Paola Subacchi
Research Director, International Economics


The following article is from the forthcoming April 2010 issue of The World Today. Chatham House has just released a major new Report entitled Beyond the Dollar: Rethinking the International Monetary System.

Can a crisis be a catalyst of change? Or, put in a different way, are there good and bad crises? A good crisis should trigger a general reassessment of the functioning of the world economy and foster change. So, to paraphrase Rahm Emanuel, United States President Barack Obama's chief of staff, a good crisis cannot, and should not be wasted.

It is almost three years since the financial crisis erupted in August 2007, and we have since gone through the greatest financial and economic turmoil since the 1930s. We cannot relax yet, as the road to 'stable, sustainable and balanced growth', as advocated by the G20 at its summit last September, is still very bumpy.

In many countries, notably in Europe, economic growth remains feeble, reducing the amount of debt still acts as a drag on recovery and global imbalances remain unresolved.

Protectionism is still a threat to the world economy, and a temptation for many political leaders. The trade system has so far held-up well and a resilient institutional framework has managed to fend-off protectionist pressures, but there is no guarantee this will continue. Where are the potential sources of tension, and what can be done to contain the risk of other episodes of economic and financial instability?

Money, Money, Money

Even if it was not at the heart of the financial crisis, the international monetary system is a lightning rod for tensions in the world economy. It is where tensions from trade and financial integration tend to cluster, and where countries' domestic policy goals and their international obligations are likely to diverge.

Currency misalignments persist and generate political dynamite. And the stability of the US dollar, the currency that sits at the core of the system, is adversely affected by large payments deficits and debt. Assessing whether the international monetary system is still adequate to respond to the challenges of a larger and more integrated world economy has never been so urgent.

The theme of reforms is not new, we have been here before. The history of the international monetary system is punctuated by dollar crises and regular predictions of the currency's terminal decline.

Having been through such crises at regular intervals since the 1960s, there is a plausible case for doing nothing. After all, over the last forty years, since the US unilaterally put an end to the gold standard for the convertibility of the dollar in 1971, the world has slowly been learning to live with floating exchange rates.

Individual countries have worked out a variety of arrangements for monetary policy, exchange rates, and financial stability to suit their circumstances. The many failed attempts to fix or manage exchange rates, and unsuccessful experiments with policy coordination, have created a great deal of scepticism on whether any form of concerted action can actually work.

Confidence and Trust

We are still too entangled in the consequences of the crisis to assess clearly what happened. But if we want this to have been a 'good crisis' when we look back sometime in the future, then the status quo is not an option. It is risky to leave the system unmanaged and broaden the scope for governments to intervene with either competitive devaluations or protectionist measures at a time when jobs and growth dominate the policy agenda in many countries.

The US may be heading towards increasing difficulty in reconciling domestic policy objectives with global exchange rate stability. The governments of the Euro area, on the other hand, may find it difficult to justify a strong Euro to their constituencies. Such a context calls for greater levels of cooperation. Only through a coordinated effort can countries - 'new and old power centres' - share global responsibility.

Greater economic integration and a larger global economy are a constant reminder of the limitations of a monetary system designed for a less internationalised world. Moreover, the critical US revenue position generates further concerns about the potential instability of the current system. This is particularly true for China, which holds more than $2 trillion in dollars and dollar-denominated assets.

There is reasonable concern that the US may be approaching the tipping point at which the world community begins to question its faith in the dollar. Such a loss of confidence and trust would damage the ability of the dollar to continue acting as the dominant reserve currency.

Change Ahead

The end of the dollar as the key reserve currency is still far away, but the steps some countries are taking signal changes ahead. The trend is towards a multi-currency reserve system with the backstop of a supranational reserve currency. But we are not there yet and any change to the current arrangements is likely to take a long time.

In the meantime, it is critical to ensure the sustainability of the present system. The transition needs to be managed through dialogue and policy cooperation. Policy cooperation, in particular, should help prepare the ground for a smooth transition by encouraging countries to exchange information about current and future policy decisions.

Dialogue between the country issuing the key reserve currency and countries with large holdings of that currency, should be mandatory to generate policies to address the imbalances. At the same time the International Monetary Fund's policy surveillance should be strengthened.

Countries should become more engaged in reforming the arrangements that underpin the dollar-based monetary system. Most of all, they should help defuse current concerns about the imminent collapse of such a system and should create a breathing space to address wider reforms.

Of one thing we can be sure: there will not be a new Bretton Woods agreement on rules and principles for monetary affairs. Any change will be gradual and incremental, and will be significantly influenced by the views, interests and requirements of new powers, especially China.

Further Resources

Beyond the Dollar: Rethinking the International Monetary System
Chatham House Report
Edited by Paola Subacchi and John Driffill, March 2010