The great crisis made evident the extreme vulnerability of the international monetary system. Although the epicentre of the crisis was the financial system of developed markets, the crisis brought to light two undeniable realities.
The first of these is that the interconnectedness of financial systems across the world accelerates the transmission of financial shocks to the real economy. The second is that the long-standing vulnerabilities of the system, including issues such as asymmetry in the adjustment process between debtor and creditor countries, global liquidity provision, financial excesses, destabilizing capital flows and accumulation of international reserves for the purpose of self-insurance, have become much more evident.
The impact on the international monetary system is that, instead of moving towards a multiple-currency system as has been the mainstream view, the world is settling into a “dollar by default” de facto arrangement. This is largely because the euro is in danger and the yen is compromised by Japan’s fiscal situation, while the role of the renminbi is constrained by its lack of convertibility and the gradual pace mindset of China’s leadership.
With international imbalances, such as asymmetric growth in different regions of the world, likely to persist for much longer, there is an acute need to be able to adjust international imbalances without causing a collapse of global demand. However, no such adjustment process exists today.
Despite the crisis, the United States remains the world economy with the largest structural strengths, but its aggregate demand fundamentals are damaged by household deleveraging, a process that could take several years to play out; a “fiscal drag” caused by tax exemption extensions; slow export growth due to Chinese exchange rate management, among other reasons; and low industrial investment.
Nevertheless, the US picture looks positively simple compared to that of Europe. There, household indebtedness may be less of an issue but the monetary union’s weak institutional architecture, as evidenced by the crisis, and the perverse interrelationship between public debt and the under-capitalization of banks, create challenges of considerable magnitude.
While European banks can absorb a significant haircut on the Greek debt, it has been harder than expected to ring-fence larger economies, the upshot of which is that what started as a financing problem for Greece, one of the European Union’s smaller economies, is now a crisis threatening the whole monetary system.
Everyone knows a fiscal union that supports the issuance of eurobonds and the acting of the ECB as a lender of last resort to governments is fundamentally required for the euro to survive. However, everybody also agrees that current European institutions are not designed to make such sweeping decisions. Nor are the rich countries enthusiastic about putting in place the reforms needed to make it happen.
In short, while markets typically overreact, European governments have consistently remained behind the curve. As a result, Europe can look forward to a future of political uncertainty, fiscal retrenchment, credit contraction and sluggish growth. The experience of Latin America in successfully combining financial adjustment with structural reforms may well be relevant to Europe’s leaders as they look to find a way forward.
Guillermo Ortiz is the Chair of the World Economic Forum’s Global Agenda Council on the International Monetary System. See also the World Economic Forum’s new scenario report, Euro, Dollar, Yuan Uncertainties: Scenarios on the Future of the International Monetary System.
Image: The US Dollar, Euro and Yuan. REUTERS/Kacper Pempel