Currencies and the International Order During a Global Power Shift

Gyohten Toyoo [Profile]

[2011.11.30] Read in: 日本語 | 简体字 | 繁體字 | FRANÇAIS | ESPAÑOL |

Since the global financial crisis of 2007, speculation has been rife that the dollar might be toppled from its position as the world’s key currency. Power is shifting to the emerging economies, and particularly from the United States to China. How will this affect the international order, including the international monetary system? Gyohten Toyoo, an expert with a lifetime’s experience in the world of finance, offers his analysis.

When World War II ended in 1945, the United States was the world’s lone superpower, with a 40% share of the global economy. It was only natural that the postwar international economic order was built under American leadership. The pillars of this edifice, which came to be known as the Bretton Woods system, were a gold-dollar standard (an international monetary system under which the US dollar was the key reserve currency, with its value backed by gold), a system of fixed exchange rates, and a short-term lending facility maintained by the International Monetary Fund. For a quarter century after the war, the world economy recovered and developed dramatically under this system.

Over time, however, contradictions became apparent in the American model of growth dependent on household consumption. US consumer goods industries lost their international competitiveness, leaving the country with a ballooning current account deficit and a growing mountain of external obligations. In 1971 the US government cancelled the dollar’s convertibility into gold, and the system of fixed exchange rates was abandoned. Stripped of its two main pillars, the Bretton Woods system collapsed. The United States had chosen to ditch the Bretton Woods system in order to sustain its own growth, rather than sacrifice its growth to maintain the Bretton Woods system. The world entered an age of floating exchange rates in which the dollar continued to serve as the key currency but with its value no longer guaranteed.

But the switch to floating exchange rates failed to resolve the US current account deficit, and the global imbalances continued to grow. Excess international liquidity heightened the volatility of financial markets.

A Global Power Shift

For years, people warned that this state of affairs was unsustainable and that the dollar was in danger of collapse. But the collapse never came. There were two reasons for this. First, as the issuer of the world’s key currency, the United States was able to maintain its growth without worrying about financing its external liabilities. Other countries experiencing export-led growth invested their earnings in US treasury bonds and other dollar-denominated assets. This circular flow of funds allowed the United States to hold its interest rates steady. The world economy was on a perilous but profitable win-win course. As we say in Japan, it was running a “bicycle operation,” staying upright only by maintaining constant forward momentum. The second reason the dollar did not collapse was that the United States continued to maintain its status as the global hegemon in terms of total national power. However big its debts might grow, no other country was in a position to challenge American supremacy. Nor was there any other currency capable of replacing the dollar in its key international role. Despite all the talk about the riskiness of the dollar, therefore, the markets did not abandon it.

Today there is a growing sense that the basic conditions that have been accepted up to now have been irrevocably altered since the global financial crisis broke out in 2007. It is this concern that underlies all the recent speculation that the dollar might be in danger of losing its position as the world’s key currency. People are sensing a coming shift in the global balance of power—the first such shift since the end of World War II.

The idea is that the center of gravity of the global economy is shifting from the established first-world countries to the newly emerging economies—or, more simply, from the United States to China. This shift began in the real economy, in the fields of production, consumption, trade, and investment. This phase is already complete. The next stage, which is currently underway, involves a power shift in the “soft” fields of the economy, such as technology, management, and finance. If this shift continues, it will probably extend to the core elements of hegemony—military affairs, diplomacy, and culture. China itself is keenly aware that this stage may be approaching. Essentially, a power shift of this kind is a natural development in the course of economic development history. But why is this particular shift taking place at this particular juncture in the twenty-first century? The reasons are to be found in both the United States and China.

The US economy has depended too heavily on household consumption and the financial sector. It has continued to run current account deficits that have left it with the world’s biggest accumulation of external debt. This has undeniably led to increasing worries about the dollar. To be sure, the crisis that started in 2007 is not a dollar crisis but a financial crisis. It is important to remember that the current crisis has actually increased awareness of the dollar’s importance as the main source of international liquidity. But the crisis has also highlighted several weaknesses in the US economy, leading to an erosion of confidence in the dollar as an international store of value.

China’s Challenge to US Hegemony

The decline of the United States is not restricted to the economy. “Imperial overreach” brought about by excessive interventions in Iraq and Afghanistan has not only created a heavy economic and military burden but has also damaged America’s international prestige as a leader.

China, meanwhile, underwent a major transformation under Deng Xiaoping, who took the helm in the wake of the turmoil caused by Mao Zedong’s Great Leap Forward and Cultural Revolution. Essentially Deng’s reform and liberalization policies represented the abandonment of communism as a moral ideology. Deng’s genius as a leader lay in his decision to free the masses to pursue their material and monetary desires while maintaining the dictatorship of the Communist Party of China. The Tiananmen Incident was the first major challenge to this new policy. Deng rode out the crisis by crushing the protests ruthlessly. China’s development since then has been a history of success for Deng’s policies. With capable leaders and the tremendous energies of 1.3 billion people unleashed to pursue their ambitions, China has followed a single-minded course of “enriching the country and strengthening the military” (the policy pursued by Japan’s Meiji-era leaders in the latter part of the nineteenth century). Sixty years after the establishment of the People’s Republic, it became the world’s second-largest economy.

This power shift will have a major impact on the international order in the years to come, including on the international monetary system. In the decades after World War II, the world accepted the United States as the hegemon. The Soviet Union never officially set forth the ambition of replacing the United States in this role as a national objective. Given the balance of strength between the two superpowers, a power shift of this kind was never a realistic prospect in any case. In due course Japan and West Germany emerged as economic dynamos, while Europe as a whole rose in stature beginning in the 1990s as the result of ever wider and deeper integration. But none of these actors were real challengers for the top leadership spot, either objectively or subjectively. A hegemon must hold a major lead in six types of power: economic, military, diplomatic, technological, cultural, and ideological. For much of the twentieth century and into the twenty-first, no other country demonstrated the will to displace the dominance of the United States in these fields.

Today the situation is different. China clearly has ambitions to challenge the United States; indeed, it is marshaling much of its national effort to this end. One of the striking things about China’s posture is its absolute conviction that the United States will decline and China will rise. For China, this is a historical inevitability—and time is on China’s side. China is prepared to wait patiently for the fruit to fall when the time is ripe, and the United States finds itself in difficult straits. America’s difficulties since 2007 have reinforced (probably excessively so) the certainty the Chinese feel about their own country’s rise.

China’s Approach to the International Monetary System

China maintains a realistic policy on the international monetary system. For China, challenging the unilateral dominance of the United States is a major national objective. This naturally includes challenging its dominant position in the international monetary system. In recent years the Chinese have been increasingly critical of the dollar’s role as the key currency. China cannot accept the status quo, under which a public good like the supply of international liquidity is subject to the arbitrary control of the key currency issuer and driven by the domestic policy considerations of the United States. China argues that the key international currency should be one whose supply can be adjusted on the basis of internationally equitable judgments and that can help encourage moderation in individual countries—a currency like the IMF’s Special Drawing Rights. This is not a new argument. It correctly identifies several of the problems with the current system. But these problems are structurally inherent to any system that uses the domestic currency of one country as the international standard. The world has been trying to find a solution to this issue for the past 40 years, but there is still no answer in sight. The Chinese are fully aware of this reality, and understand that the dollar is likely to continue as the key currency for the foreseeable future.

China’s policy toward the international monetary system seems to be based on three pillars. The first is to maximize its own benefits under the current setup, on the assumption that it will remain in place for several more decades. Specifically, this means maintaining rapid export- and investment-led growth as long as possible, while keeping the yuan fully under control. If intervention in foreign exchange markets causes China’s currency reserves to build up, so be it. As the Chinese see it, the dollar may depreciate, but it will not collapse. This means that dollar-denominated investments are strategic assets rather than risks. The second is to gradually turn the yuan into an international currency. This entails expanding its use for settlement of transactions with other countries, starting with those in the region, and increasing the issuance of yuan-denominated bonds. It will involve efforts to bring about exchange rate flexibility, liberalization of capital transactions, and convertibility over the course of about a decade. The third pillar is to develop Shanghai as a yuan-focused international financial hub comparable to New York and London.

China has become much more prominent internationally since the global financial crisis. But it faces a major risk. To avert the effects of the crisis, the authorities orchestrated more than 4 trillion yuan in investment and lending by the government, state-owned enterprises, and government-owned banks. This move was successful in keeping the economy growing, but it was a backward step in terms of reforms to create an economy led by the private sector. China’s bloated public sector has given rise to numerous special interest groups and has become a hotbed for corruption. This has exacerbated China’s economic disparities. Public frustration is mounting. China became an economic superpower by setting ideology aside in favor of development. But now, with a change of leadership imminent next year, China has reached the stage where it once more needs to find a new moral ideology.

The Demands of a Multipolar World

China is not the only country that needs to review its development model. The advanced countries of the West, whose economies were previously fuelled by a new growth paradigm based on globalization and financial capitalism, now find themselves caught up in a financial crisis caused by precisely these two factors. The frustration of the young participants in the Occupy Wall Street protests against the inequalities produced by this new growth paradigm is a twenty-first-century phenomenon with global resonance.

How should Japan conduct itself in this twenty-first-century context? The mistakes and indecisiveness of the past two decades have cost our country dearly. The situation is not easy. Several tasks need to be addressed if Japan is to maintain its high standard of living and maintain its status as a respected presence on the international scene. First of all, Japan needs to come up with a clear roadmap for dealing with two pressing long-term issues—addressing the demographic problem and putting public finances back on an even keel. Having done that, Japan must display the national will to maintain its position among the world’s top five in terms of total strength, consisting of the six types of power noted above: economic, military, diplomatic, technological, cultural, and ideological. Ideas are one area where Japan might be able to make a valuable contribution at the current juncture, with many countries experiencing confusion about their value systems. If Japan can tap its history and experience to create a logically coherent set of ideas, it may be able to earn global sympathy and trust by sharing these ideas with the world.

The twenty-first century is unlikely to see a shift from unipolar domination by the United States to unipolar domination by China. Instead, the world is likely to become multipolar, with the United States as the central power. In this context, the ability to build consensus through negotiations will be vital. In negotiations of any kind, whether about currency, trade, security, or territory, the decisive factor is how many cards you hold, and what they are worth. In previous international talks, Japan has not done enough to strengthen its hand. In the past, our focus has been almost exclusively on dealing with the United States. In order to survive in a multipolar world, our country must display greater cunning as a negotiator.

(Originally written in Japanese.)

  • [2011.11.30]

President of the Institute for International Monetary Affairs. Born in 1931. Graduated from the University of Tokyo, where he majored in economics. Joined the Ministry of Finance and served in various posts, including vice-minister of finance for international affairs. Has been a visiting professor at Harvard Business School, Princeton University, and the University of St. Gallen. Served as chairman of the Bank of Tokyo from 1992 to 1996. His works include Changing Fortunes: The World’s Money and the Threat to American Leadership, written with Paul Volcker, former chairman of the Federal Reserve Board.

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