‘Talk of scrapping the euro or of countries leaving the euro is far-fetched’

Nobel Prize winning economist Robert Mundell, who has done pioneering work in monetary dynamics and optimum currency areas, is frequently referred to as the “father of the euro”. Today, when that currency is in crisis, arising from solvency questions surrounding peripheral eurozone countries, the sins of the son are visiting upon the father. Yet, Mundell, who was in Hong Kong recently for the Asian Financial Forum meeting, maintains that all the hysterical talk of scrapping the euro or of countries leaving the monetary union is “far-fetched”. He also outlines his vision for a new global currency mechanism, which would be anchored around the US, the euro and perhaps even gold. DNA Money caught up with his prescriptions. Excerpts:

How real is the risk of a disorderly unravelling of the euro arrangement?
All this talk of scrapping the euro or of countries leaving the euro is a bit far-fetched. No country would gain from leaving the euro.

Let’s say even if one country decided to leave the euro, the assets that people hold are still in euros. Suppose the exiting country devalued its currency by 100%: that would mean that its debts would be double the amount in the local currency, and there would be no gain from that. You can’t devalue the euro itself: the only way to do that is for the head of the European central bank to
engage in inflation, but the Treaty doesn’t allow that: price stability has to be the dominant characteristic. That’s a bit different from the American system, which doesn’t specify inflation targeting.

Although it specifies price stability, it also deals with economic stability and monetary stability - and even unemployment. That gives the Fed a little bit more flexibility. It doesn’t have to rigidly
restrict itself to price stability.

But wouldn’t insolvency in any one eurozone country require it to exit to work its way out?
I think not. Every country that does it going to be worse off and feel it’s going to be worse off. So I don’t think they will do it; and there’s no mechanism by which they can be forced to do it. The question is: could one of them become bankrupt and insolvent. This would be a scenario: if bad news comes from one country and the interest rate in that country goes up to a level that would make it absolutely impossible for the government, they would be at the mercy of their allies. I can’t imagine their allies not helping; if they didn’t help them, the government would declare bankruptcy. Let’s suppose there’s no way of making it a partial bankruptcy: all holders of government bonds are cut off.  It’s not impossible that something like that could happen. Have we had anything like that before in a monetary union? We did - in the US! The US formed a monetary union in 1792. In the 1840s, there was a big crisis in the US and a large number of railway bonds issued by the state governments — particularly in the MidWest, where they’d borrowed money from English and French lenders — were in default. At that time, it used to be said that it wasn’t safe for an American to walk down the streets of London at night!

Again, in 1975, New York State was verging on bankruptcy. It asked the federal government for help, but was refused. But it was given very niggardly help: one short-term note for $1 billion… The responsibility for debts was left in the hands of the states. But the big problem in Europe is that… if any one country defaulted, it would immediately affect other countries. So I don’t think it would happen.

Do you share the assessment that policymakers in Europe are treating the crisis as a liquidity issue rather than a solvency issue? What are the risks of such an approach?
I think they are treating it as a solvency issue. But people have a short memory. You never hear the words ‘sub-prime mortgage crisis’ anymore. We had that crisis in 2007, and it came to a head in August 2008. Suddenly everybody realised they had bad assets on their balance sheets, and needed liquidity to cover their tracks and remain solvent. The European Central Bank recognised the crisis and said it would lend an unlimited amount at 4%. It created 94.5 billion euros ($135 billion) in one day — the most by a central bank on one day at any time — and the other central banks came on board later. Overall, they generated $300 billion of liquidity and averted that crisis. That was a liquidity problem, and they solved it as such.

The rest of it was for each of the central banks that were in this position to work out their own solvency problems — just as Japan has over the last 20 years work out its solvency problems. It’s a slow process. The first impact was the recognition of this weakness of the European situation and the big effects in the markets. Liquidity was the first impact that had to be addressed.

And then address the solvency problem; that requires making adjustments in the economy. First of all, stop deficits and gradually get growth going and work to a position where you can cover debt-GDP ratios.

The question is are the countries insolvent and can they solve the problem. If you believe they are solvent, there’s no need for any restructuring that involves a cut-down in the debt; there might be a lengthening of the debt, but no hair-cut. I think most people think there’s going to have to be a hair-cut; there are some elements of insolvency. They really have to do something to make sure that the back-up doesn’t allow relaxation in the countries.

Will Chinese and Japanese purchase of eurobonds prove a game-changer?
China and Japan have both said they’ll take up a good part of the eurobonds being issued. Japan has said it will take up as many assets as it has in euro and shift it; for Japan, holding eurobonds will be much better than holding national bonds of individual countries. That’s a good idea and definitely a movement in the right direction.

Right now, it’s all very complicated: all the 17 countries in the eurozone have their own national debts, and anyone who wants to hold eurobonds has to get a whole collection of them. It’s a waste
of time, and amalgamating them is a good idea. I don’t think it will have any impact on the balance of payments or on the debts, but it is a step in the right direction.

Given what we know of risks of monetary unions, should we be glad that the idea of an Asian monetary union was a non-starter?
I don’t see a monetary union coming in Asia, at least in the near future. It’s like having a monetary union (as in Europe) without any of the political unity of purpose. Take Japan and China: their problems haven’t been solved.

The whole movement towards an European Union and a monetary union was backed up by a little-understood fact: monetary union in Europe is made incomparably easy by the existence of the North Atlantic Treaty Organisation (NATO) defence pact of Europe and America. The basic purpose of the pact was defence against invasion from the Soviet Union, but a secondary,
incidental and yet fundamental purpose was to increase the confidence inside Europe that there would never be any Franco-German split. You don’t have that in Asia. You’re quite a long way from something like that between, say, Japan and China. If you could have an equivalent to the Schuman Plan, the idea that took wing in 1950, you could perhaps have one; but there’s no NATO equivalent in Asia, there’s no settlement mechanism.

Federal Reserve Board chairman Ben Bernanke said last year that the international monetary system was flawed, and ahead of his recent US visit, Chinese President Hu Jintao too said that the dollar-based world order was a relic of the past. What kind of a new arrangement do you foresee?
The major proposal I have for international monetary reform relates to exchange rates: the biggest barrier to an improvement is the split in the mainstream of the world economy between the dollar and the euro. If you could stabilise the dollar-euro rate and have a coordinated monetary policy of those two areas, you could have a euro-dollar currency that would be much better than the
dollar by itself. That would be a great thing for the world economy, because it would be a solid anchor.

If you designate the dollar area and the euro area as an anchor for a global currency, and perhaps even add gold reserves to that currency, and then have the IMF have all the countries of the IMF use that currency for the time being, it would be good for everyone. But I’m not optimistic that the US would go along with it. It has a lot of learning to do to get back up to scratch again.

You’ve argued in favour of introducing the Chinese currency, the renminbi, to become part of the International Monetary Fund’s currency unit, the Special Drawing Rights (SDR). But the renminbi isn’t convertible…
The SDR is made up of US dollars (44%) and euros (34 %); the other two currencies — the British sterling and the Japanese yen — account for 11% each in the SDR basket. That basket is reviewed every five years, and last year the IMF only tweaked the basket composition holdings by a fraction. I think this was a mistake. I had recommended earlier that the renminbi be introduced into the SDR. The main criterion for inclusion of a currency in the basket is the underlying economy’s share of world exports — and China’s is the largest: to keep it out was a mistake.
China also has the largest reserves in the world.

The argument for keeping it out was that it’s not convertible. This certainly has some bearing, but it’s not a legal requirement. When the SDR was created, it was a gold-backed currency, but in 1974, when it became a currency basket, it had 16 currencies, several of which were inconvertible. There’s no barrier in principle or law to the inclusion of the renminbi. The IMF should have done it last year, particularly because the renminbi, while it is inconvertible, is the only inconvertible currency ever to have been created that’s chronically expected to appreciate. Ordinarily, with inconvertible currencies, countries put exchange controls on them to avoid
depreciation — to beat back speculation against it. China is in a very unique position; it puts the controls on its currency not for the reason that other countries do. It’s a different kind of inconvertibility than Britain had all through the post-War period, and France and most of the other European countries had for most of the Bretton Woods period.

I think the IMF’s mistake will show up increasingly over the next five years. It won’t be until 2016 that there will be a new SDR. They missed an opportunity to improve the system. It wouldn’t have been a big improvement, but it would have been a step in the right direction.

My suggestion was not to make the renminbi a large part of the SDR basket: it has to be done in a systematic way. My suggestion was to make a small introduction, and later in 2016 it could be raised up to match its role. I had proposed that the dollar and the euro together would, between them, account for 70% of the SDR basket; and that three other currencies — the sterling pound, the yen and the renminbi — could each have 10% share. That would have been an entry for the renminbi that we could have built on and made the SDR a more productive asset.

China is under pressure to allow the renminbi to appreciate sharply. Should it?
I believe the best policy for China is to keep the renminbi fixed to the dollar; I’ve had that view for a long time. I don’t think it would do a great deal of damage if you had an appreciation of the kind that took place from 2005 to 2008, which is about 3 to 5% a year. But there is a danger to that too. If you have a currency that’s expected to appreciate by 3-5% a year, you’re creating a rate of return on the cash renminbi that makes it more valuable all the time relative to other currencies: it makes it an asset in itself. This is particularly true when the rate of return on Treasury bills is very low in Japan and other countries in the euro area and the dollar area. If hot money comes into China and it has access to the 4 or 5% interest rate that exists on those assets, coupled with that appreciation, it’s a tremendous attraction to flood capital into China and aggravate the imbalance. So I think this is a bad policy.

When is the earliest the renminbi could become fully convertible?
I used to be asked that a lot in China in the 1990s, and I would say: I’m against rushing it, but perhaps by the time of the 2008 Olympics (laughs). Well, the Olympics have come and gone, and now I’m again asked when is an appropriate time. Chinese convertibility is certain to come because it’s so useful: if the government wants to make Shanghai an international financial centre, it would have to have a convertible currency.

What would be the impact of that?
You’d have immediately an increase in demand for foreign currency; people in all countries always like to have some part of their assets outside their country. In China, part of those assets would go out, but some assets would also come in; there would be a balance of payments in the short run, and perhaps a small deficit in China. Some reserves would come out of the central bank’s holdings of $2.8 trillion; they might go down by a few hundred billion.

Whenever countries move towards convertibility, the first thing that people wonder is: will it work, and how long will it last. When Britain established convertibility in 1947, under pressure from the Americans, they lost the entire $3 billion they’d borrowed from the Americans, and so they closed up their capital account again. With that experience, people would say, we’re not sure this is going to last, so let’s convert some of our assets into a foreign currency while we can. If there were a free market in China, I think there would be a temporary deficit, maybe the renminbi might even go down instead of up; but it will come back up again, and there wouldn’t necessarily be any change in the value of the renminbi over the long run.

Instead of holding its foreign exchange reserve in US dollars, could China accumulate gold?
If China’s central bank can buy gold at very good prices, they should buy as much as they can. But I don’t know that I would recommend that they buy at the current price. Just two and a half years ago, the gold price at the end of the dollar tightening period was $720 (an ounce), but it has almost doubled since then. I don think that’s sustainable — unless we get a big outbreak in monetary inflation. But there’s no inflation one can see in the US.

There’s 2% inflation in the eurozone, and the European Central Bank is tracking it already. I don’t inflation is a problem for now.
But China, which has built up close to $3 trillion in reserves, still appears to have confidence in US dollars. Perhaps they now think eurobonds are better, but Europe is in a bad shape too.

How can the US work its way out of its structural problems?
True, the US is in bad shape. It has a big current account deficit — about $700 billion - and is trying to cut that down. But that’s historically been the magic wand that’s been keeping the world economy going. The great period of growth from 2002 to 2007 was built on US deficit, which provided the liquidity. If the US now cannot continue to do that, it starts to hurt the world economy too if the world cannot find an alternative.

The US economy is also hampered by the fact that it has become a service economy and has lost much of its manufacturing strengths. Growth recovery is historically driven by manufacturing but that’s precluded by competition from China. The rise of China is the biggest thing to happen in the world economy in the past decade; it’s a China shock. Both the US and Europe are affected as China is building up a GDP apparatus of continental proportions. Nothing looks like stopping it — not that anyone wants to stop it, since it’s a good thing that impacts the well-being of a fifth of world population.

It’s not just China: it’s happening in India too. These are the big stars of the world that is emerging. But I’m not so pessimistic about the US. When problems come, the US finds a way to reinvent itself and collect itself.

My recommendation to the Obama administration would be to cut corporate tax in the US from 35% to 20%. Given the competition from around the world, and particularly Asia, it’s too high, and corporates have to become healthy.

The world economy also needs some equivalent to the US deficit, and perhaps China could take the lead by turning its surpluses into deficits, which would then provide the renminbi as a reserve currency that would feed the world. I don’t think we’re going to see that in the next five years. Perhaps when China’s economy reaches the size of the US economy, by 2030 or so…