Dealing with a global Triffin dilemma | FT Alphaville

Dealing with a global Triffin dilemma

We love a little bit of Triffin’s dilemma on FT Alphaville.

It refers to the idea that whoever has reserve currency status thrust upon them, is simultaneously lumbered with the burden of supplying the world with extra currency — thus entrapping themselves to a permanently indebted existence.

In a recent keynote speech at the Triffin International Foundation in Brussels, Fabrizio Saccomanni, Director General of the Bank of Italy, has pondered what he describes as the current “global Triffin dilemma”.

As he notes, in a system which depends on a reserve currency issuer’s fiat supply rather than a gold-standard or any other fixed rate system, flexible exchange rates are essential for keeping imbalances at bay. The fact that we have found ourselves in the current crisis suggests something has gone very wrong somewhere in the system.

As he explains:

Since the move to floating in 1973, flexible exchange rates have not behaved according to textbook predictions:

– Their volatility has exceeded what could be justified by shocks to fundamentals.
– Persistent misalignments have emerged among the major currencies.
– Partly as a result, many countries have been reluctant in practice to allow full exchange rate flexibility (“fear of floating”), resorting to various forms and degrees of exchange rate management.

Both policy failures and market failures have been responsible for this:
– Misguided and unsustainable policies have frequently been a source of macroeconomic uncertainty and structural distortions. Exchange rate policies and capital controls have often been used to prevent the correction of misalignments.
– At the same time, market exchange rates are not guided by fundamentals in a reliable way, partly because market participants (as also economists) do not seem to share a common view of what those fundamentals are.

In other words, some countries — acting in their own interests — may have inadvertently sabotaged the global monetary system. Some, specifically, more than others (our emphasis):

The emergence of large and persistent external imbalances over the past twenty years is closely connected to the lack of an effective policy discipline.

– Some of the countries with the largest surpluses and deficits have been under no effective pressure from the markets to correct the imbalances. China and oil exporting countries seemed to be able and willing to continue to accumulate reserves almost indefinitely. As a result, the United States, issuer of the principal reserve currency, faced a highly elastic demand for its dollar liabilities and therefore did not need to incur either currency risk or a rising cost in financing its deficit.

– However, exchange rate manipulation was just an element in a broader constellation of structural factors and policy settings, in both surplus and deficit economies, that allowed the imbalances to persist. Neither multilateral surveillance nor peer pressure had sufficient “teeth” to induce a correction of those policies before the crisis.

Now, while many of these forces appeared to decline at the onset of the crisis, Saccomanni believes they remain a potent and influencing force, preventing crisis resolution. Indeed, the Triffin dilemma may be playing out on a new and extreme level — due mostly to the desire of some countries to accumulate large stocks of official reserves as a precautionary buffer, as well as a means to maintain undervalued exchange rates to support export-led growth.

This creates a strange situation. The more threatened such an economy is with slow growth, the more it translates to demand for US Treasuries — compressing yields and causing yet more financial market distortions, as well enforcing the United States’ “exorbitant privilege” as reserve currency issuer.

One solution, says Saccomanni, is a multi-polar approach to the reserve currency system. This might involve a greater role for the Chinese renminbi (RMB) as well as the Japanese yen — in the first instance, potentially achieved by Asian countries pegging their exchange rates to the RMB. Hopefully, this would make demand for US dollar reserves less elastic.

But, adds Saccomanni, no matter how pressing the need for a multi-polar approach gets, it will never work without an equally high degree of international cooperation.

Isolationism, in other words, is to be avoided if we are to make our way out of the crisis — a fact demonstrated by the current euro crisis. The answer is clearly more political union rather than less.

As Saccomanni himself observes:

– At present, both the high degree of financial integration among economies and the awareness of their interdependence have made the costs of isolationist or non-cooperative behaviour more evident than in earlier periods of systemic transition such as in the interwar years.

– However, having stronger incentives to cooperate is not enough. We also need a greater capacity to do it, which means having an effective political leadership and the right institutions. We know from experience that the ability and willingness of national policy-makers to act cooperatively, even in the face of a clear and present danger, cannot be taken for granted.

That need for political unity goes for a strategy involving the Special Drawing Rights (SDR) too:

I believe that in order to have a chance to work in practice, such actions would need to be part of a long-term strategy supported by a strong political commitment. My understanding of the experience of the private ECU is that a key factor of its success was the link to the long-term process of European monetary integration, which provided not only a legal, economic and institutional frame of reference but also a strong political constituency. By analogy, making the SDR a credible reserve asset and unit of account for both official and private agents would probably require a commitment to eventually transform it into something more than a basket, i.e. a currency in its own right. As we know, we are still very far from having a broad consensus on such a prospect.

In short, says Saccomanni, we currently have an international monetary system which lacks effective mechanisms for ensuring the mutual consistency of national policies. Thus we have something of a global Triffin dilemma taking shape:

The age of financial globalisation has brought us to the verge of this second extreme. The extraordinary growth of financial activity has far outstripped the growth of real economies, leading to the accumulation of financial assets that are largely the liabilities – i.e. the debts – of countries, banks, corporations. The markets are telling us now that this process has gone too far and that a “deleveraging” – i.e. a reduction of the indebtedness – is now required by all debtors, public and private. The world economy is, in other words, confronted with a “global Triffin dilemma” in which the excessive indebtedness of the issuers of financial assets is now affecting the value of the assets themselves; of all assets, not just of reserve currencies, as in the early Triffin dilemma.

Thus, if the entire world wanted to cash in all their financial assets, at once, this would result in the immediate bankruptcy of all debtors, be they private or public. To ensure this doesn’t happen Saccomanni believes members of the G20 must work together on a “truce” to allow for an orderly deleveraging.

Whether that solution would ever become politically acceptable, however, is another matter.

Related links:
Reform of the international monetary system: A cooperative approach for the 21st century – Palais-Royal Initiative
Shadow banking – from Giffen goods to Triffin troubles – FT Alphaville
What makes a reserve currency?
– FT Alphaville
The Fed’s 1.6 trillion ‘somethings’
– FT Alphaville