Financial Scarcity Amid Plenty

Barry Eichengreen

Puerto Rico default


MILAN – With interest rates at all-time lows and central banks buying everything that moves, the world is awash with credit. Yet, paradoxically, a dangerous shortage of international liquidity is putting the global economy at risk.
 
“International liquidity” refers to high-quality assets accepted around the world for paying import bills and servicing foreign debts. These are the same assets that central banks use when intervening in foreign-exchange markets. They serve as reliable stores of value for international investors. They provide pricing benchmarks in financial markets. And they are widely accepted as collateral for cross-border loans.
 
The key difference between these international assets and liquid assets in general, then, is that only the former are accepted in a large number of different countries and regularly used in transactions between them.
 
The single most important form of international liquidity is, of course, US government bonds, which are held by banks, firms, and other countries’ governments. More generally, international liquidity comprises the liabilities of OECD countries’ central banks (their “high-powered money”), those countries’ AAA-rated and AA-rated central-government bonds, the debt securities of supranational organizations like the World Bank and regional development banks, and gold in official and private hands.
 
But add them up and you immediately come to a startling conclusion. International liquidity has plummeted from nearly 60% of global GDP in 2009 to barely 30% today. This change is due, equally, to downgrades in the ratings of heavily indebted crisis countries’ government bonds, which make them unattractive for use in international transactions, and the inelasticity of other sources of supply.
 
Observers are perplexed by why global trade, having long grown faster than world GDP, is now expanding more slowly. They are also struggling to understand an unprecedented decline in global capital flows. A shortage of international liquidity, by making it harder to finance and settle these cross-border transactions, is one explanation.
 
Urging the US government to issue more debt is no solution; doing so would only threaten rating downgrades and make foreign investors reluctant to hold US Treasury bonds.
 
Alternatively, one could urge crisis countries whose bonds have lost their investment-grade status to repair their finances so that these securities are again attractive for financing international transactions. But financial strengthening takes time even for the most committed government, as any Greek official can tell you.
 
Can privately-issued obligations – high-grade corporate bonds, for example – supplement official forms of international liquidity? This question dates back to the 1990s, when observers quaintly worried that the US government, by running surpluses, might retire its entire stock of debt.
 
It turned out that central banks and governments, in particular, were reluctant to hold private-label securities, even when these instruments had investment-grade ratings. The reason is simple: Privately-issued assets without the backing of a government with the power of the purse might look safe in normal times; but, following a shock, they could quickly be reassessed as risky.
 
Others suggest that the International Monetary Fund could augment the supply of international liquidity by issuing Special Drawing Rights. SDRs are accounting units made up of US dollars, British pounds, euros, Japanese yen, and Chinese renminbi. They can be credited to the accounts of IMF member countries, which are obliged to accept them in cross-border transactions under the Fund’s Articles of Agreement. Voilà: problem solved.
 
Or not. There are no private markets in SDRs. To use them, a holder has to exchange them for, say, dollars in a transaction with the US government. As a result, no additional liquidity is created. The corresponding amount of dollar currency or deposits is simply transferred from one set of hands to another – from the US Treasury to the foreign holder. Meanwhile, the world as a whole has gained no additional liquid resources.
 
Things would be different if, instead of allocating SDRs to governments, the IMF could sell them directly to central banks like the Fed, which, in return, would provide the Fund with additional dollars, which the Fund could then distribute among its members. But while this is a neat solution in principle, the Fed and its political masters would surely be reluctant to cede control of the money printing press in practice.
 
Probably the most practical solution is to permit the IMF to borrow on private financial markets and use the proceeds to issue additional SDRs. With member governments collectively guaranteeing its obligations, its bonds would be as good as gold. To be sure, for their guarantee to be credible, members would have to commit to recapitalizing the Fund if it ever took losses on its loans. But, then, nothing is free.
 
Globalization’s benefits are sometimes exaggerated, but there have been important benefits.

Failure to address the international liquidity problem could jeopardize all that has been accomplished.
 
 

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