[OPE-L] Call in the reserves By Harold James

From: Rakesh Bhandari (bhandari@BERKELEY.EDU)
Date: Wed Dec 15 2004 - 18:42:50 EST

  Very strained argument that dollar depreciation may lead to new
forms of state socialism. rb

Published on TaipeiTimes

Call in the reserves
Large holders of US dollar reserves, such as China and Japan, can
learn a historical lesson from the nasty fate of big holders of
British sterling in the 1920s

By Harold James

Monday, Dec 13, 2004,Page 9

Advertising  The People's Bank of China and the Bank of Japan -- as
well as other central banks in Asia -- are in trouble. They have
accumulated vast foreign exchange reserves, estimated at more than
US$2 trillion. The problem is that almost all of it is in US dollars
-- a currency that is rapidly losing its value.

All policy options for Asia's central banks appear equally
unattractive. If they do nothing and simply hold onto the dollars,
their losses will only increase. But if they buy more, in an attempt
to prop up the dollar, they will only have a bigger version of the
same problem. If, on the contrary, they try to diversify into other
currencies, they will drive down the dollar faster and create greater
losses. They are also likely to encounter the same sort of problem
with other possible reserve currencies.

The euro has been touted as the replacement for or alternative to the
dollar. Some enthusiastic Europeans encouraged Asians to diversify
their reserve holdings. But the same scenario might well be repeated
with the euro in a few years. Large fiscal deficits and slow growth
might convince foreign exchange markets that there is little future
in the euro, fueling a wave of selling -- and hence losses for
central bank holders.

There is a historical parallel to today's concern about the world's
major reserve currency. The interwar economy, shattered by the Great
Depression of the early 1930s, offers a whole series of painful, but
important, lessons for the present.

In the 1920s, the world economy was reconstructed around a fixed
exchange rate regime in which many countries held their reserves not
in gold (as was the practice before World War II) but in foreign
exchange, especially in British sterling. During the course of the
1920s, some of the official holders of pounds grew nervous about
Britain's weak foreign trade performance, which suggested that, like
today's dollar, the currency was over-valued and would inevitably

`The sterling balances proved to be the starting point of inefficient
state planning regimes that did long-term harm to growth prospects in
all the countries that took this course.'

Foreign central banks asked whether the Bank of England was
contemplating changing its view of the pound's exchange rate. Of
course they were told that there was no intention of abandoning
Britain's link to gold, and that the strong pound represented a deep
and long commitment (in the same way that US Treasury Secretary John
Snow today affirms the idea of a "strong dollar"). Only France
ignored British statements and substantially sold off its sterling

When the inevitable British devaluation came on Sept. 20-21, 1931,
many foreign central banks were badly hit and were blamed for
mismanaging their reserves. Many were stripped of their
responsibilities, and the persons involved were discredited. The
Dutch central banker Gerard Vissering resigned and eventually killed
himself as a result of the destruction wrought on his institution's
balance sheet by the pound's collapse.

Some countries that traded a great deal with Britain, or were in the
orbit of British imperial rule, continued to hold reserves in pounds
after 1931. During World War II, Britain took advantage of this, and
Argentina, Egypt, and India, in particular, built up huge claims on
sterling, although it was an unattractive currency. At the war's end,
they thought of a new way of using their reserves: spend them.

Consequently, these reserves provided the fuel for economic populism.
Large holders of sterling balances -- India, Egypt and Argentina --
all embarked on major nationalizations and a public sector spending
spree: they built railways, dams, steel works. The sterling balances
proved to be the starting point of vast and inefficient state
planning regimes that did long-term harm to growth prospects in all
the countries that took this course.

Could something similar be in store for today's holders of large
reserves? The most explicit call for the use of dollar reserves to
finance a major program of infrastructure modernization has come from
India, which has a similar problem to the one facing China and Japan.
It will be similarly tempting elsewhere.

This temptation needs to be removed before the tempted yield to it.
Reserve holdings represent an outdated concept, and the world should
contemplate some way of making them less central to the operation of
the international financial system.

To be sure, reserves are important to smooth out imbalances in a
fixed exchange rate regime. But the world has moved since the 1970s
in the direction of greater exchange rate flexibility.

Reserves are also clearly important for countries that produce only a
few goods -- especially commodity producers -- and thus face big and
unpredictable swings in world market prices. Dependency on coffee or
cocoa exports requires a build-up of precautionary reserves. But this
does not apply to China, Japan, or India, whose exports are

Today's big surplus countries do not need large reserves. They should
reduce their holdings as quickly as possible, before they do
something really stupid with the accumulated treasure.

Harold James is professor of history at Princeton University and
author of The End of Globalization: Lessons from the Great Depression.

Copyright: Project Syndicate

Copyright  1999-2004 The Taipei Times. All rights reserved.

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