Objections Do Not Invalidate Substitution Account Benefits

Letter to the editor in the Financial Times in response to letter
by International Monetary Fund (IMF) historian James M. Boughton

December 28, 2007

I was delighted that the eminent International Monetary Fund (IMF) historian James Boughton, in his letter of December 14, 2007, viewed my proposal for a substitution account ("How to Solve the Problem of the Dollar," Financial Times, December 11, 2007) as "an excellent idea" that "could be part of the solution" to the present dilemma whereby many official institutions desire to diversify out of dollars but no other currencies want to receive the corresponding inflows.

Dr. Boughton raises two important questions about the idea. He argues that "someone has to absorb the exchange risk that the central banks are shedding" but this is in fact not essential. The special drawing rights (SDR) claims of depositors would mainly be used, if at all, via transfers to other account members. Even if the deposited dollars depreciated further, it is inconceivable that the account would be unable to meet legitimate requests for residual redemption. The only possible contingency requiring such "backing" is liquidation of the account, an even more remote prospect. In any event, Dr. Boughton's own definitive history of the Fund reminds us that a substitution account, if it had been set up in 1980 when previously considered, would have made huge profits for its first five years that would have kept it whole for at least two decades.

If the IMF membership nevertheless insisted on "backing," the IMF's gold hoard of over $80 billion provides a ready resource. The objective of a substitution account is to preserve stability for the international monetary system by avoiding disruptive currency gyrations and major new misalignments. Hence it is perfectly appropriate to use a systemic asset, such as Fund gold, to support the arrangement. This idea was proposed by IMF Managing Director Jacques de Larosière, and considered seriously, when the account was actively debated in response to the last major period of dollar diversification in 1979-80.

The second key issue is the liquidity of claims on the account. Like SDRs themselves, they would be fully usable to finance external deficits and transferable to all participants in the scheme, a number of other approved holders, and back to the account itself. The absence of a private SDR market that would permit instantaneous liquidation is in fact a virtue of the scheme, because it reduces the risk of systemic instability, and irrelevant in any event for the massive dollar holders that would still have huge amounts of fully liquid assets after making deposits at the account. The benefits of diversified currency risk and market interest rates, along with greater systemic stability, would surely outweigh any liquidity disadvantage in the calculations of IMF members as they contemplate creating such an account and participating in it.