RWER issue 55: Arista, Erturk
The case for international monetary reform
Jane D’Arista and Korkut Alp Ertürk [Financial Markets Center and University of Utah, USA]
Introduction
The conventional view on global imbalances is based on a few basic propositions: that (i) they are the ultimate cause of the financial crisis, and (ii) mainly the result of overspending in the US and currency manipulation in China; (iii) the overall policy objective should be to rebalance which requires that deficit countries should save more and surplus countries less, and (iv) that exchange rate flexibility should be enhanced. Traditionally, overspending used to be blamed on government budget deficits, so the policy prescription would call for reduced government spending. But since the crisis, regulatory failure appears to have emerged as a new culprit. Financial regulation failed to detect and stop excessive credit growth which in turn made it possible for US households to over-consume. Now that financial reform legislation has supposedly fixed that problem in the US, attention appears to have shifted onto global imbalances and exchange rate flexibility.
However, what is not discussed as much is the downside of raising savings to rebalance in the midst of an anemic recovery. Economists often talk from both sides of their mouths to deal with the problem: Spending should be raised in the short run to revive growth when in a slump, but needs to be curtailed in the long run when the economy recovers. But, the short run fix takes us further away from the long run objective and it is never clearly spelled out how one goes from the former to the latter without tripping along the way.
It is possible that the conventional view suffers from an even deeper problem, for it assumes a world that no longer exists. It implicitly presupposes an international economy consisting of distinct national economies with their own separate systems of financial intermediation tied to one another mainly through trade. But, in a world of free capital flows why should the net demand for national currencies and thus the market determination of exchange rates depend solely on trade balances? The conventional view would only make sense in a world where financial assets are traded mainly to move goods; where central banks control credit growth and where the current account rules the roost. Of course, none of this is consistent anymore with the increasingly transnational world we inhabit, a world that is interconnected through financial flows and global production networks; one where the notion of global financial intermediation is no longer an empty supposition.
You may read the whole paper at: http://www.paecon.net/PAEReview/issue55/AristaErturk55.pdf
This article makes some apparently sensible recommendations, yet it fails to connect with the underlying dynamics of the global economy. Financial flows ultimately either direct or reflect energy flows. In fact, a physicist might define economics as the study of the energy flows that sustain humanity. When those energy flows change, so too will the finance that represents them.
We are now at the cusp of an historic shift in those energy flows. The fossil fuels that have driven the expansion of industrial civilization for the last couple of hundred years are almost maxed out. When they decline, so too will this expansion. Yet our current financial systems were developed for growth and perform very poorly when faced with stagnation, let alone contraction, as the last few years have shown.
So the question to be addressed is: How will a proposed international monetary system perform when faced with persistent contraction over the coming decades, leading to many business failures and either governmental defaults or devaluations? For example, where could you find solid backing for a global currency? How would it help a country facing inevitable hardship, not a temporary recession, a country unable to repay its debts and even the stronger countries facing their own problems, overwhelmed with requests for bailouts? I proceed to an analysis, then a proposal.
Note that fossil fuels supply 80% to 90% of the energy used by the global economy, and the most important of these, oil, has already reached its limit. In fact world production of conventional oil went into decline in 2006, as now acknowledge by the International Energy Agency, with only unconventional oil (polar, deep water, tar sands, natural gas liquids, etc.) keeping production on a “bumpy plateau” until permanent decline sets in, most likely by 2015. It is expected that the decline of coal and natural gas will be only a decade to two behind. The peak of “net energy” will be even sooner, as unconventional oil is much more expensive to produce, low grade coal yields much less energy, etc.
Net energy is, of course, the ultimate source of all our wealth. Technology without energy to work with is junk. More precisely, a successful technology consists of a more effective way to utilize a given energy source for human welfare. The first problem is that the technology for fossil fuels is quite mature, so when the production of these fuels decline, then better technology may mitigate the decline, but for the most part we’ll have to “make do with less”. The second problem is that there are no other energy sources that we know will yield a net energy comparable to fossil fuels on the scale we’ve become used to. At one time it was hoped that nuclear fusion would fill this role, and other proposals appear regularly, but so far nothing has panned out.
Certainly the traditional renewables like wind, hydro, and solar, will take up part of the slack, but we would have to use them about two orders of magnitude more efficiently than we were able to in the pre-industrial era. This is a tall order considering that the modern technology for renewables was developed almost entirely from fossil fuel energy. Just look up the amount of energy that goes into constructing a hydro-electric dam or a high tech windmill. Even expanding the US power grid to accommodate the expansion of renewables, though essential, is regarded as such as a major undertaking that attention has shifted to analyzing proposals for a cheaper “smart grid”, despite the risk imposed by increasing complexity when resilience needs to be the order of the day (recall Joseph Tainter’s work on the role of excessive complexity relative to resources in the decline of civilizations).
In fact if you want solid backing for a global currency, you could do no better than by going to the source itself – energy. Actually energy is already the implicit backing for much of the global economy, but without explicit backing, money can easily become unhinged until brought back to reality by financial crashes and the like. So I would propose that a new global currency be backed by audited energy supplies, including reserves and capabilities for future production.
Loans could be made in this currency based on the net energy the resulting investment is expected to produce, interpreting net energy broadly to include long term social and environmental effects, as well as material effects. The global monetary authority would also act as a development bank by means of these loans. This would be critical because, faced with contraction, most private lending would either dry up or come with very onerous provisions. All schemes for “leverage” in this currency by any other entity would be prohibited. Thus as the net energy in the global economy declines, so would the money supply.
As a consequence the currency would maintain its absolute, or energy value, over time, though its value would increase relative to a standard of living that embodies less energy. Normally the easiest way for countries to qualify for loans on a net energy basis would be to shed non-essential expenses as part of the deal, such as war or tax breaks for wealth or luxuries. That is, a net energy calculus would force a more rational response, lessening the hardship.