KEYNESIANS ARE COMPLACENT ABOUT THE DOLLAR / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( A MUST READ )

Keynesians are complacent about the dollar

By Benn Steil and Manuel Hinds

Published: May 23 2011 23:19

A few days before the famous Bretton Woods monetary conference in July 1944, John Maynard Keynes, the UK’s lead negotiator, had one of his legendary dust-ups with his American counterpart, Harry Dexter White. It was over the role of the US dollar in the postwar world.


White was determined to make the dollar the sole international currency; legally a surrogate for gold itself. Keynes, whose country was effectively bankrupt – meaning it had not nearly enough gold or dollars to settle its international debts – was equally determined to ensure the dollar would have no such special status. The survival of the British empire itself could hinge on Britain’s ability to salvage some measure of international acceptability for the pound sterling or, at the very least, access to an international medium of exchange (which he wanted to call “bancor”) not controlled by the Americans. Britain was a desperate debtor with no cards to play, and Keynes lost that battle.


Some 65 years later, the governor of the Chinese central bank issued a public statement lamenting the fact that Keynes had not got his way. America’s exorbitant privilege had produced an unstable international monetary system. The country had reneged on its commitment to keep its currency redeemable in gold and, predictably, had made its domestic priorities paramount over international ones. China began initiatives to pave the way for what it hoped would be an eventual orderly departure from this system – such as bilateral agreements with Russia, Brazil and Turkey to conduct trade without dollars, and a slow build-up of gold reserves, which would be at least as useful in a crisis as dollars had been.


Curiously, Keynes’ most reflexive modern acolyte, Nobel Prize-winning economist and New York Times columnist Paul Krugman, thinks it would be no big deal for the dollar to lose its international status. To establish his point, he offers the argument that Australia, like the US, runs persistent trade deficits even though its currency has no special role. So it is not America’s minting of global money that matters.


He might have thrown in countries with even less significant currencies than Australia’s, such as Costa Rica. If a country’s reserves are held constant, inflows of capital produce current account deficits. As long as a country can consistently offer attractive investment opportunities, it can naturally run such deficits indefinitely. What is unique about the US is its ability to manufacture such opportunities out of thin air – the printing, or electronic virtual printing, of its own money.


Mr Krugman still insists that the benefits of the dollar’s special status could not be “more than a fraction of a per cent of gross domestic product”. Well, consider what would happen if the dollar’s role were to be taken by another currency – say, for the sake of illustration, the euro.


The Federal Reserve would now be forced to operate under external constraints comparable with those imposed by the classical gold standard, under which the US needed more gold to create more dollars. Under a “euro standard”, the Fed would need more euros to create more dollars, as its monetary expansions necessarily produce demand for more imports, and it could not endlessly run down its euro reserves to pay for them.


Since the US would no longer be able to cover its current account deficits just by conjuring dollars, it would also have to issue debt in euros. Assume the US accumulates a foreign debt to gross domestic product ratio of 50 per cent. Then if the dollar depreciates by a third against the euro (which is roughly what it has done since the euro’s launch), the US foreign debt to GDP ratio soars with it to 66 per cent – not because the US built more roads or energy plants, but merely because the world did not allow it to print dollars to pay its bills.


This is precisely the situation in which much of the world finds itself today. It is why there is endless angst over how countries should manage capital inflows and outflows.


Keynes, whose country liquidated an empire trying to pay its foreign bills, was right in observing that “the method of depreciation is a bad method, which one is driven to adopt failing something better”. The US must do better.


Benn Steil, director of international economics at the Council on Foreign Relations, and Manuel Hinds, a former Salvadoran finance minister, are co-authors of Money, Markets and Sovereignty, winner of the 2010 Hayek Book Prize


Copyright The Financial Times Limited 2011.