Summary: Global financial instability has sparked a surge in "monetary nationalism" -- the idea that countries must make and control their own currencies. But globalization and monetary nationalism are a dangerous combination, a cause of financial crises and geopolitical tension. The world needs to abandon unwanted currencies, replacing them with dollars, euros, and multinational currencies as yet unborn.
THE RISE OF MONETARY NATIONALISM
Capital flows have become globalization's Achilles' heel. Over the past 25 years, devastating currency crises have hit countries across Latin America and Asia, as well as countries just beyond the borders of western Europe -- most notably Russia and Turkey. Even such an impeccably credentialed pro-globalization economist as U.S. Federal Reserve Governor Frederic Mishkin has acknowledged that "opening up the financial system to foreign capital flows has led to some disastrous financial crises causing great pain, suffering, and even violence."
The economics profession has failed to offer anything resembling a coherent and compelling response to currency crises. International Monetary Fund (IMF) analysts have, over the past two decades, endorsed a wide variety of national exchange-rate and monetary policy regimes that have subsequently collapsed in failure. They have fingered numerous culprits, from loose fiscal policy and poor bank regulation to bad industrial policy and official corruption. The financial-crisis literature has yielded policy recommendations so exquisitely hedged and widely contradicted as to be practically useless.
Antiglobalization economists have turned the problem on its head by absolving governments (except the one in Washington) and instead blaming crises on markets and their institutional supporters, such as the IMF -- "dictatorships of international finance," in the words of the Nobel laureate Joseph Stiglitz. "Countries are effectively told that if they don't follow certain conditions, the capital markets or the IMF will refuse to lend them money," writes Stiglitz. "They are basically forced to give up part of their sovereignty."
Is this right? Are markets failing, and will restoring lost sovereignty to governments put an end to financial instability? This is a dangerous misdiagnosis. In fact, capital flows became destabilizing only after countries began asserting "sovereignty" over money -- detaching it from gold or anything else considered real wealth. Moreover, even if the march of globalization is not inevitable, the world economy and the international financial system have evolved in such a way that there is no longer a viable model for economic development outside of them.
The right course is not to return to a mythical past of monetary sovereignty, with governments controlling local interest and exchange rates in blissful ignorance of the rest of the world. Governments must let go of the fatal notion that nationhood requires them to make and control the money used in their territory. National currencies and global markets simply do not mix; together they make a deadly brew of currency crises and geopolitical tension and create ready pretexts for damaging protectionism. In order to globalize safely, countries should abandon monetary nationalism and abolish unwanted currencies, the source of much of today's instability.
THE GOLDEN AGE
Capital flows were enormous, even by contemporary standards, during the last great period of "globalization," from the late nineteenth century to the outbreak of World War I. Currency crises occurred during this period, but they were generally shallow and short-lived. That is because money was then -- as it has been throughout most of the world and most of human history -- gold, or at least a credible claim on gold. Funds flowed quickly back to crisis countries because of confidence that the gold link would be restored. At the time, monetary nationalism was considered a sign of backwardness, adherence to a universally acknowledged standard of value a mark of civilization. Those nations that adhered most reliably (such as Australia, Canada, and the United States) were rewarded with the lowest international borrowing rates. Those that adhered the least (such as Argentina, Brazil, and Chile) were punished with the highest.
This bond was fatally severed during the period between World War I and World War II. Most economists in the 1930s and 1940s considered it obvious that capital flows would become destabilizing with the end of reliably fixed exchange rates. Friedrich Hayek noted in a 1937 lecture that under a credible gold-standard regime, "short-term capital movements will on the whole tend to relieve the strain set up by the original cause of a temporarily adverse balance of payments. If exchanges, however, are variable, the capital movements will tend to work in the same direction as the original cause and thereby to intensify it" -- as they do today.
The belief that globalization required hard money, something foreigners would willingly hold, was widespread. The French economist Charles Rist observed that "while the theorizers are trying to persuade the public and the various governments that a minimum quantity of gold ... would suffice to maintain monetary confidence, and that anyhow paper currency, even fiat currency, would amply meet all needs, the public in all countries is busily hoarding all the national currencies which are supposed to be convertible into gold." This view was hardly limited to free marketeers. As notable a critic of the gold standard and global capitalism as Karl Polanyi took it as obvious that monetary nationalism was incompatible with globalization. Focusing on the United Kingdom's interest in growing world trade in the nineteenth century, he argued that "nothing else but commodity money could serve this end for the obvious reason that token money, whether bank or fiat, cannot circulate on foreign soil." Yet what Polanyi considered nonsensical -- global trade in goods, services, and capital intermediated by intrinsically worthless national paper (or "fiat") monies -- is exactly how globalization is advancing, ever so fitfully, today.
The political mythology associating the creation and control of money with national sovereignty finds its economic counterpart in the metamorphosis of the famous theory of "optimum currency areas" (OCA). Fathered in 1961 by Robert Mundell, a Nobel Prize-winning economist who has long been a prolific advocate of shrinking the number of national currencies, it became over the subsequent decades a quasi-scientific foundation for monetary nationalism...
NO TURNING BACK
Just a few decades ago, vital foreign investment in developing countries was driven by two main motivations: to extract raw materials for export and to gain access to local markets heavily protected against competition from imports. Attracting the first kind of investment was simple for countries endowed with the right natural resources. (Companies readily went into war zones to extract oil, for example.) Governments pulled in the second kind of investment by erecting tariff and other barriers to competition so as to compensate foreigners for an otherwise unappealing business climate. Foreign investors brought money and know-how in return for monopolies in the domestic market.
This cozy scenario was undermined by the advent of globalization. Trade liberalization has opened up most developing countries to imports (in return for export access to developed countries), and huge declines in the costs of communication and transport have revolutionized the economics of global production and distribution. Accordingly, the reasons for foreign companies to invest in developing countries have changed. The desire to extract commodities remains, but companies generally no longer need to invest for the sake of gaining access to domestic markets. It is generally not necessary today to produce in a country in order to sell in it (except in large economies such as Brazil and China).
At the same time, globalization has produced a compelling new reason to invest in developing countries: to take advantage of lower production costs by integrating local facilities into global chains of production and distribution. Now that markets are global rather than local, countries compete with others for investment, and the factors defining an attractive investment climate have changed dramatically. Countries can no longer attract investors by protecting them against competition; now, since protection increases the prices of goods that foreign investors need as production inputs, it actually reduces global competitiveness.
In a globalizing economy, monetary stability and access to sophisticated financial services are essential components of an attractive local investment climate. And in this regard, developing countries are especially poorly positioned.
Traditionally, governments in the developing world exercised strict control over interest rates, loan maturities, and even the beneficiaries of credit -- all of which required severing financial and monetary links with the rest of the world and tightly controlling international capital flows. As a result, such flows occurred mainly to settle trade imbalances or fund direct investments, and local financial systems remained weak and underdeveloped. But growth today depends more and more on investment decisions funded and funneled through the global financial system. (Borrowing in low-cost yen to finance investments in Europe while hedging against the yen's rise on a U.S. futures exchange is no longer exotic.) Thus, unrestricted and efficient access to this global system -- rather than the ability of governments to manipulate parochial monetary policies -- has become essential for future economic development.
But because foreigners are often unwilling to hold the currencies of developing countries, those countries' local financial systems end up being largely isolated from the global system...
MONEY IN CRISIS
Why has the problem of serial currency crises become so severe in recent decades? It is only since 1971, when President Richard Nixon formally untethered the dollar from gold, that monies flowing around the globe have ceased to be claims on anything real. All the world's currencies are now pure manifestations of sovereignty conjured by governments. And the vast majority of such monies are unwanted: people are unwilling to hold them as wealth, something that will buy in the future at least what it did in the past. Governments can force their citizens to hold national money by requiring its use in transactions with the state, but foreigners, who are not thus compelled, will choose not to do so. And in a world in which people will only willingly hold dollars (and a handful of other currencies) in lieu of gold money, the mythology tying money to sovereignty is a costly and sometimes dangerous one. Monetary nationalism is simply incompatible with globalization. It has always been, even if this has only become apparent since the 1970s, when all the world's governments rendered their currencies intrinsically worthless....
THE MIGHTY DOLLAR?
For a large, diversified economy like that of the United States, fluctuating exchange rates are the economic equivalent of a minor toothache. They require fillings from time to time -- in the form of corporate financial hedging and active global supply management -- but never any major surgery. There are two reasons for this. First, much of what Americans buy from abroad can, when import prices rise, quickly and cheaply be replaced by domestic production, and much of what they sell abroad can, when export prices fall, be diverted to the domestic market. Second, foreigners are happy to hold U.S. dollars as wealth...
Polanyi was wrong when he claimed that because people would never accept foreign fiat money, fiat money could never support foreign trade. The dollar has emerged as just such a global money...
But the dollar's privileged status as today's global money is not heaven-bestowed. The dollar is ultimately just another money supported only by faith that others will willingly accept it in the future in return for the same sort of valuable things it bought in the past. This puts a great burden on the institutions of the U.S. government to validate that faith. And those institutions, unfortunately, are failing to shoulder that burden. Reckless U.S. fiscal policy is undermining the dollar's position even as the currency's role as a global money is expanding....
It is widely assumed that the natural alternative to the dollar as a global currency is the euro. Faith in the euro's endurance, however, is still fragile -- undermined by the same fiscal concerns that afflict the dollar but with the added angst stemming from concerns about the temptations faced by Italy and others to return to monetary nationalism. But there is another alternative, the world's most enduring form of money: gold.
It must be stressed that a well-managed fiat money system has considerable advantages over a commodity-based one, not least of which that it does not waste valuable resources. There is little to commend in digging up gold in South Africa just to bury it again in Fort Knox. The question is how long such a well-managed fiat system can endure in the United States...
...Since economic development outside the process of globalization is no longer possible, countries should abandon monetary nationalism. Governments should replace national currencies with the dollar or the euro or, in the case of Asia, collaborate to produce a new multinational currency over a comparably large and economically diversified area...
As for the United States, it needs to perpetuate the sound money policies of former Federal Reserve Chairs Paul Volcker and Alan Greenspan and return to long-term fiscal discipline. This is the only sure way to keep the United States' foreign tailors, with their massive and growing holdings of dollar debt, feeling wealthy and secure. It is the market that made the dollar into global money -- and what the market giveth, the market can taketh away. If the tailors balk and the dollar fails, the market may privatize money on its own.