On currencies, global trade imbalances, money creation, and the GDR

Thinking about currency and money creation in the past few days has lately caused me to make some thought experiments on world trade, and in particular, the recently proposed idea of a global currency. Now I don’t normally go about making these thought experiments, so please let me know if I am missing something, or making some lapse in causation. If anything, I think I’m beginning to get the arguments of Marshall Auerback.

Now, a majority of economic thinkers in the world, now or in recent past, come from the United States. This causes some, if not altogether unintended, thinking of all trades purely in terms of US dollars. And why not? The US dollar is, after all, the current global currency medium. All trades the world over are priced, quoted, cleared, and settled in US dollar, the default global currency.

So let’s start our thought experiment. Let’s state that the country with the default global currency (which we know to actually be the US) is country A. It trades with another generic world country, which we shall call country B. To simplify matters, for now let’s only look at countries A and B. But know that there are a multitude of other countries that also trade with them and each other, also using A’s currency.

Now when A imports more than it exports, it incurs a deficit vis-à-vis country B. Because the trade was settled in A’s currency, B acquires foreign reserves (The reserves will be of course be in A’s currency). A, meanwhile, being the issuer of default currency, doesn’t have to do anything more than ‘print’ more currency.

Now what happens when it’s the other way, and B is the one that incurs the deficit? Because its currency is not the default, B has to buy A’s currency to settle the trade. It therefore borrows in A’s currency. The more deficits it incurs, the more borrowings it has to make in a foreign currency.

Now over the longer term, the net borrowings of B should depreciate its currency vis-à-vis A’s, which should make its exports cheaper in terms of A’s currency. Therefore, in the longer term, the balance should tilt back into B exporting more to A than A exporting more to it.

Again, when B is the surplus country, and it ends up holding more of A’s currency as reserves, its currency should go up vis-à-vis A’s currency. Therefore, longer term, A’s exports should become cheaper when converted to B’s currency. Longer term, A’s imports from B should go down and its exports to B should go up.

PEGGING TO CURRENCY A

Now suppose B wanted to peg its currency to A, because doing so makes its exports to A, as well as to the other countries, cheaper. Its continuous surpluses enables it to accumulate more reserves of A’s currency. But to keep its currency from rising, it will lend its reserves back to A. A then gets more money to finance even more deficits. B does not lend to A because A needs the money (Why would it need more of what it can just print?). B lends to A because the act of lending enables B to maintain its peg to A. It is therefore not in B’s interest to stop lending, even when A’s constant deficits results in A’s currency depreciating. For one, B needs to keep lending if it wants to keep the peg. Two, precisely because of the peg, B's currency also goes down vis-à-vis other countries’ currencies.

BORROWING IN A’S CURRENCY

Now, let’s suppose a country C, which has had a history of deficits, and therefore, has a sizeable borrowing in A’s currency. C, therefore, cannot afford a significant depreciation of its currency in terms of A's, because that would make its debt servicing more expensive. Then again, a depreciation in C's currency makes its exports cheaper in terms of A’s currency, and therefore enables C to export more, and to acquire more of A’s currency to pay down its debt. The best risk mitigating strategy for C is therefore to accumulate more and more reserves of A. Thus, to make sure it has the ability to control for potential fluctuations in its currency, and to pay down its debts, C will want to accumulate ever rising reserves of A. Thus, C provides even more opportunities for A to finance even more deficits.

Now, A, even if it eventually acquires significant borrowings from B and C, again need not worry much. As far as it’s concerned, either of two things can occur: 1) B and C stop financing more debts, in which case, A will just stop incurring deficits, but A’s currency will correspondingly fall, which will enable it to export more, and things balance out again, or 2) B and C will stick to their original objectives, to continue the peg or to accumulate more A’s reserves, which means A will be able to continue financing deficits. Also, whether scenario 1 or 2 happens, A will always be able to meet its objectives just by printing more money.

A never has to borrow (or can even manage to borrow) in anyone else’s currency because 1) other countries’ currencies are never in sufficient supply, and 2) there is not much use for anybody else’s currency when all trades are priced and settled in A’s currency.

GETTING TO THE GDR

Now, how would a move to a global currency change things? Let’s go back to the thought experiment.

When A incurs a deficit with B, it has to buy the GDR to finance the deficit. B has to sell currency to get paid the net surplus in its own currency. Over time, A’s currency goes down in terms of the GDR, while B’s goes up. Longer term, this should balance things as B ends up importing more from A than A from B.

Because all trades are already in GDR, there is no longer an incentive for B to peg its currency to A. Even more so, B cannot peg its currency to the GDR because it’s actually a basket of everybody’s currencies. Pegging to GDR causes B to have an endless loop with its own currency. So no more successful pegs.

Because all trades are already in GDR, country C, which has significant borrowing A’s currency, will still have an interest in exporting more, so that it has the reserves necessary to keep its currency from depreciating. However, because A will also need to buy the GDR to settles its trades, A will now no longer have an incentive to continue incurring deficits. This means less opportunities for C to accumulate reserves. So when the GDR comes, if C already had a sizable reserve to begin with, then maybe it will be safe. But if C had accumulated a very sizable borrowing in A’s currency, then the prevalent use of the GDR will probably ensure that C will perennially have trouble in keeping up with its debt servicing. The only way that C can pay is to continue incurring surplus with A. Thus, maybe A and C will continue settling in A’s currency, and C will continue to finance A’s deficits, until it feels it has enough reserves to maintain a stable currency.

So net, the GDR will constrain A’s ability to, in Tom Hickey’s words, “maintain order and foster the development of emerging nations, by making capital and technology available where it is needed”. It will also stop A's population from continuing to enjoy spending more than they produce, out of everybody else's need to acquire its currency. It will also entail a (probably temporary) difficulty for countries that have sizable foreign debts.

But over-all, it will probably result in less global imbalances. Does this conclusion seem complete to you?