See also related exchange of letters to the editor between the author and International Monetary Fund historian James Boughton.
The world economy faces an acute policy dilemma that, if mishandled, could bring on the mother of all monetary crises. Many dollar holders, including central banks and sovereign wealth funds as well as private investors, clearly want to diversify into other currencies. Since foreign dollar holdings total at least $20,000 billion, even a modest realization of these desires could produce a free fall of the US currency and huge disruptions to markets and the world economy. Fears of such an outcome have risen sharply in both official circles and the markets.
However, none of the countries into whose currencies the diversification would take place want to receive these inflows. The eurozone, the United Kingdom, Canada, and Australia among others believe that their exchange rates are already substantially overvalued. But China and most of the other Asian countries continue to intervene heavily to keep their currencies from rising significantly. Hence, further large shifts out of the dollar could indeed push the floating currencies far above their equilibrium levels, generating new imbalances and a possibly severe slowdown in global growth.
There is only one solution to this dilemma that would satisfy all parties: creation of a substitution account at the International Monetary Fund (IMF) through which unwanted dollars could be converted into special drawing rights (SDR), the international money created initially by the fund in 1969 and of which $34-billion-worth now exists. Such an account was worked out in great detail in 1978-80 during an earlier bout of currency diversification and free fall of the dollar that closely resembled today's circumstances.
There was widespread agreement, including from influential private sector groups and congressional leaders as well as the IMF's governing body, that the initiative would enhance global monetary stability. It failed only because the sharp rise in the dollar that followed the Federal Reserve's monetary tightening of 1979-80 obviated much of its rationale and over disagreement between Europe and the United States on how to make up for any nominal losses that the account might suffer as a result of further depreciation of dollars that had been consolidated.
The idea of a substitution account is simple. Instead of converting dollars into other currencies through the market, depressing the former and strengthening the latter, official holders could deposit their unwanted holdings in a special account at the IMF. They would be credited with a like amount of SDR (or SDR-denominated certificates), which they could use to finance future balance-of-payment deficits and other legitimate needs, redeem at the account itself or transfer to other participants. Hence the asset would be fully liquid.
The fund's members would authorize it to meet the demand by issuing as many new SDR as needed, which would have no net impact on the global money supply (and hence on world growth or inflation) because the operation would substitute one asset for another. The account would invest the dollar deposits in US securities. If additional backing were deemed necessary, the fund's gold holdings of $80 billion would more than suffice.
All countries would benefit. Those with dollars that they deem excessive would receive an asset denominated in a basket of currencies (44 percent dollars, 34 percent euros, 11 percent each yen and sterling), achieving in a single stroke the diversification they seek along with market-based yields. They would avoid depressing the dollar excessively, minimizing the loss on their remaining dollar holdings as well as avoiding systemic disruption.
The United States would be spared the risk of higher inflation and potentially much higher interest rates that would stem from an even sharper decline of the dollar. Such consequences would be especially unwelcome today with the prospect of subdued US growth or even recession over the next year or so.
The international financial architecture would be greatly strengthened by a substitution account. In the wake of the dollar crises of the early postwar period, the IMF membership adopted SDR as the centerpiece of a strategy to build an international monetary system that would no longer rely on a single currency.
The move to floating exchange rates by most major countries in the 1970s postponed the need to pursue that strategy to its conclusion but also generated the extreme currency instability that triggered official consideration of an account. The global imbalances and large currency swings in recent years, and the accelerated accumulation of official dollar holdings by countries that have essentially reverted to fixed exchange rates, replicate the conditions that led to both the creation of SDR and the negotiations on an account.
A substitution account would not solve all international monetary problems nor would it suffice to restore a stable global financial system.
The dollar needs to decline further to restore equilibrium in the US external position. China, many other Asian countries, and most oil exporters will have to accept substantial increases in their currencies now and much more flexible exchange rates for the long run. But early adoption of a substitution account would minimize the risks of adjustment of the present imbalances and the inevitable structural shift to a bipolar monetary system based on the euro as well as the dollar.