Global currency, recession and Bitcoin, part 2: Creating a global reserve currency
How exactly is the US dollar's dominance contributing to recession, and how exactly can digital currency solve it?
This is part two of a two-part series.
You can find part one here. It looks at how the current economic system was built, contextualises the current risk of recession and explores how circumstances are leading to the rise of a single global digital currency.
Part two breaks down how exactly the dominance of the US dollar is problematic, how exactly a global digital currency may be able to solve those problems and how this might inform its design.
A lot of people have recession on their mind, which is in turn bringing talk of global currencies, including Bitcoin, to mind.
On one side, Bank of England governor Mark Carney recently made the case for a new global digital currency to replace the US dollar as the standard global reserve currency. And on the other side, the most enthusiastic Bitcoin enthusiasts are entertaining the idea of Bitcoin becoming the next global reserve currency by stepping neatly into the spot previously occupied by gold.
What does a global digital currency need to do? What problems does it have to solve?
To answer these questions, we should first break down how exactly the prominence of the US dollar is contributing to the current economic climate.
As we explored in part one, the tightly interconnected debt-powered global economy of today means that when one country implements new economic policies, it has an impact on other countries, which then need to make their own adjustments, which then impact other countries, and so on.
This chain reaction typically starts and ends with the US dollar. It's not too bad when the whole world is in sync, but when the economic situation in the United States deviates from the rest of the world, it causes problems.
As Carney said:
"When US conditions warrant tighter policy there than elsewhere, the strains in the system become evident. These conditions emerged last year.
"US fiscal policy had boosted growth at a time when the US economy was near full employment. US monetary policy had to tighten consistent with the Fed's dual mandate. The resulting dollar strength and financial spillovers tightened financial conditions in most other economies by more than was warranted by their domestic conditions."
Basically, Carney is describing a chain reaction where the White House pours a set of tax cuts on an already-hot economy. This widens the deficit, increases government borrowing and forces the Fed to tighten monetary policy. The result is a stronger dollar.
Here's what the USD Index (green) has done since those cuts went through at the start of 2018, with AUD, CNY and EUR for contrast.
The problematic dollar
The strong dollar is problematic.
When controlling for the ups and downs in trade volumes, studies have found that a 1% appreciation of the US dollar against all other currencies predicts a 0.6% decline in total trade volume between countries in the rest of the world over the coming year.
This is purely the result of the dollar's influence, as borne out by the fact that it occurs regardless of whether American goods or businesses are involved and that the impact of USD fluctuations on trade volumes are strongest in countries where higher proportions of imports are invoiced in USD.
One of the major reasons for this is because global commodities are typically priced in USD and because businesses are increasingly doing trade in dollars to avoid exchange rate risks and costs.
So, when the US dollar appreciates relative to any local currency, the local currency price of imports increases around the world, proportional to the amount of imports invoiced in USD in that country.
Here are some numbers:
- More than 50% of Australia’s imports (and 80% of exports) are invoiced in USD.
- 55% of the EU’s imports are invoiced in USD.
- Only 13% of Japan’s imports come from the USA, but more than 70% of its imports are invoiced in USD.
- 86% of India’s imports are invoiced in USD, while only 5% of its trades originate in the USA.
- More than 90% of Indonesian, South Korean and Turkish imports are invoiced in foreign currencies
Theoretically, this is meant to balance out; expensive imports and cheap local goods means more demand for local stuff, which raises demand for the local currency and boosts its prices back up.
But here, when you have the whole global economy powering along on USD, you just get an international economic slowdown instead. A stronger dollar is a direct cost increase for importers and exporters. Add to that some protectionism, tariffs, trade wars and risk premiums, and these costs grow even more.
No matter how you wheedle and juggle it, the net result of these extra costs is less international trade, which means less selling, which equals global economic slowdown.
The dominance of the dollar causes problems in other areas too.
For example, that two-thirds of EME (emerging market economy) external debt that's denominated by the US dollar functionally gets more expensive to pay back as the dollar rises, which is the last thing you want to happen at a time when international trade is slowing down.
And that two-thirds of official FX reserves denominated by the US dollar are playing into the risk of a global liquidity trap, driven by demand for the dollar as a defensive investment against the backdrop of a slowing economy.
These are all part and parcel of the whole mess.
The tipping point
In this context, the global financial crisis (the impending one, not the last one) makes a lot of sense. All the ingredients for a perfect storm are coming together, with four cornerstones.
Four corners of crisis
Corner 1. USD dominance
The US dollar has retained, and even grown, its core position. The greenback now accounts for about 50% of international trade as a whole (and 80% of cross-region payments) according to SWIFT, while international trade is a more significant part of the economy than ever before.
Corner 2. A more interconnected world
The world is more interconnected than ever before. World trade as a share of global GDP has doubled since 1970, and 80% of the increase in total trade since the turn of the millennium has come from intermediate goods, which means the health of imports and exports are also more closely tied together than ever before, which globalises and amplifies the effect of trade war shenanigans.
Corner 3. Outdated economic orthodoxy
Even as the world changed, the economic orthodoxy didn't. The idea is still that central banks should target floating exchange rates and worry about their own economies first and foremost. The global economy is tightly bound together by international trade and the greenback, but the current line of thinking is still that fiscal and monetary policy is a personal endeavour.
"This consensus is increasingly untenable," Carney warns.
This ties into the fourth corner...
Corner 4. The old economic toolkit isn't working
Consider interest rates.
The go-to interest rate cuts that are meant to tickle consumer spending, and are already at record lows in Australia and elsewhere, tend to have a depressing effect on the local currency, which just exacerbates the difference between the USD and local currency and escalates that trade problem.
When this disparity grows, the effective cost of goods rises, and people who are feeling the pinch are even less likely to take advantage of low interest rates to go out and spend. Throw the larger-than-ever-before impact of things like trade war shenanigans on top of this, and it should come as no surprise that countries are having trouble motivating their consumers.
At the same time, mounting debt levels, persistent income inequality and the feeling that unemployment statistics are simply because there are more people than jobs, and that it's going to get worse before it gets better, are presenting related problems that can't be solved by anything in the classic economic toolkit.
It should come as no surprise that things don't seem to be working as they should.
How exactly does a new currency help?
It's probably safe to say we can't solve all the world's problems by dethroning the dollar as the world's global reserve currency. But it's equally safe to say we can solve some of them and remove one obvious hazard from the global financial system going forward.
Carney described his envisioned global digital currency as a "synthetic hegemonic currency", or SHC, composed of a basket of international currencies – like an international public sector version of Facebook Libra.
In implementation, it's pictured as basically just replacing the US dollar with a more diversified basket of currencies for big effects.
"An SHC could dampen the domineering influence of the US dollar on global trade. If the share of trade invoiced in SHC were to rise, shocks in the US would have less potent spillovers through exchange rates, and trade would become less synchronised across countries," Carney argues. "By the same token, global trade would become more sensitive to changes in conditions in the countries of the other currencies in the basket backing the SHC.
"By reducing the influence of the US on the global financial cycle, this would help reduce the volatility of capital flows to EMEs. Widespread use of the SHC in international trade and finance would imply that the currencies that compose its basket could gradually be seen as reliable reserve assets, encouraging EMEs to diversify their holdings of safe assets away from the dollar. This would lessen the downward pressure on equilibrium interest rates and help alleviate the global liquidity trap."
Until there is some kind of global currency, there's always an increased risk of any national currency rising up as a new dominant currency, which could bring a new set of similar problems.
A global currency will help take this problem off the table for good. The question is not whether a global currency is going to happen, so much as whether now's the right time to start thinking about making it happen.
Based on the aforementioned everything, it probably is.
But how do you actually get it done? You can't forcibly shove people off the dollar, and it will have to be a gradual process. The only way to do it is to create something better and to have a natural and orderly diversification into this new and improved reserve currency.
The need for a smooth transition will have to inform the nature of your new digital currency.
First, this means it should be useful as money anywhere you're hoping to see it picked up. For it to start making inroads, it should be accepted as currency and be able to actively present cheaper international payments.
"History shows that the rise of a reserve currency is founded on its usefulness as a medium of exchange, by reducing the cost and increasing the convenience of international payments. The additional functions of money – as a unit of account and store of wealth – come later, and reinforce the payments motive," Carney suggests.
It will also need to be able to displace or augment the network effects that currently cement the US dollar and other local currencies in place. A purely digital currency is good here. You'll ideally want something that can also navigate or interact with different payment areas of both the geographic and digital type.
Ideally, it will also be innately diversified, such as a basket of currencies, so people have more reason to regard it as a safe choice. At the same time, it can't threaten the ability of individual countries to enact their own monetary policy.
Unseating the dollar
You can't force people off the dollar, so a new currency has to be a legitimately good product that can viably unseat the dollar through its usefulness.
But as the dollar's reign has demonstrated, the currency that's best for the entire world isn't necessarily the one that ends up as a global standard. It will be the one that's good enough for a lot of people to start using it to the extent that it ends up as the de facto global standard. The challenge is to ensure that this currency is also the one that's best for the world when used as a global reserve.
Governments and central banks are a natural place for these developments to come from because they're intimately familiar with the needs of currency users and have their own vast existing "networks", but there's no ironclad rule that a future hegemonic currency has to be a government initiative or has to emerge from the public sector at all.
There aren't really any contenders right now though.
Bitcoin alone is right out. It might theoretically be nice to have a hard money-based currency that can function as a global standard for both international and local payments without inhibiting or being inhibited by monetary policy in any country, but it's volatile, the network is quite unscalable, it's prone to speculative flights of fancy and it's just nowhere near reliable, secure or tested enough to see an imminent level of serious uptake.
Similar issues face all public blockchain cryptocurrencies at this point.
Where it begins
A more relevant direction to look may be at Libra and the digital renminbi, expected to be released this November. It's the same direction and many other national digital currencies are coming as a direct response to Libra.
This may be how it begins.
As countries start rolling out their own digital currencies, eventually introducing much cheaper and faster cross-border payments, international businesses have less reason to hold USD as a universal currency, which helps ease the USD stranglehold on global trade and minimise the impacts of US policy on the rest of the world.
As these national digital currencies get built out, it gets easier to build new baskets with more currencies as well as other digital assets like Bitcoin, digitised gold and more. This diversification brings more stability, which will naturally make these preferable to USD alone for many other functions currently occupied by the US dollar and could eventually result in a suitable framework for the world's central banks to deliberately make a push for an actual global reserve currency.
With the flexibility of digital currency, the ability to more closely understand how their populations are using money and no need to reactively adjust internal policies just because the White House had a brain wave, central banks the world over may be able to respond to crises more effectively.
This level of demand could also potentially spur demand for censorship-resistant non-government digital assets like Bitcoin.
But at this point, trying to look that far down the road is much more akin to wild speculation than anything concrete.
There's still a very long way to go, and before we get there, we have to finish dealing with the consequences of the current system.
Disclosure: The author holds BNB and BTC at the time of writing.
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