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Impending dollar crisis - Time for Bretton Woods II

The world is either to witness a global meltdown of the dollar or allow a controlled dollar devaluation. A calibrated multilateral exchange rate adjustment programme may offer a solution. The IMF may be best suited to put this through.

The global trade, finance and investment architecture seems to be fast spiralling out of control. For some time now economists are engaged in the mother of all debates: Whether the US dollar will collapse by as much as 40 per cent of its present value (some are even betting on the dollar going belly-up) or if there will be an orderly devaluation that is, revaluation of other currencies. In effect, the question that is confronting us is not "whether" but "when" and by "how much."

Consider these facts: The basic structure of the US economy is that the deficit of the government is 4 per cent of GDP and the household sector 6 per cent, which are offset by a domestic savings of 3 per cent, largely from corporates, leaving a substantial national deficit of 7 per cent to be covered by the capital flows from the rest of the world. With its size and in an integrated world, this asymmetry of the US gets translated into a skew in the global economy.

US raises rates
In 2005, the current account deficit of the US stood at $805 billion, which was as much as 6.4 per cent of its GDP. This deficit translated into a current account surplus of $164 billion of Japan, $159 billion of China, and $196 billion for West Asian countries. To ensure that the savings of the rest of the world estimated in excess of $2 billion per day is channelled into the US, Washington has repeatedly raised its interest rate to 5 per cent. It is feared that this increase could result in domestic loans, especially the housing loans turning bad and leading to bankruptcies and triggering a meltdown.

By mid-May, the US Bureau of the Public Debt calculated the US National Debt at approximately $8.36 trillion dollars that is, approximately $28,000 for every American. In March 2006, the US Congress raised the national debt ceiling to $9 trillion. At the current levels of borrowings the US Congress would need to visit this subject by year-end and raise the limits further.

On March 28, the Asian Development Bank (ADB) is reported to have issued a memo, advising members to be ready for a collapse of the dollar. Since end-March, the US Federal Reserve has stopped publishing the quantum of broad money (referred to as M3) in the US economy. In a recent survey sponsored by the Royal Bank of Scotland it was found that central banks around the world are shifting from the dollar in favour of the euro. The former Federal Reserve chief, Mr Paul Volcker, said in a speech last year that current account imbalances were as great as he had ever seen and predicted "a 75 per cent chance of a dollar crash in the next 5 years."

The root cause
The US consumption is at the root of the problem. Or is it? The present stress on the dollar can be explained in economic terms as caused by the enormous size of its twin deficits trade and budgetary run by the US. Put simply, Americans have been living way beyond their means for far too long, consuming far more than what they can possibly afford. This was facilitated by an interventionist mercantile policy of weak currencies across the world, notably in Asia, and a correspondingly strong dollar. This policy of maintaining a competitive exchange rate has translated into a race to the bottom. Given these asymmetries, it is no wonder the economists are seriously worried.

Of late countries are discovering that this arrangement has its own limitations. The world is realising that while the rest of it gives products and services to US, the US gives the rest dollars (aggregating to more than $700 billion) every year. This arrangement will continue till the world "perceives" the dollar to have a value. While this is rooted in pure psychology, simple economics tells us this increased supply of the dollar of this magnitude will obviously result in a fall in its value. Economics has a knack of overwhelming psychology, albeit slowly.

Countries are increasingly realising that the value of the dollar that they are holding is fast eroding, whatever be the "officially managed exchange rate." And if fewer people want the dollar, it would lead to an avalanche and the dollar could tumble.

No wonder, the Fed is loath to making public the M3 figures, as it does not want to publicise the dollar holdings by central banks across the globe.

Interestingly, in such pessimistic situation, economists are betting on central banks to defend the dollar. This is not as simple as it is seems given that the exchange rates of the euro and the yen, the two big players, are market determined while many other currencies are "managed" or "fixed". Consequently, analysts fear that when the push comes to the shove, these currencies may have to bear the brunt of a dollar collapse.

Global dilemma
Nevertheless, countries across continents are caught in a serious dilemma should they not intervene, the collapse of the dollar is imminent, and should they continue to defend it, they will be long-term losers, as the present arrangement is self-destructive.

It is indeed tempting to blame US consumption for this crisis. However, one must hasten to add that the emerging economies, notably China, with their fixation for weak currencies, are equally to blame. After all, it takes two to tango. While the going was good, everyone profited and expected the arrangement to continue indefinitely. Linearity as a concept can rarely be applied in real life, much less in economics.

Crucial Role for IMF
Surely, the emperor is without clothes. And it may take a currency trader sitting in a remote corner of the world to push the global economy into an abyss through a click of a mouse. We are either to witness a global meltdown of the dollar or allow a controlled dollar devaluation (read revaluation of other currencies). Either way we are damned, experts nevertheless agree that while the former will result in difficult adjustments, the latter may allow for a "soft-landing" of the global economy, if handled adroitly.

Speaking on this subject at the 39th Annual General Meeting of the Asian Development Bank in Hyderabad, the Prime Minister, Dr Manmohan Singh, stated: "The present level of global imbalance cannot be sustained forever. It, therefore, calls for action from both countries having current account surpluses and those having current account deficits. A coordinated effort is necessary to correct the imbalances to prevent a sudden down turn. International financial institutions need to play a proactive role in this regard."

Clearly, in view of the wide ramifications of the issues involved, a calibrated multilateral exchange rate adjustment programme is fast emerging as a possible solution. For calibration to happen one needs to call for a multilateral consultation and also enforce a global structural adjustment programme. Who better qualified than the IMF for this task?

Given this background, one has to view the IMF's medium-term strategic review (MTS), which seeks to examine specific proposals to make global surveillance more effective through a new approach to multilateral consultations (by facilitating discussions within groups of countries on issues of systemic importance); and by broadening the IMF's internal consultative group on exchange rates to all major emerging market currencies.

Obviously, the IMF has its own compulsions to diplomatically approach this vexatious issue.

While one can be sceptical of the IMF's role and question the intention behind the MTS, the fact remains that the global adjustment programme calls for multilateral action, surveillance and consultations. The IMF is well placed to act on this issue.

One need not be dismissive of the the new surveillance programme that the IMF wishes to put in place. Sadly, there is no other way out of the current impasse but a multilateral remedy on the lines of Bretton Woods. Over to Bretton Woods II!

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Last modified on Sunday, 07 July 2013 07:36