Triffin Dilemma

Robert Triffin (1911-1993)

In October 1959, a Yale professor sat in front of the Congress' Joint Economic Committee and calmly announced that the Bretton Woods system was doomed. Years of pumping dollars into the world economy through post-war programs such as the Marshall Plan, was making it increasingly difficult to maintain the gold standard. The Belgium-born economist, Robert Triffin, was right. The Bretton Woods system collapsed in 1971, and today the dollar's role as the world's reserve currency has the United States running the world's largest current account deficit.

This reserve currency paradox, known as Triffin dilemma, says that the dollar could not survive as the world's reserve currency without requiring the United States to run ever-growing deficits to provide the world with liquidity. However, the demands on a reserve currency means that excess supply would undermine its value. Moreover, cheap sources of capital and positive trade balances cannot really happen at the same time. The flip side of "interest-free" loan made possible by selling currency to foreign governments along with ability to raise capital quickly is to endure consistently large current account deficits. Fortunately, the countries that benefited from U.S. consumption reinvested the excess dollars that they earned as foreign reserves back into the U.S. asset markets, notably U.S. Treasuries, thus supporting the dollar, keeping interest rates low, and perpetuating the imbalances. The Triffin dilemma therefore highlights fundamental conflicts that arise between domestic and international economic objectives.

Hmmm... who fell off the basket?

Triffin proposed the creation of new reserve units. Similar to Keynes' originally proposed Bancor, these units would not depend on gold or currencies, but would add to the world's total liquidity. Creating such a new reserve would allow the U.S. to reduce its balance of payment deficits, while still allowing for global economic expansion. First created in 1969, Special Drawing Rights (aka SDR) are supplementary foreign exchange reserve assets defined and maintained by the International Monetary Fund (IMF) that would serve in this role. Their value is based on a basket of key international currencies reviewed by the IMF every five years, and consists of the following four currencies: U.S. dollars, euro, pounds sterling, and the Japanese yen.

“Providing reserves and exchanges for the whole world is too much for one country and one currency to bear.”

— Henry H. Fowler (1908-2000)

Perpetual Imbalance

The notion of a “balance of nature” stretches back to early Greeks, who believed gods maintained it with the aid of human prayers, sacrifices, and rituals. As Greek philosophers developed the idea of natural laws, human assistance in maintaining the balance did not disappear but was de-emphasized. The dominance of a constantly intervening God in the Middle Ages lessened interest in the inherent features of nature that would contribute to balance, but the Reformation led to renewed focus on such features. Darwin conceived of nature in balance, and his emphasis on competition and frequent tales of felicitous species interactions supported the idea of a balance of nature. Alfred Wallace around 1855 was perhaps the first to challenge the very notion of a balance of nature. In particular, Wallace asked how “balance” could be defined in such a way that a balance of nature could be a testable hypothesis. In any case, the balance-of-nature metaphor lives on in large segments of the public imagination.

A perpetually falling geostationary satellite orbits the Earth.

Wallace's original question—how to define “balance”—would be raised again, but this time not in the field of ecology but in economics. “One of the reasons,” according to Sanjeev Sanyal, “that mainstream economists get worked up about global imbalances is that they remain endearingly loyal to the idea of the 'equilibrium' — the intellectual legacy of Newtonian mechanics and Victorian engineering.” He argued that seeing the world as a complex, adaptive systems, imbalance may actually be the natural state of the global economy. In fact, his research indicates that “virtually every period of globalization and prosperity through two thousand years of history has been accompanied by symbiotic imbalances.”

For instance, in the first and second centuries AD, the world economy was driven by Indo-Roman trade. Throughout that period, India ran a current account surplus and the Romans kept complaining about the loss of gold — but the system endured for a very long time. Therefore, Sanyal suggested that the absorption of China's pipeline of surpluses will require the world to return to an age of current account imbalances. And the trajectory of the world economy will be determined largely by how it adapts to this reality rather than by some pre-conceived notion of balance.

The scale of capital outflow from China could be so large that it may hold down the long-term cost of capital globally for many years irrespective of how much central banks in the rest of the world tighten monetary policy. This is due to the important role that China's savings-investment dynamic plays in the evolution of global imbalances; and that China will soon experience a very rapid decline in the proportion of population of working age (defined here as between 15 to 59 years of age). Experience suggests that in a rapidly aging society, the investment declines can outpace the savings rate by larger margins. China currently has the lion's share of world investments (ahead of U.S.); so as the pace of investment slows in the years ahead, it will generate very large current account surpluses over a prolonged period.

An appreciation of the yuan is unlikely to correct for these surpluses and may perversely add to them. A higher yuan will depress investment in the tradable sector that, in turn, could further feed the surplus. In other words, the loss of competitiveness is more than compensated by the decline in investment over a prolonged period. A case in point is that of Japan in the mid-eighties, where the appreciation of the Yen was followed by larger current account surpluses over the next 30 years even though Japan was constantly losing competitiveness throughout this period. This is totally contrary to what mainstream economists would expect.

A revival of infrastructure investment in the developed world, in particular the U.S., would contribute meaningfully to global economic growth. But it is more likely that surplus capital would be channeled into infrastructure projects around Asia through initiatives like AIIB or the Silk Road infrastructure fund. Without such investments, we might have to reconcile ourselves to mediocre growth, depressed yields, and high asset prices (especially trophy assets) all over the world. It would seem that to keep the world in balance, one might have to first step out of balance into a perpetual fall, while redirecting the forces into a trajectory like that of the geosynchronous satellite orbiting the Earth and yet appears stationary at one point in the sky.

References:

1. Ferguson, Niall and Schularick, Moritz (2009). The End of Chimerica. HBS Working Paper 10-037. Retrieved from: http://www.hbs.edu/faculty/Publication%20Files/10-037.pdf
2. Sanyal, Sanjeev (2014, October 15). The Wide Angle: The Age of Chinese Capital. Deustsche Bank Research. Retrieved from: http://etf.deutscheawm.com/AUT/DEU/Download/Research-Global/c6762d18-6b36-4911-9a0a-c2f08a899705/The-Wide-Angle.pdf
3. Simberloff, Daniel (2014, October 7). The “Balance of Nature”—Evolution of a Panchreston. PLOS-Biology. Retrieved from: http://www.plosbiology.org/article/fetchObject.action?uri=info:doi/10.1371/journal.pbio.1001963&representation=PDF
4. Zemrun, Josh and Cui, Carolyn (2015, April 24). Glut of Capital and Labor Challenge Policy Makers. Wall Street Journal. Retrieved from: http://www.wsj.com/articles/global-glut-challenges-policy-makers-1429867807

This Time is Different

What would China do with its massive and growing $4 trillion in currency reserves? According to Louis-Vincent Gave of Gavekal Dragonomics, there is a more attractive proposition than keeping foreign reserves in low-yielding U.S. or eurozone bonds, which is to finance “foreign infrastructure projects, even at relatively low returns.” Presumably this is where the Asian Infrastructure Investment Bank (AIIB) and the $40 billion Silk Road infrastructure fund come in to play an important role, i.e., which is for yuan to be more widely used around the world starting first in Asia.

Wider holding of yuan in the investment portfolio would also be desirable for China. However, even though foreign investors can already buy up to $1 billion worth of Chinese securities, there isn’t much for them to buy, which hampers the yuan’s internationalization. The conventional wisdom is that for foreigners to become big holders of yuan, China has to run a trade deficit. It was suggested that China could instead simply give yuan to other countries to invest in (presumably Chinese-made) equipment and know-how, as the United States’ Marshall Plan gave Europe dollars with which to rebuild. That would certainly be a more practicable approach. The AIIB and the Silk Road infrastructure fund seem to be a step in that direction.

However, there are other interesting dynamics at play on the domestic front. Under the old export-led model, currency-weakening interventions by a country’s central bank effectively transfers wealth from consumers to exporters, since they drive up the cost of imported household goods but make exports cheap overseas. Similarly, interest rate caps on deposits also penalize household savings but makes business loans cheap. Such economic distortions misdirect growth into a trap of investment for investment’s sake, the so-called “treadmill to hell” that leads to whole swaths of vacant apartment buildings – or even entire ghost cities, as is the case in China’s economy today. Reversing the household-to-business subsidy would be a first step to get off that treadmill, cool the speculative property bubble, and make China’s economy less vulnerable to flagging demand in the U.S. and Europe.

If People’s Bank of China (PBOC) subscribes to this view, then there is a very good chance that its currency would soon reverse course and go from being undervalued in the past, to requiring state support to prop up its value going forward. At the moment, people and businesses want dollars to invest overseas; the market has traded at the lower end of the PBOC’s trading band as a net $25.3 billion in foreign exchange was sold in March. What’s more, it appears that the giant inflows of “hot money” that had accumulated in recent years, attracted by earlier one-way speculative bet on the Chinese yuan, are also itching to leave. If capital flight takes hold amidst slowing growth and the yuan plunges, there will be an exodus of funds going overseas. So it looks like PBOC’s massive $4 trillion in currency reserves might come in handy on such a rainy day after all. Unless, of course, there are good incentives for foreigners to be carrying out infrastructure projects denominated in yuan or holding yuan-denominated securities before that happens.

References:

1. Ip, Greg (2015, April 16). China’s Yuan as a Rival to the U.S. Dollar? It’s Closer Than You Think. Wall Street Journal. Retrieved from: http://blogs.wsj.com/economics/2015/04/16/chinas-yuan-as-a-rival-to-the-u-s-dollar-its-closer-than-you-think/
2. Casey, Michael J. (2015, April 26). China’s Currency Move is Sign of Larger Struggle in Yuan. Wall Street Journal. Retrieved from: http://www.wsj.com/articles/chinas-currency-move-is-sign-of-larger-struggle-in-yuan-1430097995
3. Talley, Ian (2015, May 3). IMF to Brighten Views of China’s Yuan. Wall Street Journal. Retrieved from: http://www.wsj.com/articles/imf-to-brighten-view-of-chinas-yuan-1430697814

All That Glitters...

“Permit me to issue and control the money of a nation, and I care not who makes its laws!”

— Mayer Amschel Rothchild (1744-1812)

Central banks wield enormous influence over exchange rates, and currencies can unexpectedly dive or soar off of even minor policy shifts. That in turn can cause successful trades in other asset classes to unravel, as profits on stocks or bonds are eaten up by currency effects.

The Amsterdamse Wisselbank was founded in 1609 as a municipality-sponsored central bank. From 1655 it was based in the new Amsterdam city hall on the Dam Square – the current royal palace. Amsterdam created the Wisselbank to insulate foreign merchants from the debasement of domestic coins. According to Adam Smith, funds held at the Wisselbank were reputed to have an “intrinsic superiority to currency.”

The gold standard was characterized by the free flow of gold between individuals and countries, the maintenance of fixed values of national reserves in terms of gold and therefore each other, and the absence of an international coordinating organization. Together, as Eichengreen and Temin noted, these arrangements implied that there was an asymmetry between countries experiencing balance-of-payments deficits and surpluses. There was a penalty for running out of reserves, and being unable to maintain the fixed value of currency. But there was, aside from forgone interest, no penalty for accumulating gold. The adjustment mechanism for deficit countries was deflation rather than devaluation, i.e., a change in domestic prices instead of a change in the exchange rate. During the interwar years of 1920s and 1930s, it was widely believed that maintenance of the gold standard was the primary prerequisite for prosperity. The prevailing worldview was that a stable exchange implied a stable economy.

In such an environment, supplies of money and credit depended on the quantity of gold and foreign exchange convertible into gold in the hands of central banks. Indeed, a surfeit or scarcity of gold reserves drove the economic fortunes of nations during the interwar years. In the 1920s, the U.S. had become a gigantic sink for gold reserves and by the end of the decade had accumulated nearly 40% of the world’s gold reserves. In the run-up to the Great Depression, France had also increased its gold reserves at a rapid pace from 1927 to 1933. In contrast, UK and Germany never had reserves anywhere as large, and German gold reserves all but vanished in 1931.

All that glitters: It is a picture of ... penguins in Fort Knox!?

But there was only so much gold to go around. Soon the effects of asymmetry kicked in, and central banks jacked up interest rates in their desperate attempts to obtain more gold. This destabilized commercial banks, and depressed prices, production and employment. Subsequent bank closures disrupted the provision of credit to firms and households, forcing them to curtail production and cut consumption. Deflation amplified the burden of outstanding debt, forcing debtors to curtail spending still further in order to maintain their credit worthiness. As the gold-exchange standard collapsed into a pure gold-based system, economies were destabilized as never before.

What is most important to note here is that national policies had cross-border repercussions. For example, when the U.S. raised interest rates sharply in October 1931 to defend the dollar’s gold parity, it drained gold from other gold standard countries and ratcheted up the deflationary pressure on them. When France raised interest rates in 1933, it intensified the deflationary pressure on members of the gold bloc and triggered a race to the bottom. Had there been a way for countries to coordinate their actions, things might have turned out differently. As Eichengreen and Temin explained, while it was impossible for one country acting alone to cut interest rates to counter deflation, as it would cause gold losses and jeopardize gold convertibility, several countries acting in concert would have been able to do so. This is because loss of gold due to interest rate cuts by oneself would be offset by gain of gold due to interest rate cuts by all the others. But efforts to arrange this in 1933 went nowhere; as was often the case, domestic politics got in the way of international financial cooperation.

The 21st century analog – the euro – is not identical to the gold standard, according to Eichengreen and Temin, but the parallels are there. The euro did not simply follow the gold standard; it also followed the Bretton Woods System implemented after the Second World War. Both the gold standard and the euro are extreme forms of fixed exchange rates. Bounded by a common fate, the surplus as well as deficit countries are like inseparable Siamese twins; their actions have systemic reveberations throughout the euro zone, and the rest of the world beyond.

References:

1. Eichengreen, Barry and Temin, Peter (2010, July). Fetters of Gold and Paper. NBER Working Paper 16202. Retrieved from: http://www.nber.org/papers/w16202.pdf