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Is the "Mother of all Financial Crises" Imminent?

A trade-weighted devaluation of the dollar of around 25 percent is necessary allowing the US currency to skid "gradually and orderly" against free-floating currencies. The IMF could establish a "substitution account" with "special drawing rights" to avert a dollar panic.

Fred Bergsten from the famous Peterson Institute for International Economics warns of possible consequences of economic imbalances

By Rainer Sommer

[This article published in the German-English cyber journal Telepolis, 2/6/2008 is translated from the German on the World Wide Web,  http://www.heise.der/tp/r4/artikel/27/27208/1.html.]

The ultimate crisis is imminent for the financial sector according to C. Fred Bergsten from the famous Peterson Institute for International Economics in Washington [1]. At the World Economic Forum in Davos [2], he recalled a long-simmering problem that could cause the "the mother of all monetary crises" if not solved: the imminent settlement of the international imbalance of payments, the reduction of the annual US deficit that is now more than $700 billion over against the enormous surpluses of Asian export countries, oil exporters and Germany.

For years, this has been the favorite theme of influential economists who even see some positive tendencies. Since 2005 the US foreign deficit has decreased $100 billion. In the last fiscal year, the US budget deficit has declined around 1.2 percent. A trade-weighted devaluation of the dollar of around 25 percent is necessary allowing the US currency to skid "gradually and orderly" against free-floating currencies to a desired "equilibrium level." The euro could be fairly valued at 1.5 US dollars.

The "1st phase" of the necessary adjustment has ended and must be followed by a "2nd phase" that requires a further reduction of the US balance of payments deficit of around 1.5 to 2 percentage points. Then the foreign indebtedness of the US that increases every year macro-economically in the balancer of payments deficit would remain constant which Bergsten regards as "sustainable." However the presupposition for this is another trade-weighted devaluation of the dollar of ten to 15 percent.

The frightening problem that Peterson sees approaching is the danger of a disorderly devaluation. "Many dollar holders including central banks, Sovereign Wealth Funds and private investors want to diversify in other currencies. Since foreign dollar reserves amount to $20 trillion, a modest implementation of this desire for diversification could cause a free fall of the dollar and an enormous shattering of the markets and the global economy." To Peterson, this long circulating fear has risen massively in the markets and among economic policy-makers.

The big central banks must now assure that the absolutely necessary dollar devaluation will be orderly and not turn into a panic. This devaluation occurs in relation to the export currencies holding firmly to the dollar - above all China - that must bear the main burden in the approaching "2nd phase."

This does not meet much approval in the impacted countries since their competitive international position would worsen on one hand and inflict massive losses in their dollar-holdings on the other hand. China that must upgrade its currency 30 percent in relation to the dollar may expect an upgrading of $400 billion (according to current purchasing power). Otherwise Bergsten expects a balance of trade surplus of $500 billion for China, three-quarters of the US deficit. China must now intervene monthly with $40 to $50 billion in the currency markets. This is twice as much as 2005 when China publically announced it would turn more strongly to a market-based currency system.


Given these challenges, Bergsten sees the need for immediate action. Under the auspices of the International Monetary Fund, an "Asian Plaza Agreement" (named after the agreement upgrading the Japanese Yen and D-mark in relation to the dollar) should be negotiated that secures an upgrading of the export currencies. In addition, an emergency plan must be developed so an international cooperation of central banks can intervene in the case of a dollar panic.

Finally, Bergsten proposes the only monetary solution that could "satisfy all concerned parties." This solution was already suggested in Decembe4r 2007 via the "Financial Times." The IMF could establish a "substitution account" in which the surplus countries could unload their unwanted dollars and obtain so-called "special drawing rights" (SDR), a kind of international currency introduced in 1969 by the IMF and currently in circulation in the amount of $54 billion. A comparable plan was worked out in 1970 and 1978 when the dollar was in a similar plight. According to Bergsten, this plan was not realized in 1978 because the US raised the key interests to a double-digit level to counter the double-digit inflation rate. This stopped and reversed the collapse of the dollar at that time.

While such brutal measures cannot be expected from the US Federal Reserve in the foreseeable future, Bergsten sees no other way to reduce the international dollar surplus.

These SDRs could be denominated in a currency basket (44% dollars, 34% euros, 11% yen and sterling). The dollar could be invested in US stocks that could be drawn upon as additional covering for the $80 billion of IMF gold reserves. The central banks could reduce their dollar holdings without shocking the currency markets and simultaneously and optimally distribute their reserves through the currency basket in the "bipolar world currency system" envisioned by Bergsten. The euro and the dollar would coexist in this currency basket. These SDRs could always be used for balance of payments goals or other legitimate goals. Since the international money supply is not increased by the SDRs, the inflation dangers in export countries would be diminished while the US could avoid having to significantly raise the key interest rate.

Answering for the International Monetary Fund, the historian James M. Boughton described the substitution account as an excellent idea and identified two problems. The exchange rate risk that central banks want to renounce would be taken over by someone else. A formula must be found that is acceptable for the US and the other countries. Boughton fears the fund could be less liquid than the central banks desire. He can not even imagine that a private liquid market for SDRs could arise without official support.

The strengthened international cooperation urged by Bergsten in case of crisis could be realized like the successful cooperation of the central banks demonstrated on Christmas. It remains to be seen whether hindering another euro-increase with dollar support will be sensible for the European Central Bank (ECB). If it begins to finance US deficits, the ECB would face the same dilemma now confronting the Asian central banks.

(1)  http://www.petersoninstitute.org/
(2)  http://www.petersoninstitute.org/publications/papers/paper.cfm?ResearchID=873
(3)  http://www.imf.org/external/np/vc/2007/121407.htm
Telepolis Artikel-URL:  http://www.heise.de/tp/r4/artikel/27/27208/1.html

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