The Dollar Standard and Its Crisis-Prone Periphery: New Rules for the Game
Ronald I. McKinnon
September 9, 2002
New Rules for the Dollar Standard Game
"Suppose that the American government finally recognizes its central position in the world monetary system and the “unfair” asymmetry in current financial arrangements. It also becomes determined to reduce financial fragility on the American periphery—looking at the periphery as being a collectivity of developing countries whose regional fortunes interact. The IMF as lender of first resort would stay as crisis manager, but the US itself would formally agree to be the residual source of finance— the lender of last resort. The combined IMF-U.S. entity would have sufficient resources to act sooner and more assuredly to limit financial crises on the periphery.
What then would be appropriate rules for this new relationship between the United States and developing countries on its periphery? What is the appropriate conditionality on which crisis lending should be based? Recognizing the underlying currency asymmetry, consider first a set of rules for the developing countries. Then follow with complementary rules governing the position of the United States itself. In the accompanying Box, rules 1 through 4 apply to the developing countries. These rules are intended to be guidelines for policy makers there and for professional advice-giving financial-support organizations such as the IMF or World Bank—or even the U.S. Treasury. Rules 5 through 8 in the Box apply to the center country. Besides identifying the role of the United States as lender of last resort, these rules restrain American behavior. Their success depends mainly on the United States’s understanding the underlying currency asymmetry in the world economy, and then of its own volition doing something about it. International agencies have very little leverage over American behavior. These eight rules are hardly all encompassing. Yet they go some distance to resolve the philosophical impasse over the dangers of moral hazard in international rescue operations versus the need to take collective action to prevent a financial breakdown in one country from spreading to neighboring ones..."
New Rules for the Dollar Standard Game
Rule 1. Recognize that the greater fragility of financial systems on the
periphery requires prudential financial regulations more
stringent than those appropriate within the industrial economies.
To supplement domestic regulatory restraints on foreign
exchange exposure by banks, capital controls may be needed.
Rule 2. Recognize that “soft” pegging to the dollar helps reduce risk
in peripheral countries whose domestic financial markets are
incomplete—and becomes absolutely necessary in the
presence of capital controls or severe limits on net foreign
exchange exposure by banks. Desist from advising them to
float their exchange rates against the world’s dominant
money, and against their neighbors.
Rule 3. Aim for mutual exchange rate stability within natural economic
regions such as South America or East Asia. Lend collectively
through regional stabilization funds as well as to individual
distressed economies. Using the dollar as the anchor currency,
set long-term exchange-rate objectives for the group to limit
contagion from beggar-thy-neighbor devaluations.
Rule 4. Restrict short-term private borrowing by countries under IMF
or World Bank programs. Private and sovereign debt
contracts must provide for the deferral of repayment should
that country be declared in crisis.
Rule 5. Conduct an independent monetary policy to limit inflation and
stabilize the purchasing power of the dollar. Provide a stable
nominal anchor for the price levels of developing countries.
Rule 6. Supplement the resources of the IMF in major crises and, if
necessary, act as lender of last resort—subject to the
conditionality laid out in Rules 1 through 4.
Rule 7. In noncrisis periods, remain passive in the foreign exchanges
without exchange rate targets. Allow foreigners to transact
freely in dollars. No capital controls for the center country.
Rule 8. Do not force developing countries to open their financial
markets—and cease pushing the entry of American banks and
other financial institutions into their domestic economies.
"An important reason for the great financial instability in developing countries is the doctrinal failure to come to grips with international currency asymmetry. Most of the world is on a dollar standard with a strong central money where one set of rules is appropriate, and a periphery of more fragile monies where a somewhat different set of rules and modes of operation are necessary (see Box). One manifestation of this doctrinal failure has been the advice commonly given to developing countries “float your exchange rate and open up your domestic capital to foreign capital flows and foreign banks”. Here, I have tried to show that such advice is misplaced for most developing countries, which need to cosset their financial systems until they become industrialized and their long-term bond markets are developed. Even more serious is the failure of such advice to consider cross-country spillover effects from changes in exchange rates. On the periphery, exchange rate policy should be a collective endeavor within economic regions whose economies are linked in trade and finance. In contrast, the capital markets for the center country, the United States, must remain open so that foreigners can freely transact in, and hold, dollar assets at all terms to maturity. Otherwise the world’s payment mechanism would be seriously impaired. So too should the United States generally remain passive in the foreign exchange markets except in major crises where its unique access to capital makes it the natural lender of last resort. Finally, the United States should not use leverage from its central position in the international monetary system (which, after all, is just an accident of history) to push the commercial interests of American commercial and investment banks in foreign markets."