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This is why dollar alternatives are non-starters

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America's "exorbitant privilege" of being able to pay its bills in the currency it prints at a zero marginal cost has been a matter of great controversy ever since the term was coined in the mid-1960s by the former French President Valéry Giscard d'Estaing, who was serving as a young finance minister at that time.

Various attempts have been made since then to provide alternatives to the dollar as the world's predominant transactions and reserve currency. One such instrument was created in 1969 in the form of a composite financial asset called special drawing rights (SDR). That was intended to offer a supplementary reserve asset and the IMF's unit of account.

The SDR basket currently consists of the dollar, the euro, the British pound, the Japanese yen and the Chinese renminbi. As of the end of last year, 204.1 billion SDRs (equivalent to $287.6 billion) have been allocated to IMF member countries. That represents only 3.4 percent in the pool of reserves held by the world's largest reserve holders.

In spite of that, some people just won't give up. SDRs as an alternative reserve asset were one of the topics of last Thursday's (March 28) meeting in Paris, attended by about 30 high-level financial officials from G20 countries, IMF and other (official) international organizations.

A perennial talking point

The SDR issue will also be tabled for discussion during the next G20 summit chaired by China in Hongzhou on September 4-5, 2016. The main analytic input for that meeting on SDRs and a number of other topics on global capital flows will be provided by an expert group led by France and South Korea.


Apart from politics, of which there is plenty, the main motivation for re-launching this old debate is a concern expressed by some countries, such as China, that the international monetary system based on national currencies – mainly the U.S. dollar – is unstable and crisis-prone. The last financial crisis is taken as an example of that. The SDR proponents therefore believe that a composite reserve unit would shield the world from contagion of similar shocks in the future.

That, however, was not what some of SDR architects and early users thought. The late Lord Barber, the British Chancellor of the Exchequer in the first half of 1970s, is reported as having said that the UK would put SDRs in the "forefront of its reserves," implying that they would be the first ones he would get rid of. That was a perfect example of Gresham's law in action.

The same considerations are still there. For example, how would the SDR reserve swaps work in a world where monetary authorities hold a stock of $4.1 trillion of highly liquid U.S. Treasuries? And how would one impose SDRs on countries that may be perfectly happy with the vast liquidity and financial infrastructure of a largely dollar-based reserve system?

It's tough to beat the greenback. The only credible potential competitor could have been the euro. But that is gone now, because the euro's main stakeholders – France and Germany -- have gravely compromised the viability of Europe's greatest economic and political achievement.

Still, all this noise about the SDR has a serious message for Washington: The world economy cannot function without a truly global currency, because savers and investors need a stable unit of account, a widely accepted means of payment and a reliable store of value.

That's what the SDR can't match, and won't be able to match anytime soon, if ever. Sadly, that is also the lost promise of the euro – a currency born out of enormous efforts and sacrifices since the late 1960s.

A sound dollar is irreplaceable

But all that gives no reason for smugness and complacency. Those constantly yelling at the Fed to print more money to support equity markets should think again.

The best the Fed can do for everybody, including those asking for sure fire puts, is to run an honest currency that will provide stable purchasing power rather than permanent uncertainty, volatile business cycles and stealthy taxes through inflating consumer prices. Only an economic system based on credible price stability can provide a framework where savers and investors make their resource allocations with predictable price and credit cost parameters.

Whether one likes it or not, that is the world of a German obsession with the sacrosanct Stabilität.

If the Fed lived up to a similar notion of stability, then those of our foreign kibitzers, who are now complaining that the Fed is devastating emerging markets (which ones? China or other trade surplus countries in East Asia?) with pinpricks of 25 basis-point rate hikes would have to think. What is better for emerging markets: an American inflation-recession roller coaster or a steady growth where Uncle Sam writes a $759 billion check to the rest of the world, as it did last year, after a $741.5 billion contribution it sent out in 2014?

I am definitely not one of those globalists who think that the Fed should sacrifice national interests for the sake of running a world currency. The Fed does not have to do that. U.S. monetary officials are providing the best service to global economy by honoring their public policy mandate of price stability with growing output and employment.

Investment thoughts

No SDR, or any other financial contraption, can beat the liquidity and the formidable global banking infrastructure offered by the U.S. dollar. Not now, and not in the foreseeable future.

Think of this: What do some of the countries trading in their national currencies (ostensibly to avoid the dollar for political reasons) do with these illiquid and inconvertible assets? They get rid of them, just like what Lord Barber said about SDRs, or they try to find a greater fool to exchange them for something they can hold in their reserves or settle their bills in the rest of the world.

But the Fed must resist siren calls. It has to normalize financial conditions after years of struggling to repair the huge damage the Fed caused with the Great Recession and a devastated credit system.

I am betting that the Fed will do that, because anything else seems to me too horrible to contemplate.