Current global imbalances and the Keynes Plan

1. Current global imbalances and the Keynes Plan by Lilia Costabile Università di Napoli Federico II

2. Current global imbalances • wide and persistent current account deficits run by the US, with correspondingly high surpluses in some emerging economies; (ii) a US deteriorating net external position, reflected in large accumulation of US financial assets in international portfolios, particularly in the Central Banks of emerging economies (China, India, Brazil, Russia etc.); (iii) low saving rates in the US and high saving rates in the developing countries; (iv) a tendency for emerging economies to peg their currencies to the US dollar, etc.

3. Hard landing ? • falling domestic demand in the US, reduced saving inflows and rising interest rates, as foreign investors and Central Banks diversify their holdings away from US assets, etc. • In turn, falling demand in the US may impose severe worldwide recession, given the role of the US economy as the world’s “engine of growth”

4. Balance of financial terror • Summers (2004) depicts the current situation as one in which “we (i.e., the US) rely on the costs to others of not financing our current account deficit as assurance that financing will continue”. • Costs to othersof continuing the policy of financing US deficits include earning negative real interest rates on US short-term securities (ibid.), and loosing control on domestic monetary policy; • Costs of discontinuing this policy may include sharply rising interest rates and a shrinking US market, with deflationary repercussions on the international economy.

5. Purpose - trace the origins of the “balance of financial terror” back to the basic rules of the international monetary system; -ask whether the “Keynes Plan”, i.e. the Clearing Union scheme, may still provide useful remedies for this “terrorist” type of international balance; -present a “logical experiment”, illustrating how alternative models of international financial organization may produce opposite results in the global economy.

6. Structure Part 1. ASYMMETRIES BUILT IN “KEY CURRENCY” SYSTEMS Part 2. REMEDIES IN THE KEYNES PLAN

7. Part 1 ASYMMETRIES

8. Global imbalances and the international monetary system monetary vs barter economies • Main advantages of international money: efficiency gains, as a “double coincidence of wants”is not needed; multilateral, rather than bilateral, system of exchanges. • Main disadvantage: money may be a potential factor of disequilibrium and asymmetry, depending on the nature of the international currency. “The problem of maintaining equilibrium in the balance of payments between countries has never been solved, since methods of barter gave way to the use of money and bills of exchanges” (KCW, 25, p.21).

9. “Key currencies” vs. a supra-national money Crucial point where the current international monetary system and Keynes’s Currency Union system part company: -in the current financial organization of international transactions, the national currencies of some individual countries (K countries) work as the international money (“key currencies”) - in the “Keynes Plan” international money is a supra-national money, issued by a supra-national agency

10. ASYMMETRY 1 Key-currencies as international currencies Because of their pivotal role in international transactions (as “vehicle currencies”, in which payments are made; and “quotation currencies”, in which imports are quoted), key currencies (KC) also become the medium in which international debt-credit relationships are established, and “reserve currencies”, i.e. the currencies in which exchange market support is operated by Central Banks. .

11. Because of this lack of synchronisation, individual countries need to accumulate international reserves (“liquid” assets for transaction and precautionary purposes). Thus, Central Banks “institutionally” need to keep reserves in KC denominated assets (+ currently other motivations). An international (private and institutional) demand for the KC is thus generated. By contrast, the logic of the Keynes Plan does not contemplate this privileged position for any national currency, or the holding, in Central Banks’ portfolios, of foreign countries’ currencies as reserve.

12. ASYMMETRY 2.Seignorage The only thing country J can give in exchange for the international currency are the goods that it produces. Country K can be viewed as the provider of either “the public good of international money, or the private good for itself of seignorage” (Kindleberger, 1981, p.248). There is a built-in mechanism whereby goods are transferred from J to K.

13. This mechanism is absent from the Keynes Plan, since under its provisions no “foreign currency” provides services as a key currency and reserve asset. Consequently, the supra-national nature of the international money excludes seignorage accruing to any country.

14. ASYMMETRY 3Control of the world money-supply K’s reliance on J’s demand for its currency makes its expansionary monetary policies relatively easy and convenient, so that the country is able to finance its demand flows towards the rest of the world, both for consumption and for investment purposes. As international trade grows, it is a good thing for both countries if the international means of payment grow correspondingly, thus avoiding liquidity constraints.

15. Country J may either benefit or lose as a result, but is not in a position to do the same. This asymmetry is absent from the Keynes Plan, since, in its logic, monetary policy for the international economy is the responsibility of a supra-national authority, according to rules which would be defined, and agreed upon in advance, by all countries joining the system

16. ASYMMETRY 4“Fiscal stances” K may finance government deficits. This is desirable,as be at a risk of paying its arguably high propensity to import (or, high income elasticity of imports) with a downward pressure on domestic production. Risk reduced if other components of aggregate demand are high enough. Built-in mechanism making expansionary fiscal policy “desirable” in K. By contrast, country J should adopt more severe fiscal policies, as expansionary fiscal policies may crowd out exports. Keynes’s Currency Union does not stimulate these asymmetric fiscal propensities

17. ASYMMETRY 5GROWING EXTERNAL DEBT, LOW INTEREST RATES (5.1) Reserve accumulation by country J (and, more generally, its demand for K’s assets) is reflected into K’s growing external debt. (5.2) The correlation between interest rates and country K’s financial liabilities may become relatively weak. From the point of view of national accounting, K can only finance its current account deficit by borrowing abroad. From the point of view of the driving economic mechanisms, the “essence of the regime” was clarified by Rueff :

18. “What is the essence of the regime, and what is its difference from the gold standard? It is that when a country with a key currency has a deficit in its balance of payments – that is to say, the United States, for example- it pays the creditor country dollars, which end up in its central bank. But the dollars are of no use in Bonn, or in Tokyo, or in Paris. The very same day, they are re-lent to the New York money market, so that they return to the place of origin. Thus the debtor country does not loose what the creditor country has gained. So the key-currency country never feels the effect of a deficit in its balance of payments. And the main consequences is that there is no reason whatever for the deficit to disappear, because it does not appear. Let me be more positive: if I had an agreement with my tailor that whatever money I pay him he returns to me the very same day as a loan, I would have no objection at all to ordering more suits from him”(Rueff and Hirsch, 1965, p. 3).

19. Low correlation indebtedness/interest rate • Institutional demand for $ (2) country J, as an emerging country, has strong incentives to accumulate reserves in order to avoid appreciation of the national currency (USD depreciation), for competitiveness reasons. (3) country J also has incentive to resist capital losses due to USD depreciation (see below). (4) country J’s Central Bank’s precautionary demand may rise in periods of turbulence in financial markets, as it buys USDs as an insurance device against speculative attacks. Speculative attacks as a “discipline device”. (5) J’s private investors will be encouraged to buy country K’s assets by their Central Bank’s support for the external value of the USD.

20. PARADOX Paradox of poor or emerging countries lending to “superpowers” (Roubini, 2005; Triffin, 1984 had similar worries). But, to some extent, this systematic borrower/debtor position is conferred on K by the very “special international status of the US dollar”: this happens because country J’s reserves need to be kept in the international currency, and because it does not pay country J’s Central Bank to keep them idle and barren in their vaults. This disturbing paradox could not materialise under the Keynes Plan, because no special status would be bestowed on any national currency.

21. ASYMMETRY 6. External adjustment Is country K living “beyond its means”? In the long run normal borrowers pay back their excess “present consumption” with foregone “future income”. By contrast, country K may benefit from a depreciation of its currency. Depreciation restores its competitiveness but, above all, has the effect of improving its net foreign position.

22. “Valuation effects” of USD depreciation • Value of country K’s external assets rises when USD depreciates • - Value of external liabilities falls (although a dollar is still a dollar when country K pays off the loan, foreigners bought US assets when the dollar was expensive in terms of their own currencies). Debasement • “Valuation effects” can play a substantial role in international adjustment. From the Seventies onwards contributed to 30% of the US financial adjustment (Gourinchas and Rey, 2005). (Domestic cost: changes in the “terms of trade”, i.e. rising prices of imports, impose a real income loss on “fixed-incomists”).

23. By contrast, depreciation of domestic currency is not good news for country J’s external debt. This asymmetry could not materialise in the Currency Union scheme, where countries would all stand on a par in their international status. Moreover, they could only become debtors and creditors towards the International Bank, not towards each other: consequently, changes in exchange rates would not result in international redistributions of wealth. (Virtual discipline exerted by gold in “Bretton Woods I” but not in “Bretton Woods II”. “Fiat money”, inconvertibility)

24. SUMMARY • Thanks to the international status of the USD, country K enjoys a certain flexibility concerning its monetary policy, and both its external and public deficits. • (i) K’s reliance on continued demand for USD as the international currency makes expansionary monetary policies relatively easy because, as Rueff explained, whatever amount of money is created, it comes back straight away to K’s Central Bank. • (ii) Capital inflows buy the country’s financial liabilities, and may help finance country K’s investment, consumption, or public deficits, in the latter case allowing the country to adopt a relatively relaxed fiscal stance. • (iii) Thanks to these macroeconomic policies, country K experiences a model of growth led by domestic demand. Symmetrically, country J’s growth is export-led.

25. LOGIC • The relationship which binds the two countries together is rooted in the very nature of the monetary system: in a monetary economy country J needs K’s money, and hence K’s demand for goods “made in J”, in order to stimulate its growth. K, in turn, becomes dependent on the goods made in J for satisfying the needs of its population. • Because country K specialises as the locomotive of the world economy, the rest of the world needs the expansion of K’s demand for foreign goods, and –in return- is willing, or compelled, to accept K’s liabilities. • When the net financial position of country K becomes risky or unsustainable, external adjustment may be restored through exchange rate adjustment, which are helpful on both sides of the balance of payments… And the process is ready to start again.

26. NEXT QUESTIONS Thus, the next questions are: • Are there alternative monetary arrangements that may be substituted for the current “key currency” system? • Specifically: would the world look different under the Keynes Plan? • What kind of international balance would be established under its rules, and would such a “Keynesian international balance” be desirable?

27. PART II REMEDIES IN THE KEYNES PLAN

28. Keynes’s Clearing Union Plan Why is Keynes’s Clearing Union (CU) Plan relevant? • First best solution: pure credit system without the asymmetries. • CU plan can only be understood with reference to the specific circumstances of post WWII international disequilibrium, but its logic goes well beyond them. (This logic has to be “disentangled” from the specific circumstances of post-war circumstances.)

29. Post WW2 facts (i) specific roles played by different countries • British economy was a debtor country, US was the creditor country. • USA was pushing for free trade, in order to break the protective belt around the British Empire • UK’s objective was to shift part of the burden of the adjustment on the creditor country. (ii) specific problems faced by the world at the end of World War II (wartime destruction of productive potential in UK and generally in Europe; need for “financial disarmament”) (KCW, v.25, p.57);

30. (iii)lesson from the Great Depression. Keynes, worried about deflation, wanted to substitute “an expansionist, in place of contractionist, pressure on world trade” (KCW, vol.25, p.46, 2nd Draft, 18 November 1941). In the Twenties and Thirties, surplus countries (the US and France) had imparted such a “contractionist pressure” on the world by sterilising their gold inflows, thus preventing the increase in their international reserves from initiating a monetary expansion. • (iv)Post-war financial architecture seen as the product of Anglo-American wartime alliance, although with conflicts between national interests.

31. THE KEYNES PLAN I. OBJECTIVES. • Objective: “devising a system by which a state of international balance may be maintained once it has been reached” (KCW, v.25, p.24, 1st draft). • External surpluses and deficits would be reduced to a minimum, as economies, or groups of economies, would live on virtually balanced accounts. • Although it might be impossible in practice to eradicate international imbalances completely, the international monetary system would work, under the provisions of the Plan, so as to curb, rather than amplify, their emergence.

32. A “Keynesian international balance” is desirable because: • First reason: every country (or group of countries) would live within the limits set by its own resources. Relevant welfare and, possibly, political implications: Countries, freed from the need to run systematic external surpluses, would not pursue aggressive (“Mercantilist”) commercial policies. Hence, domestic resources could be devoted to the satisfaction of citizens’ needs, and Governments would be free to pursue the domestic objectives of “providing continuous good employment at a high standard of living” (KCW, 25, p.27, 1st draft).

33. Symmetrically, no country could run systematic deficits, which would allow them to live “profiglately beyond their means” (KCW, 25, p.30). Internal resources would constrain alternative domestic goals. • This may eventually help nations to perceive more clearly the trade-offs between alternatives (consumption, investment, and governments expenditures, the latter either for welfare purposes or for the financing of wars). • Possibly, the clear perception of these trade-offs would enable countries to make democratically accountable choices.

34. (2) Second reason: external surpluses and deficits tend to destabilise the world economy, whether in a contractionist or an inflationist direction, by facilitating the international transmission of imbalances. Keynes was mostly concerned with deflations, because he had lived the experience of the Twenties and Thirties (sterilizasion of gold inflows in France and the US). Contrary to Keynes’s expectations, after World War II deflation failed to materialize. Ever after the initial period of post-war reconstruction in Europe, the world witnessed an expansion of international liquidity, which has been interpreted by many scholars as the means for running US payments deficits (e.g. Eichengreen, 1996, pp. 115-116). This imposed an expansionary impulse on the international economy, both in the Bretton Woods and in the post-Bretton Woods periods.

35. Although Keynes conceived of his Clearing Union system as a remedy for contractionist pressures, the logic of his plan would curb the international transmission of both contractions and excessive expansions, because its foundational principles and basic provisions were such as to make both surpluses and deficits (i.e. the very roots of destabilizing pressures) difficult to run.

36. II . MEANS. KEYNES PLAN BASED ON TWO BASIC PRINCIPLES: • BANKING PRINCIPLE (2) ONE-WAY GOLD CONVERTIBILITY

37. PRINCIPLES: (1) THE BANKING PRINCIPLE IMPLICATIONS of the BANKING PRINCIPLE (i)BANK MONEY. • International liquidity was to be bank-money. The issuing institution should be a supra-national Bank, the International Clearing Bank (ICB), whose establishment would be the task of the International Clearing Union, itself a supra-national agency. • International money would be the liability of a supra- nationalBank, not of any individual nation.Consequently, there would be no demand for any “key currency” as the means for international payments and, consequently, as a reserve in Central Banks’ portfolios.

38. (ii) OVERDRAFT FACILITIES • International liquidity would be created as overdrafts to member banks, according to their quotas. Quotas would: • represent a claim to borrow at the ICB • be proportional to (specifically, one half of) the average of each country’s total trade for the previous five years (the most remote year in the average being replaced each year by the latest year available). • NO link between quotas and gold reserves/ capital subscriptions, ecc. • Rules would be agreed upon by all countries entering the Union, and equally apply to all of them. No country would be favoured or discriminated against, each falling under these quota regulations. Also, these regulations would determine the creation of international liquidity. Rules, rather than national discretion, would be the norm for the creation of international liquidity (regulation of international money supply).

39. (iii) NO CREDIT CREATION WHEN TRANSACTIONS BALANCE • Credit money would be created when an agent entered a debit relation with the bank. Under the Plan’s provisions, this could only happen when a deficit country borrowed from the ICB in order to finance its excess demand for a foreign currency. • Implication of the Plan is that balancing transactions between any two countries would not result in the creation of international liquidity (they would simply be cleared between the Central Banks concerned, operating on their accounts with the ICB). • Thus, in the hypothetical case that all member countries were in external equilibrium at the end of the accounting period, the sum of bancor balances would be equal to zero (as duly noticed by Skidelsky, 2003, p.677).

40. Only residual transactions, i.e. those which would not spontaneously balance, would be settled by Member Banks by buying or selling their own currencies from the I.C.B. For instance, a deficit country would settle its balance by withdrawing parts of its overdraft facilities, up to the maximum limit set by its index quota. Correspondigly, surplus countries would accumulate unused overdrafts in their clearing accounts. Logic of the Banking Principle implies that the creation of international liquidity would be limited to unbalancing transactions.

41. (iv) CURBING BOTH CONTRACTIONIST AND INFLATIONARY PRESSURES Because deposits of bank money (credits and debits) would be created by external deficits and surpluses, and extinguished by their liquidation, international liquidity would be absolutely elastic, i.e. automatically adjusted to the needs of trade. Logic of the Banking Principle responds to Keynes’s desideratum that contractionist pressures on the international economy, arising from liquidity constraints, should be avoided.

42. But the Plan also included measures apt to curb the opposite type pressure, i.e. inflationary pressures. C.U. Plan combined the confinement of liquidity creation to the financing of unbalancing transactions with a strong pressure on countries to avoid these unbalances (penalties): debtors could only borrow within the maximum limit set by their index quotas, and only at rising interest rates; creditors would be required to transfer to the Union any surplus above their quota, and also to pay charges to the Union if their credits exceeded one quarter of these quotas.

43. PRINCIPLES: 2. ONE-WAY GOLD CONVERTIBILITY Central Banks, while allowed to pay gold into the ICB in order to replenish their accounts, would not be allowed to withdraw it. Hence, gold would in fact gradually exit the international circulation and Member Banks’ reserves. Anti-contractionist interpretation (Skidelsky, James): make “liquidity preference”of creditor countries vacuous, by removing the object of their desires, gold, form the international circulation. In this sense, gold was to be demonetised by fiat.

44. “ANTI-ASYMMETRIES” INTERPRETATION. DOUBLE DEMONETISATION: what had to exit the international circulation and reserves was not just gold, but also any national currency which may otherwise come to assume the role of the international money. National currencies demonetised (from the point of view of international circulation), because the demand for these currencies as international currencies was to be abolished by fiat. Logic: “Key currencies” a logical impossibility; international monetary system absolutely symmetric.

45. Asymmetries would be cut at their roots: not only would international imbalances (as their normally arise between symmetric countries) be discouraged by means of “penalties”; most importantly, what would be disempowered is the basic source of international imbalances, i.e. the basic asymmetry between countries issuing the international money and countries deprived of this privilege.

46. Combination of measures gives rise to international symmetry (i) link between the gold and international liquidity severed: distribution of international liquidity becomes independent from the distribution of gold reserves among countries; (ii) national currencies stand on a par: none of them allowed to work as the international currency; (iii) any remaining imbalances between countries (now made symmetric by the operation of the system), would be kept under control via the penalties envisaged by the Plan.

47. IMPLICATIONS illustrated via “conjectural history” • because ICB the only issuer of international currency, collective control over liquidity creation • no “key country” imposing seignorage on the rest of the world. In other words, countries would not need to buy -with goods- the currency of one particular country - vanishing role of international reserves (change in credit availability instead)

48. no country enabled to renege on its own debt. Thus, while in the system we live in, “key countries” have an incentive to run external deficits (because they are aware that the corresponding external debts can be wiped out through depreciations of their national currency), in the Keynes Plan this adjustment mechanism is non-existent.

49. CONCLUSIONS Keynes Plan “perhaps Utopian, in the sense not that it is impracticable, but that it assumes a higher degree of understanding, of the spirit of bold innovation, and of international co-operation and trust than it is safe or reasonable to assume”. But “a good schematism by means of which the essence of the problem can be analysed”(KCW, 25, p.33). In the same vein, main objective here has been to present a “logical experiment”, illustrating how alternative models of international financial organization produce opposite results in the global economy.

50. FINANCIAL TERROR vs. FINANCIAL DISARMAMENT Because the world currently lives in what has been defined a “balance of financial terror”, the need for “financial disarmament” that motivated Keynes’s proposal (KCW, 25, p.57) is now felt more than ever.