On Mark Carney’s Globalcoin

Most likely inspired by Facebook’s Libra project, Mark Carney recently presented the case for a supra-sovereign multipolar global currency (globalcoin). The goal of this project is to rectify the destabilising effects of the dollar cycle on the global economy, particularly on emerging market economies (EMEs). In order to progress to a hegemonic multipolar currency, alternatives to the dollar must be able to shoulder a greater weight in backing it than their market share under the current regime represents. There are structural reasons as to why they have been unable to capture more of the currency market. The primary factor is the dollar’s network effect but fragmented or restricted capital markets, market valuations of government debt, legal budgetary restrictions and attitudes to budget deficits also play a role in restricting the international role of these alternatives. I believe the migration to a globalcoin would overcome many of these hurdles but introduce new deflationary and coordination pressures for participants. Despite initially alleviating the stress created by dollar hegemony, the new globalcoin will eventually develop an even larger network effect than the dollar and present an even greater destabilising force to those not in the club. The G7 should instead focus on fostering a truly multipolar system as opposed to a dominant hegemon backed by multiple currencies.

The Role and Consequences of Dollar Hegemony

When world powers decided to bestow the US with the exorbitant privilege of printing the global reserve currency, they certainly wouldn’t have envisaged the situation as it is today. Long gone is gold backing and pegged major currencies and in its stead there is a free floating dollar whose powerful network effect has bestowed it with an ever greater role in global commerce and placed huge demands on the US government to supply the concomitant demand for US safe assets as a hedge against dollar exposure.

Like all network effects, the dollar’s network effect is self-reinforcing. It being “the chosen one” as the global reserve currency gave it a head start on alternatives. Since the 1980s the Federal Reserve has been very effective in containing inflation and maintaining price stability, thus bolstering its “safe haven” status. Monetary policy is also predictable, permitting users to safely plan for future changes. Furthermore, US capital markets have been very open for a long time. Institutions have been able to park and remove large amounts of money on a daily basis in the US for many years. This is an essential property of the system because the dollar’s widespread use in trade invoicing and its increasing prominence in global banking and finance are mutually reinforcing. With large volumes of trade being invoiced and paid for in dollars, it makes sense to hold dollar-denominated assets, thus demands easy access to these assets. As Mark Carney said at Jackson Hole:

“Increased demand for dollar assets lowers their return, creating an incentive for firms to borrow in dollars. The liquidity and safety properties encourage this further. In turn, companies with dollar-denominated liabilities have an incentive to invoice in dollars, to reduce the currency mismatch between their revenues and liabilities. More dollar issuance by non-financial companies and more dollar funding for local banks makes it wise for central banks to accumulate some dollar reserves.”

In 2008 the dollar network effect for the US were laid bare. The morning after Lehman Brothers collapsed, the US Treasury Secretary Timothy Geithner received a call from Europe. He was told that since the US government had allowed Lehman Brothers to collapse, dollar liquidity had completely evaporated in Europe (and elsewhere) and if the Federal Reserve didn’t lend money to various central banks, the financial system would collapse. It duly obliged by lending to 14 central banks, thus somewhat unwillingly becoming the lender of last resort to the global financial system. The issuance of more dollars of course created more demand for dollar denominated safe assets meaning the US government, in turn, has been required to run regular budget deficits and to increase the national debt in order to satisfy the global demand for US dollar safe assets. This is quite a responsibility that hasn’t always sat comfortably with policymakers in the US despite dollar dominance granting them huge leverage over other global powers.

On the other side of the ledger, it’s not as if everyone else’s dollar woes have gone away just because the Fed stood up in 2008 either. Movements in the price of USD continue to apply real pressures on other economies, most notably in emerging markets. This is particularly the case when domestic conditions require the Fed to tighten monetary policy while economic activity in emerging markets is weakening. This creates upward pressure on the dollar, greatly affecting those firms that are forced to borrow unhedged in dollars — despite earning in local currencies — by increasing their liabilities. A strengthening dollar and a strong US economy relative to the rest of the world also greatly alters the risk incentives of speculators and can cause a surge of capital to leave emerging markets. This can occur even when emerging markets maintain sensible fiscal policies, implement inflation targeting and generally keep their house in order. For example, last year, despite adhering to the IMF playbook by the letter, Argentina was unable to stop the rot as money fled its economy and was forced to accept a bailout which in turn still failed to retain investors fleeing to the dollar. Again, as Mark Carney says:

“this means that in the face of foreign shocks, EMEs are forced to compromise their monetary sovereignty, temporarily diverting monetary policy away from targeting domestic output and inflation and instead using it to try to stabilise capital flows.”

The issuance of huge amounts of dollar denominated assets to EMEs by the US has consequences beyond EMEs and the US. It has pushed down the global equilibrium interest rate which is an economist’s way of saying central banks around the world have been compelled to offer negative interest rates in order to meet their inflation targets. One might argue that the world is a riskier place as a result. I’m not at all convinced that that in itself makes the world a riskier place but the upward pressure on the US dollar certainly does. The current protectionist policies being pursued by the US government are a direct result of this and it doesn’t look like they’ll end with this administration either. This significant drag on global growth suggests a multipolar system would be far more desirable than the current unipolar one.

The Obstacles to a Multipolar Currency System

A multipolar currency would first and foremost be a pooled asset. Constituent members would back an agreed upon share of this asset with their own currency. The most likely members of this currency board would be the current membership of the IMF’s Special Drawing Rights. As we have seen in the case of the US dollar, a liquid market for safe assets is also essential. The best way this would be achieved would be for the participants to offer a shared safe asset in order to avoid fragmentation. The likelihood of this happening is close to zero however. Take the Eurozone as a history lesson in why. The Euro is 20 years old and is in turn built on top of 70 years of deep economic and political cooperation via the institutions of the European Union. Despite the level of economic integration and shared interests, it has still been impossible to cajole the economically strong Member States into sharing risk with the weaker economies (There is the European Stability Mechanism but it stops far short of a European safe asset). Armed with this knowledge, I think it is a very uncontroversial claim that the likes of the US, China, Japan and the EU could never possibly agree to issuing a shared asset in the near future.

If we rule out a shared safe asset, we’re left with the eminently more possible system of each participant member issuing their own safe assets. Since all likely participating states issue debt in their own currencies today, on the face of it, this isn’t asking for much. However, in order to rectify inefficiencies associated with dollar dominance non-US participating states would be required to increase their share of safe assets at the expense of US’ share. This, on the one hand, requires countries to foster liquid capital markets through openness and to possibly also show a willingness to run larger budget deficits. In return, the US would be required to spend much less than it has done in recent history and tighten its supply of dollar assets. Let’s take each potential member individually to see how equipped they are to assume their respective roles.

The Eurozone

The Euro is the second-most used currency in the world. It is the second most traded and the second most held in reserve. It is unique among the major currencies of the world in that it isn’t governed by a single nation state. As a consequence, it is constrained by internal politics much more than the other major currencies are. Consequently, despite it being close to the US in terms of the size of its economy, it hasn’t made much inroads into dollar dominance. I mentioned earlier the failure to issue a European safe asset. A similar scenario exists with fiscal policy. Although the Member States agreed to a currency union, they never agreed to a fiscal union. In its early years, all government debt denominated in Euros was deemed equally risky as default was not considered a possibility under the single currency. Balance of payments accounts within the Eurozone, were (somehow) considered to be somewhat irrelevant to a country’s economic health. Both these assumptions were obliterated by the Eurozone sovereign debt crisis that begun in the earlier in the decade.

There have been a number of fallouts from the Eurozone crisis. The most significant one for the purposes of this essay is that all Eurozone debt is no longer treated equally, something that has greatly reduced the amount of safe Euro-denominated assets. Only three Eurozone members have a AAA rating for example. The other is that countries that found themselves unable to service their debts have greatly changed their spending habits and are now net savers, with most of the PIIGS (Portugal, Ireland, Italy, Greece and Spain) boasting balance of payments surpluses and much smaller budget deficits than in the past, with some even registering budget surpluses. Furthermore, even if Eurozone governments wanted to be more spendthrift, they are unable to do so because the EU, unlike in the past, no longer takes a l’aissez-faire approach to the Stability and Growth Pact. The rules are now much more diligently enforced. If a Eurozone Member has a debt-to-GDP ratio above 60% they are only permitted a deficit of .5%. If it’s below 60% a deficit of 3% is the maximum permitted.

So what does all this mean for the Eurozone’s ability to fulfil the role it would be required to in order to allow globalcoin achieve its goals of reducing the effects of dollarization? Even though Eurozone sovereign debt is no longer treated equally, half of it, a figure of €4tn, still exists in the top two tiers of debt and could thus be called “safe”. Given that US national debt stands at $22tn, these countries would be required to substantially increase this amount in order to support a multipolar stablecoin. The six countries in question are the three AAA rated countries Germany, Luxembourg and the Netherlands and the slightly lower rated countries of France, Austria and Finland. Considering Japan (a smaller economy than this combination of countries) has run up a debt of $10.5tn which accounts for 240% of GDP, one would think that the market would be well able to support these European countries in sustainably doubling, tripling and in some cases even quadrupling their national debts and taking on a much greater role on the international stage. As I outlined above however, the budgetary policies of these countries are dictated more by EU law than by market forces (and in the case of Germany even more restrictive national law). Long story short, under current EU rules, these countries are in no position to make changes that would aid the Euro become a bigger player internationally.

There is currently a proposal on the table to expand the European Stability Mechanism into a European Monetary Fund that would support Eurozone states in trouble after private bondholders were bailed in. As part of this agreement Treaty-based deficit rules would be replaced by market forces, freeing the stronger countries to pursue more aggressive spending policies. Even if this occurred however it is far from a given that some or all of these countries would want to take on such a responsibility. Germany for example, the country far best equipped to grow its debt in absolute terms, still bears the scars of Weimar era hyperinflation and is extremely conservative when it comes to spending.

So on paper, the changes the Eurozone would have to make, both in general and with the ideologies of certain members are so great that it is difficult to see them happening any time soon, and impossible to see them happening on the scale that would be required to take some more weight off the dollar’s shoulders. However, under a globalcoin regime these domestic and regional restrictions may matter less. This is something I will return to later.

China

Despite the size of the Chinese economy, the Renminbi is a ridiculously small player on the global currency markets. Nevertheless, a few years ago many speculated that the Renminbi would quickly become an international force. China was added to the SDR basket in 2016 and also initiated its vast Belt and Road initiative funded by loans denominated in Renminbi. A number of international treasuries also issued Yuan denominated bonds. However, since then, its influence has waned. As per the WSJ:

“When enthusiasm about an internationalized yuan peaked, about the time of the IMF endorsement, almost 30% of Chinese trade was settled in yuan, Hong Kong banks held deposits of 1 trillion yuan and issuance of yuan-denominated “dim sum” bonds totalled nearly $10 billion a month, the Citigroup research showed. More recently, it says, the trade figure has halved, deposits are down 40% and bond issuance has slipped to a 10th of its highs.”

In many ways China is stuck in a paradoxical situation. In order to truly internationalise its currency, it would need to allow the Renminbi to float freely, open its financial markets — and economy in general — to foreigners, have a more predictable monetary policy and not throw up capital controls. However, China is a new global power, that although possessing economic might, most of this might is down to its sheer population size. Its GDP per capita is still far behind the west and it hasn’t learned a lot of the painful lessons developed economies have through multiple economic cycles including crises and depressions. In sum, despite making noises to the contrary, it’s simply not ready to take the steps necessary to become a global monetary power as it is concerned about the ability of foreign capital to outcompete domestic interests.

So where does this leave China in regards to its ability to facilitate a greater international role? Not in a very strong position. Related to the state and governance of its economy (and political system), China has a bang average credit rating. Its government debt is certainly not considered “safe”. Those looking to use and hedge globalcoin instead of the dollar would therefore have to accept holding riskier government debt. At first glance this doesn’t seem like a likely proposition but it’s also another a question I will return to later.

The UK and Japan

The UK and Japan both possess highly rated government bonds and have open, concentrated, liquid capital markets, but have shown very differing attitudes to budget deficits and national debt. The UK has championed budget discipline whereas the Japanese act more like the US and have run up the largest national debt in the world. Interestingly, this hasn’t actually led to the Yen being used to a much greater extent than the pound which highlights that although a supply of safe assets is important, the network effect of currency is still the primary driver of its use. Regardless of what policies they adopt, these countries will represent small shares of any globalcoin and ergo I won’t spend any more time discussing them.

Could Globalcoin Work and Would it be a Good Thing?

As I have outlined, there are clear structural reasons as to why the dollar is the dominant currency in the world. The other pretenders to its crown face regional and domestic constraints that limit the internationalisation of their currencies. These same constraints appear to limit their individual abilities in shouldering more of the weight in backing the global financial system as part of a globalcoin project. However, there are good reasons to think that if the concept became a reality, the constituent currencies would actually be able to account for a larger share of the globalcoin backing than their current share of the currency market.

First of all, although domestic policies can and do place a ceiling on the internationalisation prospects of a currency, the network effect is still king. It is perfectly reasonable to assume that becoming part of the global reserve currency board would create increased demand for its constituent currencies regardless of the quality and quantity hedging options available for larger trades.

Even given the likelihood that unhedged use of the non-dollar constituent currencies will rise via the use of globalcoin, there are also reasons to believe that the very existence of globalcoin will enable hedged usage to grow. The reasoning here is diversification of risk. Even given a lack of Euro or Renminbi-denominated safe assets, the very fact that users looking to hedge globalcoin are required to purchase five government bonds reduces the need for all of the assets to be rated “safe”. Consequently, an entity that needed to acquire Euro-denominated assets need not rely on Germany, or the Netherlands, or Finland. They could purchase Irish or Spanish bonds. China’s credit rating becomes less of a worry as well. There may be more friction involved as multiple assets must be purchased but purchasing assets from 5 or more diverse entities reduces risk.

All in all, there are good reasons to believe that globalcoin would ease global reliance on the dollar. However, its existence and likely dominance of international transactions would create domestic pressures on monetary policy and would require participating members to cooperate with each other to initiate swaps and rebalance the basket as and when it was required. This is not something that can be taken for granted but since central banks are relatively insulated from politics, and these central banks are accustomed to cooperating with each other, it may be possible if, at times, extremely challenging. As mentioned above, it’s also the case that the countries would be required to take on more debt in order to replace some of the supply of dollar assets. This is not a gargantuan task considering this would be spread across all participants but certainly a collective action problem that still must be overcome. It is also entirely possible that one or more members may decide to leave if their currency appreciates too much for their liking on account of membership. This event would likely result in quite a large shock for the global economy.

So, assuming globalcoin is achievable and its goals are successful, can we take it that the destabilising effects of the US dollar would be rectified, and the global economy will live happily ever after? Not necessarily. Upon launch, and for some time thereafter, one would certainly expect that given the asymmetries between its membership, the effects of what was previously the dollar cycle would indeed be tempered. But let’s go back to the root cause of the dollar cycle in the first place: Its network effect. Recall Carney’s account of some of the effects of this network effect that I quoted above? Let me requote it but this time replace “dollar” with “globalcoin”.

“Increased demand for globalcoin constituent assets lowers their return, creating an incentive for firms to borrow in globalcoin. The liquidity and safety properties encourage this further. In turn, companies with globalcoin-denominated liabilities have an incentive to invoice in globalcoin, to reduce the currency mismatch between their revenues and liabilities. More globalcoin issuance by non-financial companies and more globalcoin funding for local banks makes it wise for central banks to accumulate some globalcoin constituent reserves.”

If the dollar’s network effect created this feedback loop why wouldn’t the same happen with globalcoin? It’s not only difficult to see that it wouldn’t, it’s difficult to see that the network effect wouldn’t be even more pronounced. Why? Because globalcoin wouldn’t just replace the dollar as the world’s reserve currency, it would likely replace all the main international alternatives to the dollar as well. Since the Eurozone and the China are part of globalcoin, and can potentially greatly benefit from it, they’re not going to pit their currencies against it. On the contrary, they would actively encourage its use. The idea is to create a single global hegemon after all. As a consequence, if/when globalcoin becomes dominant, unlike in the case of the dollar, there would be a dearth of trusted, liquid alternatives to use in its stead. Forced to use globalcoin to an even greater extent than the dollar, the cycle outlined above would be even more entrenched and logically even more destabilising to those not in the club. Considering the SDR currencies account for over 90% of international currency transactions as it stands, the power of globalcoins network would likely be destabilising not only for emerging markets with weaker currencies but destabilising for anyone not in the club. Those members in the club (China) that have not been used to existing with a strong currency would also find their competitiveness eroded. This greatly increases the chances of protectionism and trade wars and even an exit from the currency board.

In sum, we’d be right back where we started at Jackson Hole but in an even more destabilising situation for the global economy. If a more multipolar, balanced financial system is to be achieved, we’re going to need more trusted major currencies, not less. The G7’s focus should be on encouraging the structural changes required in the Eurozone and in China to make that a reality rather than on a globalcoin project. Out of the protaganists, it is the Euro, not the Renminbi that is currently best placed to take on a greater role. For it to do so would require more of a change in attitudes than massive economic and political reforms. There are signs in Germany that its attitude might be shifting slightly. This should be encouraged.