A Reformed Monetary System? There's An Elephant In The Room

Written by Henrik Ræder Clausen



While academia, government and finance have yet to field a persuasive explanation of what caused the financial crisis, there is no shortages of proposed remedies. EuropeNews posts this report from the first day of a conference held by DIIS, Danish Institute for International Studies in Copenhagen, September 16th 2009, entitled:

Reforming the Bretton Woods institutions

(Note: The Bretton Woods institutions refer to the trio of the International Monetary Fund (IMF), the World Bank and the World Trade Organization. These were created in conjunction with the long-defunct Bretton Woods agreement concerning our monetary systems.)

Conference Opening
Dr. Per Stig Møller, Minister of Foreign Affairs of Denmark

Mr. Møller touched upon a variety of issues, including:

September 15th marks the anniversary of the failure of Lehman Bros, the first major banking failure in many years. As to why the US government refused to rescue this bank, after having saved several others, is a mystery. Some say it was a mistake, others that it provoked the earthquake needed to make people take the problems seriously. Lehman was considered 'too big to fail', but was permitted to fail anyway. This caused a near-fatal paralysis of the financial sector, with extensive mistrust, credit freezing, and a need for state intervention.

The Minister went on to praise the Central Banks for their decisive action and saving the world economy in "new and creative ways", that the G20 countries had embarked on a radical expansionary fiscal policy, and that the IMF had been allocated further resources in the order of $1.1 trillion to fix the problems.

The Minister then proceed to quote Marx: Politics is the art of looking for trouble, finding it everywhere, diagnosing it incorrectly and applying the wrong remedies.  

After this confidence increaser, he announced a new major initiative to find a solution to the challenges: A prize competition, open to anyone under 30, for papers on the subject:

"The financial crisis and the consequences for the international monetary system."

As to why the competition would only be open to young writers was not explained by the minister. One should think that any relevant entry should be considered, that age should not be an obstacle to fielding new ideas, and that people over 30 just might have read more books and gained more life experience, enabling them to avoid obvious fallacies.

Welcome and Introduction 

Georg Sørensen, Professor, Chairman of the Board of DIIS 

Mr. Sørensen noted that the crisis constitutes a failure of the free markets, and that it had not been predicted. Paul Krugman has blamed academics for the failure - which makes sense. Academics would not read people like Peter Schiff or Marc Faber, who accurately predicted the crisis some three years ago. This constitutes a major state and regulatory failure.

On a second level, we may need to reshuffle the international economic and political order. The modernizers are serious players these days.

On a third level, this crisis may be systemic. Although Capitalism doesn't seem to deliver, there can be no turning away from it.  

(Reporters note: There seems to be some misunderstanding concerning the meaning of 'Capitalism'. Capitalism is an economical system based on productive work, saving money and investing savings into capital goods. The current economical system in the West is more based on consumption, credit and stimulus, and can hardly be described as 'Capitalism'. 'Centralbankism' isn't exactly an easily pronounced alternative, but at least describes the system more appropriately.) 

Keynote Address: From Global Imbalances to Global Reorganizations: 

Steps Towards a More Stable and Equitable Global Financial System

Robert Wade, Professor, London School of Economics, UK 

Mr. Wade in his keynote address made it clear that we are not headed to a 2nd Great Depression, as was the fear from Sept. 2008 through March 2009. This is not going to happen. This crisis should last 20-24 months, and we should soon see the return to full employment.  

The goals in the current situation should be:

The G20F (G20 on the level of finance ministers) recently debated possible solutions. However, the British PM Gordon Brown (Labour) refused to take action on controlling the financial sector and bankers' bonuses in particular, as he feared the loss of London's status as a major financial center. Little came of that meeting. 

As for implementing a system of global governance over the financial sector, G20 suffers problems of legitimacy. There is no rotation provision for other countries, the current selection of countries is somewhat arbitrary, and it is not viable in the long term without significant changes.  

Reporters' note: I have serious reservations about the legitimacy of any organization operating above the state level. They have a strong tendency to evolve into clubs of specialists, preparing all proposals and recommendations far removed from public debate and scrutiny, effectively implementing an extra layer of government beyond the checks and balances that function quite well within nation-states such as Denmark. Democratic control is vital everywhere, yet few citizens (if any) seem to have any idea of how to influence, say, the IMF, in any significant way. That is troublesome. 

The Financial Stability Board (FSB) has a staff of 9 (perhaps 10) and is thus unable to execute independent analysis. Thus, it would have to rely on analysis performed by the member states (which, by definition, are not trustworthy). 

As for the United Nations, the Stiglitz Commission fielded some radical ideas in June 2009, but they have watered out (watered away, actually) by the G7. Major G7 countries (in particular G2 = US + UK) deliberately snubbed the UN by sending low-level officials to the Commission. In total, the United Nations is a marginal and hardly relevant player in the reform process. 

Prof. Wade went on to explain how the Effective Market Hypothesis (EMH - the theory that markets largely find the correct price of a given asset) has failed. This theory underpins a significant part of the IMF efforts to "restore confidence in the financial markets". Instead of this theory based on rational expectations, we should instead devise economical theories based on irrational expectations or "psychological economics", focusing on explaining momentum trading.

As an example, Wade noted that end investors tend to withdraw their investments from underperforming money managers, without knowing clearly if the money managers were being prudently conservative or simply incompetent. This rational behavior leads to mispricing of assets and systematically overextends financial risks.  

There's an elephant in the room

Reporters note: There's something missing here. First, the idea of leaving investment to money managers isn't entirely sound. Investment means allocating your money to projects that you expect to be profitable. Doing so requires understanding and knowledge, and is the contribution of the investor (apart from his money) to funding profitable ventures. Leaving that to professional money managers is hardly sensible investment, it borders on gambling.

Worse, however, is the lack of attention paid to the rapidly increasing money supply and the impact this has on investor choices, systemic risk and the creation of bubbles. This is like an elephant in the room, but was unfortunately not addressed. 

What should be done?


It was expected by many, including Prof. Wade, that the US deficit in 2006 would lead to a collapse in the dollar. Instead of hitting the monetary recycling, it hit the credit side. The Global Financial Crisis (GFC) is caused by a rupture in the credit recycling (no mention of the elephant). 

Proposals to solve the problems include:

  1. Curb external surpluses / deficits
  2. Develop a global currency
  3. Create an International Clearing Union (ICU)
  4. Coordinate exchange rates, make real exchange rates correspond to nominal ones.
  5. Use Capital Account Managers (CAM). (Note: This is a less offending phrasing of the widely unpopular concept of capital control. Some may object to the weasel word approach here. But if this was to be phrased openly, it would have no chance to pass.)
  6. Confiscate excessive trade surpluses through the ICU.

Back to Which Bretton Woods? Liquidity and Clearing as Alternative Principles for Reforming International Finance. 

Luca Fantacci, University of Bocconi, Italy 

Mr. Fantacci presented his paper on the subject. He stressed the importance of the International Clearing Union, a proposal originally set forth by Lord Maynard Keynes during the original Bretton Woods negotiations. Since the system that was eventually implemented did not include this component, and subsequently failed, it might be wise to return to this rejected proposal. 

Further points made by Mr. Fantacci was that money is the first economic institution. Without money, there can be no financials. Currently, we have no international monetary system, but we do have global imbalances (trade deficits / surpluses). Money is, according to Mr. Fantacci, only there if we think about it and design it. 

Reporters note: This would seem to contradict historical evidence. Money has been invented independently in every major culture, using all kinds of items to store value and facilitate trade. Eventually, gold and silver became default money worldwide. But this was not by design or government decree, this was by mutual consent between traders. 

The Chinese have recently deliberated on the need for a new international reserve currency to replace the aging dollar. On March 23rd, Chinese central bank chairman Zhou Xiaochuan published a report Reforming the International Monetary System" on the subject. Here, it is stated that we have a clearer need for an international currency than a reserve currency per se. The Chinese do not desire the Yuan to become a new reserve currency, due to the dangers inherent in doing so - in particular the problem known as the "Triffin Dilemma", that creating enough of it to serve foreign needs will overstimulate domestic demand. In other words: The temptation to print too much of the reserve currency may ultimately lead to its demise in uncontrollable inflation. 

Instead, the Chinese wish for a reserve currency that is not also a national currency. This dual-currency approach raises interesting possibilities. Keynes has proposed a scheme of this kind, named the 'Bancor' (without any commodity backing to provide it value), but that was rejected.  

There's an interesting differentiation here between a 'reserve currency' and a 'currency unit': 

The Bretton Woods final definition of money was more conservative: Gold or dollars. Note the 'or'. 

Reporters note: Since the gold was to be provided by the United States of America, this was (in contrast to the dollar) a limited reserve, and the 'Gold window' was closed on August 15th 1971, during the Nixon administration. That marked the end of Bretton Woods. 

According to Mr.  Fantacci, the ICU is a beautiful mechanism to create a balanced international economy. Traditionally, only countries bearing deficits would incur an obligation to set the imbalance right, while creditor nations would have no such burden. The ICU system would create a symmetric system, where incurring excessive surpluses would lead to a similar obligation of the creditor, an obligation to get rid of the surplus or have it confiscated. ICU can be created in such a way that excessive money disappears from the system, for instance at each years' end. This would also eliminate the dangerous 'Trap of liquidity'. 

As for the Chinese reform proposal, it would constitute of the following elements:

Reporters note: Since SDR's are basically created out of the blue, with no commodity backing, this looks like a dubious idea. An endless inflationary potential could quickly destroy the value of the SDR.  

Some of this is already in progress. SDR allocation has been dramatically increased, with the proposed SDR 250 billion of April 2009 becoming effective at the end of August. The Yuan, however, is not convertible and thus cannot qualify to be part of the SDR 'basket'.  

The current creditor position of China is roughly $2500 billion, and a new global currency should be designed in such a way that it always ensures the availability of liquidity,. The ICU, furthermore, would render existing capital markets obsolete.

Mechanisms to accomplish this would be:

Towards a New Bretton Woods?  

The Global Governance of Finance since the 1970s: Problems and Prospects 

Thomas Kalinowski, Ewha University, South Korea 

This discussion was based on the premise that deregulation leads to crises in the markets, and that re-regulation is the proper cure for it. Mr. Kalinowski discussed the 'financialized countries' (as opposed to 'industrialized'), and lamented the fact that some freewheeling exporting countries were creating imbalances in international trade. These unruly countries, mainly in East Asia, show strong reluctance to accept global solutions to the problems. A "Bretton Woods II" would implement global governance to ensure that export orientated countries do not gain unreasonable benefits over financialized countries. 

A related problem is that the export-orientated countries actually benefits from the bailouts elsewhere, as the bailouts enable them to uphold exports and increase profits. All major countries have accepted an increased role of international institutions. IMF, on the brink of death before the crisis, is back in business. The German Constitution has been amended with a debt limitation. This is expected to lead to significant deflationary pressure. 

And, while exporting oneself out of the crisis does indeed work, there is a need for a more 'fair' financial system, one that would inherently reduce any imbalances. 


Chair: Robert Boyer, National Centre for Scientific Research, Paris

Ehm, there's an elephant in the room...

In this discussion, I asked if any research has been done on the connection between increased money supply and the appearance of bubbles in real estate, stock and financial markets, as this seemed to have been similar developments before the crash of 1929 and the current crisis.  

Prof. Robert Wade did not want to reply to that question, but did mention an interesting parallel between the two, that income redistribution had been severely skewed in both periods.

Adviser to the Danish National Bank, Jakob Ekhold Christensen, found the question interesting and would like to examine it further. He just might notice the elephant in the room, though I doubt it. 

A question was fielded about the ICU as an ideal solution. Mr. Fantacci is open to various implementations, but insists on the principle of distributing the burdens of imbalances between debtors and creditors alike. 

The Geo-Political Order and the Future of the Bretton Woods System 

Christopher Balding, Peking University HSBC School of Business, China 

Christopher Balding underlined that although he was critical of the Bretton Woods institutions, it would be a mistake to think that he wanted them abolished. Policy responses to the current crisis have been quite limited, where one would expect bold leadership and radical new initiatives. The fact that the economy is much more diverse than in 1945 contributes to this, as emerging economies and export-orientated countries tend to reject proposal seen as detrimental to their situations. 

It would be possible to give the IMF 'ex ante' powers, the ability to act before an actual crisis erupts. The IMF, however, is not interested in becoming a financial enforcer, apart of course from the conditions tied to the granting of SDR's to member countries. 

The world today has two major sets of fixed exchange rates: The Chinese Yuan towards the US dollar, and Arab currencies, also towards the dollar. It is no coincidence that the two most significant balance of payment problems exist in exactly these places - fixed exchange rates have a direct correlation to large deficit/surplus relationships. 

China is not exactly promoting a Bretton Woods II system, which on the other hand is not feasible without Chinese consent and cooperation. Europe certainly does not have the
political strength to lead it. 


Chair: Lars Engberg-Pedersen,
Senior Researcher, DIIS 

Here I asked Mr. Balding if not the connection between fixed exchange rates and large trade imbalances had an obvious implication: Abandoning the fixed exchange rates (floating the currencies) would lead to a significant reduction in the imbalances. CB responded that while this would not happen overnight, it would certainly go a long way toward fixing the problems. 

Mr. Balding made some further comments on the situation China finds itself in today, holding an excess of dollar-denominated assets, and incurring significant losses on those due to inflation. They must have deliberately chosen to do so, but cannot quickly and easily diversify away from those assets into other currencies. Doing so has potential to significantly harming the dollar. 

Regulatory Reactions to the Global Credit Crisis 

Eleni Tsingou, University of Warwick, UK 

Mrs. Tsingou stressed the need for stronger international institutions to regulate the markets, that we can no longer manage the economy on market terms. The current situation with extensive bailouts and artificially low interest rates, and the clear message that financial institutions are largely not permitted to fail, has reinforced the special status of the financial sector. 


Chair: Jakob Vestergaard, Project Researcher, DIIS 

Here I fielded the following question to Mrs. Tsingou, again pointing to the elephant of money printing that everyone in the room had neglected:

I noticed that the money supply is growing rapidly in the United Kingdom, US, the eurozone etc., due to various forms of quantitative easing, artificially low interest rates and monetizing debt. This money is largely created in the financial sector, for obvious reasons, causing this sector to grow disproportionately. Would not halting the growth of the money supply lead to a reduction of finance, rendering any further regulation initiatives redundant?


She responded that she believes that halting the growth of the financial sector is best achieved through regulation. Not noticing the elephant. 

One instructive example of regulatory failure was discussed, the fact that the US Securities and Exchange Commission did not discover the BernardMadoff fraud.

Sure, they had noticed that he was running his investment business in an unusual way. But since he had met his obligations and didn't seem to harm anyone, and had paid his obligations without problems, the SEC did not sound the alarm. This is no mere failure, but constitutes a significant betrayal of trust. The SEC exists in order to increase investor confidence by ensuring that fraud is discovered early. This sense of security was obviously false. Private companies committing failures of this magnitude, for instance ArthurAndersen, would usually fold. That is obviously not the case for a government agency like the SEC.  

How similar failures can be avoided in the future was not directly addressed. 

What is finance for?
Through the conference, Mrs. Tsingou and others put forth the interesting question: "What is finance for?" While some may say that a bloated financial sector is a prime tool for government to assume controls of the means of production, there really is a more down to earth explanation: 

Finance is the art of allocating money in the best possible way to profitable ventures. This money (not to be confused with capital) is then spent on capital assets - buildings, machines, staff - expecting eventually a decent Return on Investment. This is also known as 'profit', but is not mentioned frequently, even in a conference like this, and rarely as a positive thing. This is unfortunate, for profit - and saving of a part of profits - is a prerequisite for further investments and improvements in the productive part of the economy. 

Manipulating the markets also makes it difficult to invest profitably. I have over time, not least inspired by an amazing article How the thundering herd faltered and fell (IHT, November 2008), acquired the opinion that low interest rates lead to lack of profitability, not only in finance, but in every part of the economy. I asked Christopher Balding about this, and he confirmed my understanding of the problem. 

Final notes
Striking in its absence was concrete proposals on how to implement some "Bretton Woods II" system, in particular discussion on how to practically ensure stable exchange rates, and what kind of commodity (gold, silver, oil?) could be used as the ultimate holder of value for the currencies in such a system.

The original Bretton Woods system was based on the US holding some 85 % of the worlds' gold, and an unprecedented generosity in actually using this reserve to guarantee the value of the participant currencies, a generosity widely abused and scarcely returned by the participant countries. No such large, benevolent backer of a new set of fixed exchange rates can be identified anywhere, rendering the label of "Bretton Woods II" clearly misleading. Further, no alternative mechanism to perform this function was proposed.

I have recently read From Bretton Woods to World Inflation, and had expected the issues described therein to be discussed. The book is basically a collection of editorials from The New York Times, most written at the time of the original Bretton Woods conference, and predicted with great accuracy many of the problems that later turned up in the system. To understand money further, I also read What Has Government Done to Our Money? and What You Should Know About Inflation. These books provide interesting theoretical background on the nature of money and the nature of inflation.

Being a firm believer in the value-creating activities of production, marketing and trade, I must say I left this conference somewhat disappointed. Many of the proposed 'remedies' seemed arbitrary. Or worse, they looked tools to institute government or bureaucratic control over what used to be a free and prosperous economy. The issue of quantitative easing, the immediate consequences and the long-term risk of (possibly runaway) inflation was not discussed, the emphasis (as mentioned) being instead on increased regulation and global governance.

And, quite honestly, I do not want to be governed by people who can not even field a coherent explanation of what led to the current financial mess. I don't trust them.


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