This post is part of a symposium on inflation. Read the rest of the symposium here.
When Milton Friedman suggested that inflation was always and everywhere a monetary phenomenon—the result of too much money chasing too few goods—he was wrong thrice over. It is only sometimes a monetary phenomenon. And only in some places. And when it is a monetary phenomenon, it is not because too much money chases too few goods. The reality is much more complicated, more interesting, and more dependent on global power relations. In this post, we focus on the ways in which inflation affects countries differently depending on how their currencies are situated in the global monetary order. Crucially, the underlying dynamics of the international monetary system render the global periphery inherently more vulnerable to monetary-driven inflationary pressures.
The closer one gets to the periphery of global capitalism, the more likely inflation is to be a product of monetary power. To explain why this is so, we first need to unpack the concept of monetary power. A state’s monetary power is determined by the interaction between two components: the degree of monetary sovereignty it possesses, and the place occupied by its currency in the global hierarchy of money.
Monetary sovereignty comprises the multiple legal prerogatives of the state, such as the creation of money through the issuance of currency; the regulation of how currency is used within its territory; and the operation of exchange rate, monetary, fiscal, and current or capital account policies. Even though public international law tends to conceive sovereignty as an absolute power, it is more useful to conceive it as a spectrum that reflects the various degrees to which states can effectively exercise the aforementioned sovereign rights over money and finance. The greater the ability of a state and its citizens to settle their financial obligations in that state’s own currency, the closer to full monetary sovereignty the state will be situated on the spectrum.
Currency hierarchy refers to the degree to which a national currency performs the functions of money at an international level—that is, to act as a unit of account, as a medium of exchange, and as a store of value in cross-border transactions (in the later sense, as a de facto international reserve currency). Money that can function as an international reserve currency is highly sought after because it provides security in the face of economic uncertainty. The international monetary system comprises a wide range of domestic currencies with asymmetric powers to function as international money.
At the summit of the hierarchy lies the US dollar, which is the most widely accepted currency for a great variety of cross-border transactions and is treated as the safest of assets by international financial actors in a range of markets and products. Thus, in 2021, the dollar comprised 60% of globally disclosed official foreign reserves, and the Federal Reserve estimated that roughly half of total US dollar banknotes outstanding are held by foreign investors.
In the next tier sit other core currencies, such as the euro, the pound sterling, the Swiss franc, the Canadian dollar, and the Australian dollar. These currencies—while not used to anywhere near the same extent as the US dollar—still possess a significant degree of acceptance for international exchange. And, at the ‘subordinate’ end of the hierarchy lie peripheral currencies issued by developing and emerging economies. Such currencies do not perform the classical functions of money at an international level and, therefore, are only internationally demanded as financial assets. Rather than being used to pay for goods and services or to settle debts, these currencies are predominantly vehicles for short term investment or speculation in either commodities or stocks and bonds of companies.
These two components of monetary power are distinct and yet intimately related. A currency’s position in the global hierarchy is not the sole determinant of a state’s economic autonomy, but the status of national currency does make a significant contribution to the degree of monetary sovereignty that states enjoy. Demand for a countries’ currency shapes how countries attract long-term outside investment, pay for goods and services, and raise revenue for government expenditure. A significant proportion of global GDP is produced in countries whose currencies are pegged to or closely follow the US dollar. As a result, states with subordinate currencies must accept US dollars in most international transactions and will therefore experience increased monetary volatilities and constraints on macroeconomic autonomy.
Vulnerability to Inflation
There are several reasons why monetary power—or, more precisely, a lack thereof—is a structural determinant of inflation. First, the more monetarily subordinate a state is, the more vulnerable it will be to inflationary pressures caused by fluctuations in the foreign exchange rate. The price of key supplies, commodities, and services is typically pegged to (although not necessary quoted domestically in) the top currency in the international monetary system (that is, it is ‘dollarized’). International commerce is (almost) never conducted in a currency near the bottom of the hierarchy, and this leaves countries at the periphery at the mercy of the monetary policies of those higher in the monetary hierarchy. As prices increase in US dollars, the value of peripheral currencies depreciates. This depreciation of the domestic currency reduces the purchasing power of peripheral currency states and their residents over key goods and services, as well as their ability to pay down debt denominated in foreign currencies. This raises the spectre of a currency mismatch, namely a deterioration in the balance sheet of debtor nations and companies caused by the exchange rate of their domestic currency (or the currency in which they obtain high proportions of revenues) falling in comparison to the currency in which their financial obligations are denominated. This may, in turn, lead to inflationary pressures, as a higher portion of domestic output will be required to purchase the same good or service in foreign currency. In fact, many developing and emerging economies are currently experiencing an inflationary process caused by supply chain and food price increases in US dollars.
Additionally, currency hierarchy may impose inflationary pressures onto the monetary periphery due to global liquidity cycles. When a credit cycle begins to turn downward, peripheral currency states are more vulnerable to rapid withdrawals from contracts denominated in their currency, particularly financial contracts. The result of such outflows is significant and sudden currency depreciations, which may create price instability in the peripheral currency country. To offset this trend of volatility, central banks in emerging countries have been holding more reserves, intervening in the foreign exchange market, or adjusting short-term interest rates. Thus, the need to implement such anti-inflationary policies intensifies the dependence on foreign currencies and is a significant constraint on macroeconomic policy autonomy.
Finally, these underlying vulnerabilities are intensified by the present techniques used to manage global liquidity cycles. Ultimately, when the credit cycle turns downward, the most powerful central banks predominantly backstop currencies higher in the monetary hierarchy. The US dollar’s key role in the global financial system places the US Federal Reserve as the world’s top central bank. In the current system, these backstops generally take the form of currency swaps that make US dollars readily available—swaps that have only been available to the United Kingdom, the Eurozone, Switzerland, Japan, and Canada, with limited exceptions during the 2008-9 Global Financial Crisis and the COVID-19 pandemic. The lower-ranking peripheral currencies are not backstopped in this way and are likely to find investors and international users fleeing to the stability of currencies that do have such a backstop when inflation-driven depreciation emerges and intensifies.
Reforming the Core-Periphery Dynamics
So far, we have analysed the global inflationary consequences of the clear hierarchies and asymmetric relations that are embedded within the international monetary system. The example of inflation vividly illustrates how peripheral states with subordinate currencies are both vulnerable to, and constrained by, monetary policy decisions at the core. Therefore, present international monetary arrangements systematically penalize the global periphery in ways that parallel historical patterns of uneven exchange, where the political autonomy and needs of the global core are prioritized at the expense of some of the most vulnerable people in the world.
Looking ahead, at least two avenues for further enquiry in legal scholarship are crucial towards reforming the global core-periphery dynamics of inflation. The first avenue should consider how capital account regulation can help alleviate inflationary pressures in the periphery, as well as how to code those rules in law. This account records the part of a country’s trade balance comprised of transnational loans (either by private creditors, multilateral institutions such as the IMF and the World Bank, or foreign governments) and investments (mostly by transnational corporations). Capital flows to the periphery increasingly depend on external forces, such as the US interest rate. Highly mobile capital can create inflationary pressures whenever there is suddenly a slow down or reversal in these external flows. Suddenly, periphery countries are left with a lack of a core currency to pay for imports alongside a devaluing domestic currency. In such instances, countries can decelerate or halt capital outflows using capital controls, such as transaction taxes, legislation, or volume restrictions. While the IMF and the World Bank have recently viewed capital controls more favourably as a crisis management tool, there remains an open research question for legal scholarship on the legality of countries employing capital controls in relation to their specific commitments within existing Foreign Investment Treaties, or whether an international regime is needed to determine the appropriate use of capital account regulations.
The second research avenue is oriented towards reducing the way that the currency hierarchy is a structural cause of asymmetric inflationary pressures. Arguably, this can only be achieved by designing an international monetary system in which a national currency cannot function as an international currency. Instead, an international unit of account would function as a mere book-keeping instrument for the denomination of international trade transactions, rather than as a store of value. During the prelude to the 1944 Bretton Woods Conference, John Maynard Keynes proposed one such alternative system: an International Clearing Union. Within this proposal, each country would hold an account denominated in an international unit of account—which Keynes called ‘Bancor’—and all international trade would be settled by transfers of this unit. Keynes envisaged regulations to restrict the convertibility between Bancor and each domestic currency, as well as rules to manage the accumulation of deficits and surpluses. As we know from the failure of this proposal at Bretton Woods, any step in this direction would require a colossal shift in the geopolitics of global money away from a US-centric system and towards principles of global justice and redistribution.