Christine Lagarde And The Demand For Dollars

By Simon Johnson
After receiving US support at the critical moment, Christine Lagarde was named Tuesday as the next managing director of the International Monetary Fund.  In campaigning for the job, Ms. Lagarde – the French finance minister – made various promises to emerging markets with regard to improving their relationships with the IMF.  But such promises count for little and the main impact of her appointment will be to encourage countries such as South Korea, Brazil, India, and Russia to back away from the IMF and to further “self-insure” by accumulating larger stockpiles of foreign exchange reserves – the strategy that has been followed by China for most of the past decade.
Seen from an individual country perspective, having large amounts of dollar reserves held by your central bank or in a so-called sovereign wealth fund makes a great deal of sense; this is a rainy day fund in a global economy prone to serious financial floods.  But from the perspective of the global economy, such actions represent a major risk going forward – because it will further push down US interest rates, feed a renewed build up in private sector dollar-denominated debt, and make it even harder to get policymakers focused on a genuine fix to our long-term budget problems.
Ms. Lagarde is a sincere person and will no doubt try to be friendly to her supporters, for example perhaps by creating a new senior management level job at the IMF and making sure this goes to China or another emerging market.  But what the emerging markets really want is more “quota” (the term used for share ownership and therefore votes at the IMF), as well as more seats on the fund’s executive board.  These are not within Ms. Lagarde’s purview to grant – rather the European Union, at the highest political level, would have to agree to give up some of its votes and reduce its voice.
The European Union is overrepresented at the IMF, both in terms of shares and – most egregiously – with 8 or so seats on a board of 24 members (the exact seat count depends on how you score some seats that are shared by Europeans and non-Europeans).  But the EU has just proved to itself and to everyone else that it both cares a great deal about who controls the IMF and that it can continue to assert this control.
To be fair, the control this time was partly about organizing early and unanimous support for Ms. Lagarde – and there was an understandable desire to appoint a woman, given recent events.  But partly EU predominance in this forum continues to be about disorganization among the emerging markets; countries which, despite the widely used collective moniker, do not really see themselves as having convergent interests either now or in the near future.
If you look at these events from the perspective of countries such as South Korea, India, South Africa, Brazil, or Russia, what conclusion would you draw?
Emerging markets cannot rely on the IMF to provide help on generous terms during a crisis – such support looks like it is available to European countries but not to others.  As a result, an appropriately cautious strategy is to hold a great deal of reserves – the only form of unconditional “foreign” support in a serious financial crisis comes from your own hard currency, perhaps in the form of US Treasury securities that can easily be sold in a liquid market.
What else constitute appealing foreign exchange reserves in today’s world?  The euro has some use, but this is limited as long as a serious sovereign debt crisis looms – very few eurozone governments now look to be “risk-free”.  The Swiss franc continues to do well, but this is a relatively small volume of available assets.  The British pound and the Japanese yen have lost a lot of their traditional allure as reserve currencies.
This leaves the US dollar which, despite all our obvious problems, is still the world’s number one reserve currency.  Emerging markets are likely to increasingly follow in the footsteps of China – attempt to run current account surpluses, intervene to prevent their currencies from appreciating (selling local currency and buying dollars), and invest the proceeds in US dollar assets.
If our fiscal and financial house were in order, the resulting inflow of foreign capital would constitute a bonanza – allowing us to invest productively while paying low interest rates.  But given the way our financial system operates and the dysfunctional nature of our budget politics, the availability of this capital will just encourage us further to overborrow, both in the private sector and in the public sector.
An edited version of this column appeared this morning on the NYT’s Economix blog; it is used here with permission.  If you would like to reproduce the entire blog post, please contact the New York Times.