Historical precedent to the USD musical chairs end game:
By Harold James
The Australian, Sydney
Saturday, January 1, 2005
The People's Bank of China and the Bank of Japan,
as well as other central banks in Asia, are in trouble.
They have accumulated vast foreign exchange
reserves, estimated at more than $US2 trillion
(AU$2.6 trillion), but almost all of these reserves are
in US dollars -- which are rapidly losing their value.
All policy options for Asia's central banks appear
equally unattractive. If they do nothing and simply
hold on to the dollars, their losses will increase, but
if they buy more in an attempt to prop up the dollar,
they will only have a bigger version of the same
problem.
If, on the contrary, they try to diversify into other
currencies, they will drive down the dollar faster and
create greater losses.
They are likely to encounter the same sort of problem
with other possible reserve currencies.
The euro has been touted as the replacement for, or
alternative to, the dollar. Some enthusiastic Europeans
encouraged Asians to diversify their reserve holdings,
but the same scenario may well be repeated with the
euro in a few years.
Large fiscal deficits and slow growth may convince
foreign exchange markets that there is little future in
the euro, prompting a wave of selling, and hence
losses, for central bank holders.
There is a historical parallel with today's concern
about the world's major reserve currency.
The inter-war economy, shattered by the Great
Depression of the early 1930s, offers a series of
painful, but important, lessons for the present.
In the 1920s, the world economy was reconstructed
around a fixed exchange rate regime in which many
countries held their reserves not in gold (as was the
practice before World War I) but in foreign exchange,
especially in British pounds.
During the 1920s, some of the official holders of
sterling grew nervous about Britain's weak foreign
trade performance, which suggested that, like today's
dollar, the pound was overvalued and would inevitably
decline.
Foreign central banks asked whether the Bank of
England was contemplating changing its view of the
pound's exchange rate.
Of course they were told there was no intention of
abandoning Britain's link to gold, and that the strong
pound represented a deep and long commitment (in
the same way that US Treasury Secretary John Snow
today affirms the idea of a strong dollar).
Only France ignored British statements and
substantially sold off its sterling holdings.
When the inevitable British devaluation came on
Sept. 20-21, 1931, many foreign central banks were
hit hard and were blamed for mismanaging their
reserves.
Many were stripped of their responsibilities, and the
persons involved were discredited. The Dutch central
banker Gerard Vissering resigned and eventually
killed himself as a result of the destruction wrought
on his institution's balance sheet by the pound's
collapse.
Some countries that traded a great deal with Britain
or were in the orbit of British imperial rule continued
to hold reserves in pounds after 1931.
During World War II, Britain took advantage of this,
and Argentina, Egypt, and India, in particular, built up
huge claims on sterling, although it was an unattractive
currency. At the war's end, they thought of a new way
to use their reserves: spend them.
Consequently, these reserves fuelled economic populism.
Large holders of sterling balances, such as Nehru's India,
Nasser's Egypt, and Peron's Argentina, all embarked on
major nationalisations and a public-sector spending spree.
They built railways, dams, and steelworks.
The sterling balances proved to be the starting point of
vast and inefficient state planning regimes that did
long-term harm to growth prospects in all the countries
taking this course.
Could something similar be in store for today's holders of
large reserves?
The most explicit call for the use of dollar reserves to
finance a major program of infrastructure modernisation
has come from India, which has a similar problem to the
one facing China and Japan. It will be similarly tempting
elsewhere.
This temptation needs to be removed before those
tempted yield to it.
Reserve holdings represent an outdated concept, and
the world should contemplate some way of making them
less central to the operation of the international
financial system.
To be sure, reserves are important to smooth out
imbalances in a fixed exchange rate regime, but the
world has moved since the 1970s in the direction of
greater exchange rate flexibility.
Reserves are also clearly important for countries that
produce only a few goods -- especially commodity
producers -- and thus face big and unpredictable swings
in world market prices. Dependency on coffee or cocoa
exports requires a build-up of precautionary reserves,
but this does not apply to China, Japan, or India, whose
exports are diversified.
Today's big surplus countries do not need large reserves.
They should reduce their holdings as quickly as possible,
before they do something really stupid with the
accumulated treasure.
---------
Harold James is professor of history at Princeton University
and author of "The End of Globalisation: Lessons from the
Great Depression." |
