worked on it with Albert Hart at Columbia University in the 1960s and 70s).

In addition a CRC would create a bufferstock of storable raw materials and allow for the stabilization of their price index over the cycle.  The stockpiling of these goods (located at regional futures exchanges and trading centers) would be paid for by the issuance of the reserve currency (redeemable inventory receipts for the basket).  The targeting of a commodity price index could be done with open market operations – buy the basket and increase the supply of CRC when demand and commodity prices were low, or sell the basket and decrease the supply of CRC when demand and commodity prices were high.  This new currency offered a standard of value that can grow or contract counter cyclically to world trade, and most importantly provide a source of stable income to commodity producers (including the developing world).  Unlike the SDR this currency could be internationally traded by public or private participants and did not require liquidity or mass acceptance to make it valuable.  It would be independent of national currencies, hence exempt from the Triffin paradox, and its supply was endogenous to rising world demand

This new reserve would exist alongside individual sovereign currencies which could peg or float to the international reserve. Importantly, each nation would be free to choose their monetary, fiscal, exchange rate and trade policy with their own citizens’ priorities in mind.

In 1977 Kaldor thought his commodity reserve currency proposal was at least 20 years ahead of its time.  Keynes back in 1943 was far more pessimistic.

“The right way to approach the ‘tabular standard’ [CRC] is to evolve a technique and to accustom men’s minds to the idea through [individual] international buffer stocks. When we have thoroughly mastered the technique of these, which is sufficiently difficult without the further complications of the tabular standard and the oppositions and prejudices which this must overcome, it will be time enough to think again” (Keynes 1943).

Keynes thus took the pragmatic route and instead of finding an equilibrating exchange rate process he proposed the balancing of deficit and surplus reserves through member cooperation and agreement to automatic rules and penalties. His international clearing union (or world central bank) would impose penalties on trade surplus and deficit countries and offer strong incentives for surplus countries to spend their reserves held in excess of their quota. (I can offer details here if requested). Exchange rates would for the most part be fixed with capital controls, though adjustable to equate wage efficiencies across countries and balance trade. The International Clearing Union would finance commodity stockpiles to stabilize individual commodity prices and thereby create a counter cyclical international incomes policy to smooth the world business cycle.

Both the Kaldor and Keynes proposal required a new international central bank (or IMF) and both called their international reserve ‘bancor’.  Kaldor’s was backed by commodities, Keyes’s was not. Kaldor’s was meant to be an automatic stabilizer primarily non discretionary in reserve expansion or contraction, while Keynes’s was much more discretionary and required coordination, penalties, and lender of last resort functions. Both had endogenous reserve supplies, although Kaldor’s was fully backed and Keynes’s was not.

Kaldor thought that he had found a tool that would not only cure global imbalances but would create investment into renewable resources that could sustain the industrialization of the developing world in a steady and sustainable manner without the need for coordination.

It is easy to say that both plans remain futuristic utopian policies. But I believe it is important to understand the mechanisms of each and work out whether they can actually do what they promise, regardless of political viability. And then put them in the tool box for future reference.

The monetary Three Body Problem

Over coffee at the workshop this morning I had some interesting conversations about the “three body problem in global finance”. So there is this idea that we are moving from a Dollar based system towards a system based on the triad of Dollar, Euro and “an Asian currency”. There was a time when the latter was likely to be the Yen, but given the long-lasting depression of Japan and the rise of China, it might well be the RMB. This development raises the problem whether such a system is stable, or what it would take to make it stable.

There may be an important relation with the Sonnenschein-Mantel-Debreu theorem in general equilibrium theory: with three or more goods, any kind of chaotic dynamics is possible. What we are to make out of this in view of a multiple reserve currency system, I don’t know, but forgetting about it does not look like a very sound approach.

Experience has shown that in a system with a single reserve currency, markets and central banks dealing with other major currencies tend to focus on the relation between those currencies and the reserve currency. (“Small” currencies may focus on a major currency of particular relevance to them, the way the Swiss Franc is related primarily to the Euro. Exchange rates with the reserve currency then show long swings – typically lasting a couple of years – around the trend of purchasing parity. Between the non-reserve currencies, this then leads to further random fluctuations. The latter are bounded, however, by the “anchor” provided by the reserve currency.

With several reserve currencies of similar weight, the anchor is missing, and the long swings between different currencies can amplify each other, resulting in chaotic dynamics that can include very large and fast swings – leading to major financial crises.

It is interesting to compare the situation with a famous problem of dynamics arising in physics. In the solar system, the sun is much larger than the planets, and these are sufficiently distant from each other not to start to circle around each other, while their moons in turn are small in comparison with the planets and again sufficiently distant from each other. As a result, the solar system is sufficiently stable to allow for life and human cultures to evolve on planet Earth.

Things are very different if one considers the dynamics of bodies of similar size moving through space. With three and more such bodies, chaotic dynamics is the norm. Anything to be learned about currency dynamics from this?


Some Remarks on Governor Zhou’s Suggestion to Reform the International Monetary System

By Armin Haas and Ulf Dahlsten


Two Challenges

As a prerequisite for sustainable development of both developed and developing societies, we need sustainable financial markets. We deliberately use this notion in two meanings. The meaning familiar to the business and academic sustainable finance community is the instrumental use of financial markets for bringing about a transition from an ecologically unsustainable “real” economy towards a sustainable one. The other meaning is the long-term resilience/stability/viability of financial markets. Concerning the resilience dimension, we identify two major challenges:

i) The first challenge is that since the breakdown of the Bretton-Woods system and the liberalization of the financial markets, there is no financial mechanism for keeping current accounts balanced. The Euro experience is telling in this respect. Without a mechanism that gives incentives to counteract current account imbalances that occur for whatever reason, current account imbalances tend to fuel themselves and eventually render the whole system unsustainable.

ii) The second challenge is a progressive decoupling of financial markets from the real economy. Several metrics show this phenomenon. The growth rate of many indices measuring assets values, for example stock price, commodity price, or house price indices, was way above the real growth rate of the economic entities the indices are based on. The Bank for International Settlements, for example, follows the volume of cross-border transactions; while transactions for export and import have grown linearly, the purely financial transactions have, after a temporary backlash, continued to swell in a significant way. Such transactions now amount to 98 % of all transactions. (See figure 1) The financial speculation in commodity markets is also mounting, in this case exponentially (See figure 2).

This is a dangerous development as the progressing self-referentiality of financial markets threatens their ability of actually controlling the proper working of the real sector. The fact that five years of on-going financial crisis have not been “sufficient” to substantially change the picture and align the financial and the real sphere again is telling about the magnitude of the problem.

Figure 1: Daily cross-border payments in Billion USD
Source: The Bank of International Settlements (BIS)


Figure 2: Number of annual trades by commodity, 1996–2011
Source: Maystre and Bicchetti (2012)


Historic Approaches for Dealing with these Challenges

Also in the time of the Gold standard, these two challenges had to be addressed. Between the wars, ongoing problems with destabilizing current account imbalances where are major issue. Keynes was well aware of the fact that for stabilizing the world financial system after the ending of WWII, innovative solutions would be needed.  When conceiving his Bancor as a supra-national reserve currency, he therefore worked out a mechanism for keeping current account imbalances in check.  In the wake of Keynes work, several other proposals, like the work of Kaldor, suggested mechanisms for addressing the current account challenge.

Concerning the coupling of the financial sphere and the real economy, there are basically three approaches and respective traditions for addressing this challenge. One approach is to use precious metals, i.e. silver or gold, for backing currencies. An alternative approach is to use a basket of commodities for the same purpose. This basket could include precious metals, but only to a certain extent. A third alternative is to issue money by buying or using as collateral commercial papers, i.e. financial assets that originate from economic operations in the real sector.


After Bretton Woods

Since the breakdown of the Bretton Woods system in 1971, the world financial system operates with no mechanism for addressing the two challenges. Instead, two approaches gained widespread acceptance, i.e. monetarism and the idea that financial markets are basically self-regulating. Until the outbreak of the contemporary financial and economic crises, the practical consequence of the dominance of these approaches was that most financial actors, i.e. politicians, regulators, central bankers, and decision makers in the financial sector, did not see a necessity for installing mechanisms for addressing the two challenges that we sketched above. After the outbreak of the financial and economic crisis, the situation has changed. We currently witness the beginning of a debate of how to organize the financial system in the decades to come. One important school of thought suggests that in the decades to come, the US Dollar will loose its role of major world reserve currency, giving way to a multi-polar system in which several regionally dominating currencies will be used as reserve currencies. A possible future world could, for example, see a tri-polar structure using the US Dollar, the Euro (however the Euro will be organized), and the Chinese Renminbi as reserve currencies. However, it is not clear how such a scenario could evolve or be managed. The People’s Bank of China is presently carefully increasing the convertibility of the Renminbi. Many expect that it will be fully convertible in a relatively near future, at the latest when China surpasses the US as the world’s largest economy, something the IMF predicts will happen before 2020. If there is no managed process in place, there is a risk is that there will be an uncontrolled flight from the Dollar to the Renminbi, in practice establishing the Chinese currency as a new reserve currency. Such a disruptive development could create financial instability with unforeseen consequences.


The Chinese Proposal

It is important to understand that the proposal that Governor Zhou made in 2009 envisions an alternative future. Under the impression of the contemporary financial and economic crisis, he suggests to create an international reserve currency that is disconnected from individual nations and managed by a global institution. Moreover, this currency should be organized so as to be able to remain stable in the long run. He thus wants to overcome the inherent deficiencies caused by using credit-based national currencies.

A striking aspect of Governor Zhou’s proposal is that he conceives China as a nation that endorses international co-operation when it comes to re-organizing the World financial system. This is in contrast to the view that China will, descriptively speaking, or should, normatively speaking, establish the Renminbi as dominating World reserve currency in the future. Both the descriptive as well as the normative view build on the expectation that China is set to grow into the World biggest economy.

Governor Zhou explicitly builds his proposal on Keynes’ Bancor concept developed in the 1940s. He is well aware of the fact that the creation of an international currency unit along the lines of Keynes’ proposal is a bold initiative that requires extraordinary political vision and courage and will take a long time.

In a pragmatic perspective, Governor Zhou suggests to use a gradual process that is guided by a grand vision and builds on what is currently already established. In particular, he suggests giving the Special Drawing Rights a greater role and broadening the scope of using them with the eventual goal of developing SDR to a point so that they satisfy countries’ demand for a reserve currency.

Governor Zhou does not explicitly discuss how to address the two challenges that we discuss above. He does, however, make it clear that his grand vision includes establishing a stable valuation benchmark. Moreover, he states that the allocation of the SDR can be shifted from a purely calculation-based system to a system backed by real assets, such as a reserve pool.

As Keynes’ original proposal came with an explicit mechanism for keeping current account imbalances in check, and as Governor Zhou envisions establishing a stable valuation benchmark, we think that he is very well aware of the two challenges and the need to explicitly address them. Thus, his proposal is in sharp contrast to the above-mentioned vision of a multi-polar world that comes without established mechanisms for addressing the two challenges.