Sunday, May 7, 2017

The Real SDR Proposal - A Deeper Dive

Since we now have a very current paper on Dr. Warren Coats Real SDR proposal, I think it might helpful to take a deeper dive into it. The point of this exercise is to illustrate that in order for ANY proposed major change to the existing monetary system to happen, there has to be a realistic detailed plan of implementation available. 

Dr. Coats proposal attempts to do that so I will use it here to demonstrate the kinds of questions that have to be considered to make any kind of change to a new system. Below I use a Q&A format to try and get the point across.

Q: How realistic is it that there will be any major changes to the existing world monetary system based on the US dollar as global reserve currency?

A: That is the first and most important question. Unless someone comes up with a realistic detailed plan on how to transition from the existing global system to a new one, no major change is likely to take place at all. At least not very quickly. The status quo is very heavily entrenched and it takes an enormous amount of political will and global consensus to make major changes. With the US now being led by President Trump, the political will for this kind of major global change may not exist at all in the US. So, as we have said here many times, unless a new major global crisis unfolds that forces major change, it may be almost impossible to get the political consensus needed for major change.

Q: If something does prompt a consensus for major change, why would anyone consider using Dr. Coats Real SDR proposal?

A: That is a good question. Who knows for sure what plans for major change might be considered? If you spend any time at all doing real research on this issue, you will quickly learn that there are all kinds of ideas and general concepts out there for major monetary system change. Everything from a full return to the classical gold standard to a new global blockchain supported cryptocurrency is out there. But let's get real. How many of these ideas and concepts have an actual detailed plan of implementation that has been tested in any way in the real world in recent times to work on a global scale? Policy makers (politicians) who will be the ones to decide what will be done tend to lean on plans that have been out in the public domain for consideration for awhile. They tend to look towards those they view as experts for such plans. This is what I think sets Dr. Coats proposal apart. In the real world, I think it is more likely that his plan (or something similar to it) would get a serious look. In a major crisis, there won't be time to do a years long study for a solution.

Q: How do you transition from a US dollar based system to something else like the Real SDR?

A: This is one reason Dr. Coats suggests using the SDR. The SDR already exists in concept and is available now. Changing to the Real SDR he proposes would require a change to current IMF rules. This is how he explains that in his paper linked above:

"Two further enhancements could transform the SDR’s attractiveness and potentially precipitate a virtuous cycle of its wider adoption as an exchange rate peg, invoicing unit, means of payment, and reserve asset to such an extent that dollar holdings in reserves might actually fall. First, allocations could be augmented or replaced by issuing (rather than allocating) SDRs with open market sales (and repurchases) of SDRs according to currency board rules. Second, the SDR’s valuation basket, though marginally attractive relative to the behavior of a single currency, could be significantly improved by giving it a constant real value (basket of goods). The first of these would require an amendment to the IMF’s Articles of Agreement."

Q: What prevents the IMF from just issuing SDRs at will whenever they want?

A: Dr. Coats answers this question in his proposal as follows:

"If the IMF were to issue SDRs under currency board rules rather than allocate them, only those wanting them would acquire them. Thus they could be used freely like the monetary liabilities of any “other” central bank. The rules required to ensure the usability of allocated SDRs would not be needed. Under currency board rules the IMF would not and should not be given discretion to determine the global market’s need for liquidity. Currency board rules oblige a central bank to passively buy and sell its currency at its fixed price in response to public demand. Under the Gold Standard, the price of the currency was set as an amount of gold (a gold anchor). For existing currency boards, the price is an amount of another currency (its exchange rate). The IMF would provide the amount of SDRs demanded by the market by passively buying and selling them for dollars or other key currencies at the SDR’s officially fixed price for its anchor (the SDR valuation basket)."

However, this is where public trust comes into play. Dr. Coats clearly trusts that the IMF would abide by the Currency Board rule he proposes. Critics are skeptical that the IMF could be trusted to do that. This is one of the major obstacles to anything like this actually being adopted and implemented. In a world almost completely divided politically where trust and consensus are very low, it becomes very hard or perhaps impossible to obtain widespread public trust or confidence in any system. That is just the reality of where things are today. I will add that Dr. Coats points out in his writings that no matter what system you use, the people running it have to agree to follow the rules for it to work. If you don't have that, you cannot trust any system no matter what label you put on it, even a gold standard (President Nixon arbitrarily changed the gold convertibility rules overnight in 1971). This is why people to need to understand these issues and make a personal plan so as to have as a backup in case of a failure of the overall monetary system in my view. There is no guarantee that any system can be fully trusted so long as human beings are running it.

Q: How would the currency issuer of the Real SDR handle gains and losses on the changes in value of the currency versus the basket of goods (or change in the price of gold for example) that would happen over time?

A: Dr. Coats answers this question in his proposal as follows:

"Over time the value of the assets held by the IMF against the SDR currency it would issue, consisting of the eligible government debt it had purchased when selling its SDRs, would not necessarily match the market value of its liabilities (the SDR). These assets would earn interest from which the IMF’s operations could be financed and any valuation gains or losses relative to the valuation basket defined value of its SDR liabilities could be covered. In an all SDR world, one in which all countries have pegged their currencies to the SDR or used it directly, the only valuation risks to the eligible SDR denominated debt held by the IMF would arise from changes in interest rates (and default). Thus the IMF’s holdings of such assets should have short maturities.

The possibility of net gains or losses on the assets held by the IMF against its Real SDR liabilities relative to the value of those liabilities raises the same issue faced by any central bank. Who would cover any losses should they arise? When this issue was discussed in the 1970s in connection with a proposal to substitute US dollars held in central bank reserves with SDRs (the so-called Substitution Account), many IMF members argued that the U.S. should cover any losses because the Account directly benefited the U.S. The U.S. saw it differently, as do I. The proposal was dropped when no agreement could be reached on how to share this risk.

 Revival of the old substitution account idea lacks “only” political will and would allow large-scale substitution of existing U.S. dollar reserves with SDRs without exerting exchange rate pressure on the dollar. Substituting issued SDRs would be dramatically more attractive than the earlier proposal to substitute allocated ones with all of their regulations for their use. Agreement would still be needed on how the IMF’s collective membership would stand behind the integrity of its Real SDR liabilities issued under this proposal. To the extent that the eligible assets purchased by the IMF when issuing SDRs were denominated in SDRs, there would be no exchange rate risk. In a recent study, Peter Kenen found that had it been adopted in the 1970s when proposed, the Account would not have resulted in any maintenance of value cost (to the U.S. or the IMF’s members collectively).   The IMF and the United States would be wise to have a Substitution Account ready in the wings in case there is a sudden drop in the demand for dollars in reserve holdings."

This is  a perfect example of the kind of issues you run into no matter what kind of monetary system you advocate. Even under a gold standard where the issuer of currency makes it directly convertible into gold at any time, someone has to maintain a constantly changing inventory of gold that changes price every day. Do you then fix the price of gold so it can't change? If you do that, what happens if the price gets fixed too low and gold producers can't mine it to increase supply? This is what I mean when I say it is easy to just throw out a statement about how the monetary system should work without thinking through all the many questions and issues that arise trying to administer it over time. At least Dr. Coats has thought of these kinds of questions and tries to address them in his proposal. 

 Q: Why should anyone trust the IMF to administer a global reserve currency system?

A: Dr. Coats answers this question in his proposal as follows:

"While the world benefitted greatly from the single world currency created by the gold standard, few countries would be willing to give discretion to the IMF or any other world central bank to determine the supply of issued SDRs. The proposals by some developing countries in the 1970s to allocate SDRs for development finance were greeted with alarm. Issuing SDRs under currency board rules would give the issuer no monetary discretion at all. Following the Bosnian war, which ended in 1995, I was impressed that the three warring factions (Bosniak, Serbian, and Croatian), who had great difficulty agreeing on most issues concerning the establishment of a new central bank, agreed immediately without discussion that it should be a currency board. Currency board rules were the only thing all three groups were prepared to trust to the new central bank. The same is likely to be the case for issuing SDRs."

Here we get right to the heart of the matter. It comes down to who will people trust to run a monetary system? Dr. Coats clearly feels he can trust the IMF to follow the rules in his proposal. IMF critics won't agree with that for sure. Would the nations of the world ever achieve that kind of trust? It certainly does not exist today in terms of a consensus.

So the real questions for me (and what I try to follow here on this blog) is:

1- Will we get a new major global crisis so severe that the world is literally forced to abandon the present system and create a new one? (Otherwise, I don't see change happening very quickly)

2- If #1 above does happen, who will most people trust to create and administer a new monetary system?

I don't have the answer to either question. My goal here is to encourage people to take this topic seriously and learn about what could cause such major change to take place and what the realistic options are out there for a new monetary system. Not just general ideas or concepts, but realistic plans that could actually be implemented in the real world we have today. Dr. Coats has at least put such a plan out there that could actually get considered which is more than I see elsewhere when I research this topic.

It's pretty hard to have an intelligent opinion on this if you know nothing about the issues or any proposed solutions at all. The answer to question #2 above will most likely determine what actually happens. If people still trust the central bank/IMF structure that exists now, then they are more likely to accept the kind of Real SDR proposal that Dr. Coats has put forward. If most people have lost trust in these institutions, then the more likely outcome is some kind of decentralized system  where every nation is pretty much on their own. It's entirely possible that gold or a basket of goods might be used again in either case to try and restore public confidence in whatever new system is created either globally or by individual nations.

The main point I want to make in this article is that no matter what system is put forward, there are many complex issues and questions that have to be thought out for the plan to work. When you see people proposing one kind of change or another will happen or should happen, at least dig deep enough to see if they have any kind of detailed plan that tries to address these questions that will surely arise. Without that, all they really have is an idea and some imagination. That won't help much if push comes to shove.

News note 5-8-17: In a new article published in The Dallas Morning News, George Gilder calls for a return to the gold standard.

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