The US received a number of advantages in being the world’s reserve currency, especially in the years following the breakdown of the Bretton Woods system – the continuing demand for dollars for international trade lowered the US cost of financing and allowed it to run larger trade and financial deficits than those possible for other economies.

However, such a system encourages economies to run too-large deficits, leaving inflation as the only escape. The current situation is unsustainable – it has not been effective in dealing with the past few years of global economic instability; the US has a large deficit that it may need to inflate its way out of; and emerging export economies have been encouraged to continually undervalue their currencies against the USD to make their exports more attractive, and now do not believe they could succeed if they allowed their currencies to appreciate naturally.

So what would a more stable currency system look like?

Restoring the gold standard is impractical – a pure gold standard tends to be deflationary, while a not-so-pure gold standard based on derivatives could be manipulated like the current currency system.

A global currency is another possibility, and was suggested by John Maynard Keynes. However, current problems with the eurozone highlight how unrealistic it is to have a single currency representing relatively independent economies, with widely varying industries and political systems To be successful, a common currency would require a loss of sovereign power to a certain degree, with one agency overseeing trade policy, including limiting surpluses and monetary policy to avoid inflationary temptations.

Another alternative was suggested in early 2011 when the International Monetary Fund issued a report on Special Drawing Rights (SDR) as a replacement of the USD as the world’s reserve currency.

SDRs were created in 1969 as a more limited global currency. Representing potential claims on the currencies of IMF members, they can be converted into a required currency at exchange rates based on a weighted basket of international currencies. When the IMF issues funds to economies, they are typically dominated in SDRs, the largest such issue being the equivalent of USD250 billion in April 2009 in response to the private-lending collapse in the financial crisis.

While they are not a tangible currency, some argue that they could be a less-volatile alternative to the USD.

Increasing the global role of SDRs and issuing more SDRs would reduce the current problem of recessionary bias – during and after financial crises, the burden of adjusting to payments imbalances falls on nations running deficits, the US in particular – by allowing central banks to exchange the SDRs for hard currency, rather than exchanging dollars. This would also reduce the need for countries to accumulate reserves, facilitating a reduction in the global imbalances that result from countries stockpiling USDs. And, the smaller scale of SDRs would help sustain the recovery of the global economy without leading to inflation. That being said, the final point is dependent on the IMF members limiting the introduction of SDRs into the market over the next few years.

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