The Triffin Dilemma Revisited

Lorenzo Bini Smaghi of the Executive Board of the ECB explains the Triffin Dilemma (excerpt):

The Triffin dilemma revisited

The intellectual heritage of Robert Triffin begins with the relevance of his “dilemma” to our days. We still have a situation in which one national currency – the US dollar – serves as the main international currency. It remains at the heart of the international monetary and financial system (or IMS). And we still have a fundamental tension between the currency demands of rapidly growing economies, the domestic policy incentives of reserve issuing/holding countries, and global economic and financial stability: in Triffin’s words, the system remains “highly dependent on individual countries’ decisions”.

This tension – the Triffin dilemma – was linked to the specific modalities of the gold-exchange standard in 1960, when his Gold and the dollar crisis was first published. Today we are in a much more flexible system, where the demand for global liquidity can be more easily accommodated. But even if the mechanics have changed, the dilemma is still valid if we capture its essence and formulate it in broader terms, as I will do in the first part of my comments today. In second place, I will briefly recall how the dilemma came into being and was addressed in Triffin’s times. This will allow me to better identify the main differences and similarities compared with our times, which will lead me to conclude that it is indeed correct to talk about a “Triffin dilemma revisited”. Finally, I will look ahead and ask whether and how it is possible to escape the dilemma today.

My main policy conclusion is that we need a number of incentives for the major reserve issuers and holders so as not to cause negative externalities for other countries, thereby helping to ensure global stability.

One of the reasons behind the current US Dollar paradox is this – countries who issue reserve currencies are subject to demand for safe assets and liquidity. In short, for a currency to be accepted as a reserve currency there needs to be a large, deep, and liquid market for safe assets denominated in that currency, typically government securities (in Malaysia, that would be MGS at the long end and BNM Bills at the short end).

But that implies an inefficiency – countries issuing reserve currencies have heightened demand for their sovereign borrowings, and can thus borrow more cheaply than if the market for their securities were truly efficient. In aggregate, this also means a heightened currency valuation, and a corresponding propensity for higher domestic consumption. Hence the Triffin Dilemma – for broad acceptance, a reserve issuing country has to run either a trade deficit, or face downward pressure on its currency and eventually lose reserve status.

You see there a number of good reasons why China’s Renminbi won’t be a reserve currency anytime soon – the market for safe government assets is too small, too illiquid, and too underdeveloped.

Smaghi’s speech outlines the Triffin Dilemma in modern terms, and suggests that the evolution of the modern international monetary system means that at some level, the Dilemma can be resolved – IF the correct policies are followed. In his narrative, the biggest reason for the continuance of the Triffin Dilemma is due to official flows into the USD – the finger’s pointed squarely at countries accumulating international reserves and largely parking these in USD assets, i.e. Japan, China, Singapore, Malaysia et al.

That’s a fair critique, but ignores the other side of the story, which is the desire for self-insurance among emerging markets against sudden stop reversals of capital flows, a consequence of free capital mobility. Smaghi suggests moving towards a multipolar reserve currency system, but he’s sceptical about the propects. So am I.