If Mao Zedong had said that the era of dollar dominated international currency system was a thing of the past, he would have been shrugged off. But that’s precisely what Chinese President Hu said this week during his visit to Washington. He’s right. But American officials are also right that China’s currency is under-appreciated, and as China allows increased domestic consumption, this will yield inflation. Already there are signs that China realizes that just as the current international currency system is becoming obsolete, so is their weak Yuan policy.
Presidents Obama and Hu stand at the edge of a new reality. It is not an exaggeration to say that this summit could be one of the most important in the post-Cold War era, as the way the two countries choose to manage the tumultuous global economy will determine what kind of future we face.
We are at a pivotal point in determining the shape of the new global political economy. The Bretton Woods system of fixed exchange rates based on the gold standard lasted from shortly after WWII to 1973. At that point the gold standard and fixed exchange rates were dumped in favor of floating rates. This was made necessary by the need for a system that could serve a rapidly growing, more complex world economy. Many scholars look at the seventies as the start of the movement to what is now called “globalization” (in 1976 Keohane and Nye labeled it “complex interdependence”).
The dollar remained the world’s main reserve currency, even as the Yen, Deutschmark and Dutch Guilder stood out as stable, safe currencies. Nothing could touch the dollar’s global importance, and this gave the US a lot of leeway in economic policy. Policies that might cause inflation if undertaken elsewhere could be projected globally, meaning the world would absorb that inflation and the US could be relatively unaffected. Nixon’s Treasury Secretary John Connally put it this way: “our currency, your problem.”
Up until the global crisis that began in September 2008 the dollar seemed secure. The Yen had fallen from grace due to Japanese deflation, and the Euro was still new. To be sure, the Euro had strengthened considerably — it nearly doubled in value relative to the dollar between 2001 and 2008, and there was talk about OPEC shifting towards Euros for oil trade. Yet when the crisis broke out in 2008 countries and investors showed that they still had faith in the greenback, as the dollar rose in value, even before the Greek crisis hit the Eurozone. The only competitor was gold, whose value also increased dramatically as investors also saw the writing on the wall — the dollar may be the safest currency, but that doesn’t mean it’s safe.
China has been supporting the dollar and the US current account deficit through its continual purchases of US debt. China, with a current account surplus, had money to invest. By investing in the US, they gained two benefits. First, they helped enable US consumerism, meaning their economy would keep growing. Second, they gained leverage over the US. If they were to dump US bonds, stocks or currencies it could devastate the US economy. However, even with recent market diversification, China is still years away from being able to do such a thing without doing considerable harm to themselves. There is no sign that they desire US collapse — the global instability that would cause would endanger their successful economy.
Since 2008, though, the Americans and Europeans realized that they cannot sustain debt-driven economies any longer. China realizes that it can’t rely on the US market, and that the investments in US bonds and currency aren’t as safe as they had assumed. The Chinese also recognize that besides diversifying their export market, they need to increase domestic consumption. They’ve brought 400 million out of poverty, but want to avoid instability caused by relative deprivation.
What Obama and Hu have to do is figure a process for countries to decide how to restructure the currency system without sacrificing free trade and stability. If the US and China could agree on a broad framework, the rest of the world would go along and negotiations could get underway. However it ends, one result is pretty clear: a weaker dollar, and less US clout in global economy. Already demand for the Yuan is strong in the places where China lets it be officially traded, a sign they are moving towards making it an international currency. Assuming the Euro weathers its crisis, it will come out stronger than before. People are still uncertain about the long term viability of the European currency, but if they show the capacity to overcome the current crisis, the Euro will have established itself. In such a case, the dollar and Euro will be on relatively equal footing.
The best bet for weathering this crisis is not to stumble through, but to develop a political agreement that incorporates the interests of a wide spectrum of interest — state and non-state alike. Right now the main alternatives seem to be: 1) simply allowing multiple global currencies to co-exist, much as how things were before WWI. The Euro, Yen, Dollar and perhaps later on the Yuan and other currencies from new economic powers will share the role the dollar has played since WWII. 2) Using the “Special Drawing Rights” of the IMF as a guide, create a single global currency that’s really a basket of existing currencies, weighted relative to the economic strength of the participants (the pre-Euro ‘ECU’ did that for the EU). This would limit the power one country could have, and perhaps promote cooperation. 3) Return to some kind of revised gold standard. This one isn’t likely because such a system is considered rigid working against market mechanisms, and which may have prolonged the Great Depression.
Just as the Bretton Woods agreement was not just about currency, there needs to be movement on defining the nature of how globalized trade and investment will be regulated in this new era. Bretton Woods yielded a free trade regime, and set up institutions like the IMF and World Bank to try to maintain stability to bring about development. Those goals remain — sustainable development for third world states, and stability for the world economy. No one knows how the new system might function, other than markets would be central. Moreover, non-state actors like large multinational corporations and non-governmental organizations exist alongside sovereign states, and they need to be involved in the process as well.
Nothing could be better for our future prospects on the global economic front than for Presidents Obama and Hu to make a significant breakthrough, and agree to start the process of negotiating a new system. It may not be announced as such, but the sooner we part with the illusion that the old system can function well in this new era of globalization with no dominant world power, the more likely we’ll find a way through this crisis without economic collapse or global conflict.