Is the concept of a reference (or reserve) currency fit for the scrapyard?
It looks like the UN thinks it is. In a report published at the end of June 2010 (“ World Economic and Social Survey 2010 – Retooling Global Development ” published by the Department of Economic and Social Affair) the UN calls for abandoning the US Dollar as a reserve currency because it has been unable to safeguard value.
The question to ask here is, would any other currency do a better job ?
International trade needs long term stability in its frame of reference. Any currency would eventually fluctuate (even the Yuan had to abandon a strict peg to the US Dollar). So the problem is not with a specific currency, the problem is with the idea of using a reference currency.
So far so good. Things start to get worse when the Special Drawing Rights is suggested. The report basically paints a scenario where the SDR is used as an actual currency. This would not necessarily safeguard value because the composition of the basket that defines the value of the SDR is politically rather than financial (or market) driven and the mechanism of establishing the weights of the basket is not completely transparent. In other words, it could be argued that moving towards the SDR as reference ‘tool’ to define value of international trades would not be dissimilar to having a currency called UN Dollar (Or UN Dinar, or UN Yuan or UN whatever you like).
Using a basket of currencies reduces the consequence of volatility but in the long run the definition of the basket needs to be transparent and the value of the basket needs to be periodically reassessed. Value is by its very nature volatile, you cannot ‘abolish’ volatility but you can manage it – or even better – reduce it.
In a white paper I recently wrote for the WDX Organisation (WOCU: the currency shock absorber) I showed how using a basket of currencies called WOCU reduces the effect of currency fluctuation by reducing volatility and therefore safeguarding value for both parties in a trade. The WOCU is transparent (its valued is determined by an algorithm based on the currencies that are legal tender in the top 20 jurisdictions by GDP), it is reassessed twice a year (and in the past 10 years the composition of the basket has changed in nature and in weight) and the reassessment is completely transparent and free from political interference (in so far as a government cannot cheat on the published GDP data).
The WOCU allows each party in a trade to fluctuate independently from the other one, it could be compared to the self-adjusting hub in a wheel axle where each wheel has an independent shock absorber. The rigidity of the SDR will make it more prone to ‘crack’ under severe shock.
One of the other points of the WOCU is that it is not a currency that can be bought or sold; it is a reference unit which is introduced without any contribution from central banks, government, etc. In a way it might work globally like the ECU did in Europe before it was replaced by the EURO in 1999. A ECU based banking facility meant an account (or a loan) where the value is defined in ECU but each operation used to take place in the local currency with the value fluctuating depending on the exchange rate of the day. So, for instance, a mortgage in ECU had its repayments determined in ECU but the borrower had to pay back Deutsche Marks (or Guilders, Lira, etc.) depending on the value of the Mark against the EURO on that particular day.
So why would this safeguard value better than any reference currency or the SDR ?
In the current system, prices of commodities reflect both the fundamentals of the specific commodity (supply/demand, geopolitical and environmental factors that may affect either the supply or the demand) and the strength/weakness of the reference currency (mostly the dollar), if the reference currency is replaced by a basket of currency (i.e. a reference unit the value of which is determined by a basket of currency) , then the value is kept more stable because there is only a very small probability that all the currencies in the basket move in the same direction (and if that happens the currency of the commodity producing country would follow anyway).
More specifically, why not the SDR ? The SDR is not transparent, politically determined (and therefore politics can interfere with it) and it is readjusted every five years and that does not make it flexible enough and therefore unable to cope with short term ‘jolts’ in the global economy. Transparency is a much bigger issue, the composition of the SDR has not changed in thirty years (the Euro replacing the Deutsche Mark and the French Franc is not really a change) in spite of changes in the world ranking of the major economies. In ten years of life of the WOCU idea the composition of the basket has changed considerably, with country leaving it (e.g. Taiwan and Argentina) , others joining (Indonesia) and countries leaving it and then coming back again (Switzerland), and the weight is readjusted. These changes are achieved through a transparent process of revision that takes place around mid-May and mid-November. This flexibility allows the WOCU to cope with short terms abnormalities (e.g. a very serious natural disaster affecting the economic viability of one of the top 20 economies) and changes in the world economic outlook (with the consequent change in the ranking of the top 20).
[For further information about the WOCU www.wocu.com. The author is a member of the WDX institute, has written the Wocu white paper mentioned in the article but has no permanent commercial affiliation with WDX Organisations Ltd, the entity that is currently promoting the commercial use of the WOCU]
