Exploiting Central Bank Reserve Profiles

It's about time our economic leaders started thinking about what reserve currencies are for, and how we can start moving away from the current system and towards something that is a tool for economic stability instead of a thinly-veiled global tax.

My sense of the problem is that we should be basing all countries' reserves on a GNP ratio or something such indicator. That is, that the proportion of each currency held in reserve by any country exactly corresponds to the relative economic strength of the country of that currency.

Of course your first reaction would probably be that such a system would be untenable. That even the evaluation of the "relative economic strength" indicator would be subject to endless debate. True.

But just because something is difficult, does not mean that it should not be done.

Lets imagine a perfect world where the system is already in place. Some central world agency publishes the "reserve profile" at some set period. The Fx markets fluctuate for several days afterwards. National banks take their time and buy and sell currency during a grace period until they reach the required profile.

After the reserve adjustment, country A finds that it's currency is selling for less. In fact, it's because its economy has taken a downturn. Traders react by snapping up stocks and commodities on its exchanges at the slightly lower relative prices. With a little luck, country A's economy improves slightly.

Country C decides it is not going to try to meet the reserve profile. Instead it starts buying up its trading-partners' currencies.

So we can see that a reserve-profile is not the only tool that needs to be created. We also need something that encourages country C to play by the rules.

My second suggestion is that a reserve-profile could be adjusted by one of two means to counteract this situation.

The first mechanism is that the "economic strength" function S_C that returns a currency's proportion of the reserve should be adjusted by some function D_C to indicate that the country has a distorted reserve. That is, that all other countries will act to counter the decision of country C to buy its trading partners currencies by in turn buying C's currency.

The second mechanism is that any given currency "overbought" by C could have its proportion S reduced by the appropriate margin to account for C buying it. That is, other countries could sell more or buy less than usual of C's trading partners' currencies. This mechanism has the advantage of looking a bit more elegant because the total world reserve of any currency would then correspond to its S function.

Some consideration could be taken to making the buying and selling as non-disruptive as possible and to making the correction of "overbuying" or distortions obvious. For example, a world bank could sell its reserves of a given currency to counteract a distortion at which point it buys back the currency from other central banks. Some such "float" mechanism might simplify the process. It could even be taken so far as to say that the central banks only buy their reserve currencies from this bank. This would allow that bank to prevent country C from buying too much.

The definition of the strength function S should not be underestimated as a stabilizing tool. For example the S function could incorporate a component function that might act to stabilize carry-trades when a given national bank has been forced to reduce its rate disproportionately. Likewise, other such "nudging" of ratios could be used to temporarily prop up unstable currencies.

I understand that there are many factors that make such a system difficult to implement. I know that it is simplistic to look at a currency such as the US Dollar as if it was only bound to the economy of the US. However, that currency is closely bound to the politics of the US and it is clearly a matter of sovereignty that our reserves are not independent of those politics.

It is my belief that my suggestion is probably difficult to implement, but could yield a number of tools that central banks could use to stabilize the world economy. The public would likely find it a great deal more palatable than the current reserve system or any proposed by an emerging power. It would let us finally escape the vestiges of the Bretton Woods agreement in a rational and fair manner.

I understand that my idea is not weighted with the strength of years of economic study and experience that a true economist undoubtedly has access to, but I could not in good conscience fail to pass it on considering what I believe its potential for good to be. I hope you will consider it as carefully as I have.