Speech by Lorenzo Bini Smaghi, Member of the Executive Board of the ECB,
Conference in memory of Tommaso Padoa-Schioppa,
Rome, 16 December 2011
1. Introduction"It is a great pleasure to attend this conference today in honour and memory of Tommaso Padoa-Schioppa and to be a member of the panel discussing the reform of the international monetary system. That was a field Tommaso bore responsibility for at the ECB and which I inherited from him.
I would like to focus my remarks on his main critique – which he shared with Robert Triffin – that the international monetary system remains incapable of imposing an acceptable macroeconomic discipline on the world economy. I also wish to examine the reservations he expressed about international policy cooperation being enough to ensure stability.
I would like to organise my remarks as follows. First, I would like to explore the theoretical underpinnings of international policy collaboration, and explain why in practice it seems to fall short of what is needed in today’s global world and why countries remain trapped in short-term policy-making. I will then review some proposals made by Tommaso to correct today’s international monetary system, including the provision of an anchor and an exchange rate mechanism, and consider the consequences of maintaining the status quo. In conclusion, I will argue that it is better to prevent volatility than to cure it. The deployment of ever larger official resources to cope with potential crises cannot be the solution – neither conceptually nor practically.
The policy implications are that there are three key areas where preventive action could and should be taken, and which require structural change by major economies: first, financial developments in emerging market economies (EMEs); second, further financial and economic integration in Europe; and third, reforms to ensure that financial markets serve the real economy and support stability..."
How should these weaknesses be corrected? Is the answer to be found indeed in international policy cooperation?
I tend to share Tommaso’s view that soft international cooperation alone, though necessary, would be sufficient. In his words, “coordination fails precisely when it is most needed, i.e. when policy preferences are most divergent”. My experience confirms that even in the wake of the global financial crisis – which brought home global interdependencies and the porosity of national boundaries for national policies – international cooperation continues to be based on the premise that the pursuit of national interests is the best approximation of the Pareto superior result. It is the philosophy underlying the G20 Mutual Assessment Process, which seeks to achieve strong, sustainable and balanced growth.
Another weakness of the current international monetary system is that in its centre of gravity – the United States – economic and monetary policy are shaped to suit domestic interests. The current system mimics therefore, as I said earlier, a generalised version of the Triffin dilemma. Tommaso recognised it as such and identified some of the elements of a solution.
First, he argued for some sort of “common exchange rate mechanism” which would ensure that every country agrees to shoulder its responsibility for the appropriate valuation of their currency and that exchange rates are determined by the interaction between the market and economic policy. He anticipated that this would be well supported by floating regimes for large currencies, while smaller countries may thrive with an intermediate regime consistent with the geographic pattern of their economic and financial linkages, possibly a managed peg to the regionally dominant currency. He observed, for example, the very strong regional interdependencies in East Asia and the momentum these create for a regional monetary arrangement comparable to those which Europe sought after the Bretton Woods system came to an end.
The distinctions between large and small economies, and floating and managed currencies, are particularly revealing at the present time, when we are seeing a large anomaly. We are currently facing an unprecedented situation in which a once-small economy that pegged its currency to that of a large economy has since grown to become the world’s second-largest national economy. The result is a giant economy running a fledgling currency internationally, outsourcing its monetary policy and its international requirements for money (as a medium of exchange, unit of account and store of value) to the globally dominant currency. This has been a major source of imbalances in recent years. The way in which it has been addressed has been unsatisfactory and the effects on the prospects for the global economy are likely to become graver over time.
The major economies, while recognising the domestic impact of the policies of others, have yet to appropriately factor mutual interdependence into their utility functions and policy deliberations. In Europe, we had the luxury of reflecting on European interdependencies in decades of calmer conditions when making successive attempts to produce a stable European monetary order, leading up to European monetary union. And still, we did not learn the lessons well enough and are now having to do so the hard way. There is no alternative but for a stricter supranational disciplinary element in Europe and, by corollary, at global level. As Tommaso said, it is nonsensical for countries to believe that they can reap the benefits of economic and financial integration without their policies acknowledging the two-way street.
The second issue is the need for an anchor to ensure the stability of a reformed international monetary system. More specifically, the interplay of demand for, and supply of, the reserve currency should be limited to what supports global stability. Just as Triffin saw an unresolvable tension for global stability arising from the subordination of the management of reserve-issuing currencies to domestic policy interests, Tommaso considered that this tension was keeping the disorder alive. In his view, what was needed was a quantum of supranationality that would hold sway over the global monetary policy stance. And here, he thought more could be made of a supranational currency, the Special Drawing Right (SDR). Tommaso recognised the hurdles to the SDR assuming its heralded role as the key reserve asset, in particular, the need for a critical mass of SDRs in both public and private sector circulation.
Although the SDR may have the potential to reduce the Triffin dilemma, it cannot remove it. As a basket of currencies, it would not reflect the domestic policy interests of the dominant economy, but rather the ‘average’ for the economies of all the currencies in the basket. And in this respect, it would only improve on global stability to the extent that the ‘average’ policy stance was better than the dominant policy. However, a mere average of policies driven by national objectives is no guarantee for the public good of a stable monetary anchor on a global scale. This would require a policy framework anchoring the global standard to an objective of global stability.
An alternative view is that of a multi-polar currency system. The emergence of such a system would accompany the global rebalancing of economic power that is taking place. It would be a market-driven process rather than requiring an international agreement, framework or mechanism. And to be most conducive to global stability, the shift to a multi-currency system should ideally occur gradually.
Like the SDR, it offers a welcome alternative to the reliance on one dominant national currency for stability, and should have the effect of eroding the exorbitant privilege of the US dollar and increasing the policy discipline on all major, internationally-used currencies. But also like the SDR, stability under a multi-currency system would still ultimately rely on nationally-oriented policies, though in the case of the multi-currency system, market participants would choose directly the sets of national policies they prefer. Would this reduce volatility, or would it be even greater, as players switch among currencies, particularly in the transition phase as the currency composition of reserves is re-weighted?
Of course, a shift to a multi-currency system requires that the privilege of incumbency of the US dollar be removed, that the sovereign debt weaknesses in the euro area be resolved, and that the renminbi develop its full international potential.
[Mrt: Freegold? :o)]
"...what kind of world are we heading for in the absence of a mechanism or anchor for global stability? The focus is likely to continue to be on measures to deal with volatility, such as increasing reserve buffers, restricting capital flows and heavily managing currency values. All of these come at a cost:
- excessive reserves, especially for EMEs, represent a tax on domestic consumption and, if widespread across countries, would produce a systematic excess of planned savings over planned investment, leading to a deflationary bias;
- capital controls are an understandable, if unfortunate, response to exceptional surges in inflows and outflows, but they produce externalities of their own, including increasing inflow or outflow pressures on other countries; and
- devaluing currencies can trigger beggar-thy-neighbour retaliatory measures that push the global economy into a downward spiral.
It is clear from this that prevention is always better than cure. Therefore, we must find better ways to reduce financial market volatility. Policy measures to address the problem need to be tailor-made.
In emerging markets, where financial sectors are underdeveloped, policy measures need to foster financial development. Domestic savings could then be more easily channelled into domestic investment, promoting domestic income growth and consumption, and rebalancing economic growth away from exports and reducing the incentive to maintain a low currency value. It would also lower the need for reserves and official outflows to advanced countries, and the excessive demand for US dollar-denominated financial assets.
In Europe, especially the euro area, we need deeper financial and economic integration to reduce the uncertainties and inefficiencies in the current institutional framework, so that the region becomes a core area of stability..."
[Mrt: Looks like a proposal for a postponement: E.M.-> Develop! EU -> Fix!]
Financial markets need reform so that their structure, conduct and performance supports stability. This calls for acute risk awareness, responsible risk analysis and appropriate risk pricing. It requires that participants are able to, and do, bear the consequences of their decisions without jeopardising system stability. And achieving these things necessitates an interplay between markets and regulators in such a way that balances dynamism with stability.
[Mrt: So, there is a realization that the FM is not ready yet.]
Efforts are under way in all these areas, and yet there remains much work to be done. We cannot afford to wait for the cathartic effects of the (next) crisis to improve the functioning of the international financial system.