The result: A sharp fall of the dollar against particularly the euro and the yen. The European authorities have already started voicing fears that the strength of the euro is making economic recovery more difficult. A further rise in the currency would mean an even deeper recession. The impact on Japan would be little different. In the US market, bond yields would rise sharply, steepening the yield curve and dampening the reflationary impact of the cheaper dollar. And, with the three big economies in deeper recession, even dynamic Asian economies would suffer, particularly if trade protection gains ground. Overall, the costs to the global economy of a chaotic, unplanned shift out of the dollar as the principal reserve currency would be very high.

What about the other possibility of a gradual shift over a period? Is an expanded role for the SDR an answer? The draft report of the UN Commission of Experts on Reforms of the International Monetary and Financial System, chaired by Joseph Stiglitz, has made several points on the subject. To quote from chapter 5, “Since the 1960s, the system has indeed been plagued with cycles of confidence in the US dollar. These cycles have become particularly intense since the 1980s, leading to unprecedented volatility both in the US current account deficit and the effective exchange rate of the US dollar. As a result, the major attribute of an international store of value and reserve asset, a stable external value, has been eroded. There is another sense in which the current system is unstable.”

“A global reserve currency whose creation was not linked to the external position of a national economy could provide a better system.”

After discussing the merits of a supranational reserve currency managed by a global central bank (as Keynes had recommended during the Bretton Woods conference in 1944 which gave birth to the IMF and the World Bank), the Commission argues that “One institutional way of establishing a new global reserve system is simply a broadening of existing SDR arrangements…”.

The Chinese too have referred to the need to expand the role of SDRs as a reserve currency.

There are obviously major issues if the idea is that a part of the existing reserves in dollars could be exchanged with the IMF for SDRs. This would clearly create a major exchange risk (the exchange rate between the dollar and the SDR) and the IMF obviously does not have anywhere near the financial strength to take such a risk, or be credible about its ability to do so. If, at some stage, SDRs are to replace dollars as the reserve currency, the exchange risk may well need to be guaranteed by the member countries of the IMF. And, perhaps a condition precedent would be managed exchange rates at least amongst the G-3 currencies within a reasonably narrow band. But then this goes against the market-knows- best ideology which has mesmerised many people in the world for the last three decades. The recent financial crisis has clearly demonstrated the hollowness of the doctrine and the need for government interventions. Will managed exchange rates become part of global financial reform? Will the possibility of a reserve currency crisis help the G20 concentrate their minds? The need is there. But it can be met only by something like a Bretton Woods II, something that even the market fundamentalist magazine, The Economist (September 26), contemplated not so far back. To quote, “It is hard to think of a parallel in history. A country heavily in debt to foreigners, with a government deficit it is making little attempt to control, is creating vast amounts of additional currency. Yet it is allowed to get away with very low interest rates. Eventually such an arrangement must surely break down and a new currency system will come into being, just as Bretton Woods emerged in the 1940s.” If central banks manage the domestic value of the currency (that is, inflation), why not the external value as well?

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