As the International Monetary
Fund and World Bank redouble their warnings on the prospects for global growth,
central banks continue to flood the markets with liquidity. The US Federal
Reserve began its third round of quantitative easing in September; the European
Central Bank is offering unlimited purchases of bonds of troubled eurozone
countries. The People’s Bank of China, responding to slowing growth, has cut
interest rates repeatedly and trimmed reserve requirements.
It may seem a strange time to
worry about a shortage of global liquidity. But precisely this risk looms and,
if nothing is done, it will threaten 21st-century globalisation.The global
trading and financial systems require lubrication by an adequate supply of
homogeneous assets that can be bought and sold at low cost and are expected to
hold their value. For half a century, US Treasury bills and bonds played this
role. Their unique combination of safety and liquidity has made them the
dominant vehicle for bank funding globally: it explains why the bulk of foreign
exchange reserves are held in dollar form, and why the role of dollar credit in
financing and settling international trade far exceeds the US share of
international merchandise transactions.
But as emerging markets continue to rise, the US will unavoidably
account for a declining fraction of global gross domestic product, limiting its
ability to supply safe and liquid assets on the scale required. The US
Treasury’s capacity to stand behind its obligations is limited by the revenues
it can raise, which depend, in any scenario, on the relative size of the US
economy. With emerging markets’ growth outstripping that of the US, the
increase in the capacity of the US Treasury to supply safe and liquid assets will
inevitably lag behind the increase in global transactions.
For the US not to address its
looming fiscal
challenges would be more alarming still. America may not be at risk of default,
because the Fed is there to backstop the market in Treasuries. But if the
current situation persists, America’s sovereign obligations will not hold their
value indefinitely. And if they fail to hold their value, they will not hold
investors’ confidence. If they no longer offer the safety that investors have
come to expect, they will not function as the stable collateral required by
bank funding markets. They will not be regarded as an attractive form in which
to hold international reserves. And they will not be seen as a convenient
vehicle for merchandise transactions.
A serious shortage of
international liquidity would spell the end of globalisation as we know it.
International financial and merchandise transactions would become more
expensive. Without an attractive means to hold the reserves they need to
intervene in international markets, central banks and governments would be
reluctant to give those markets free rein. Controls would become widespread.
The only other economies large
enough to supply safe and liquid assets on a meaningful scale are the eurozone
and China. Europe is currently in
no position to do so. Eurozone bonds would have the requisite uniformity and
liquidity but they remain a bridge too far.
China, however, has not yet
succeeded in developing a liquid bond market. Beyond that, there is the fact
that every reserve currency in history has been the currency of a political
democracy. In a democracy, the executive is subject to checks and balances.
This reassures investors, including foreign investors, that they are safe from
expropriation. It is not yet clear whether China, as a one-party state, can
finesse this problem.
If they are not to come from
the US, European or Chinese governments, then where can an adequate supply of
safe and liquid assets come from? Some observers point to the private sector.
They suggest that international transactions can be financed and settled using
high-grade corporate bills and bonds.
Corporate obligations,
however, lack the uniformity of sovereign debt. To use them, those engaged in
cross-border transactions would have to make expensive investments in
information or, worse yet, rely on the rating agencies. Either way, the costs
would be significant.
Others propose empowering the
IMF to create international liquidity by authorising it to issue additional
special drawing rights and, more importantly, requiring the Fed to accept them
in return for dollar liquidity. This is a clever scheme, but Congress will
never agree to it.
The only solution, then, is
for the US, Europe and China to share the burden. They can do so by putting in
place measures to enhance investor confidence in their sovereign issues. And in
each case the solution is at least as much political as it is economic.
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