"Bretton Woods II" - Monetary System or Excuse

by Marshall Auerback
International Perspective
May 24, 2005
http://www.prudentbear.com/internationalperspective.asp

We don't really have a problem of excessive 'US-centric' growth, if the 'Bretton Woods II' advocates are to be believed. You haven't heard of 'Bretton Woods II'? It is the latest hypothesis used to rationalize today's perverse global financial architecture, the main proponents being three leading economists: David Folkerts-Landau, Peter Garber, and Michael Dooley, who have all written extensively on the subject. Dooley forcefully advanced the thesis again at a PIMCO Secular Forum held a few weeks ago.

The Bretton Woods II hypothesis posits the notion that the world is effectively back to a regime of global fixed exchange rates pegged to the US dollar like the original Bretton Woods regime that lasted from 1945 to 1973. Unlike the formal regime that existed over that time frame, this 'new and improved' version is more or less bi-regional. It bypasses Europe altogether and largely consists of an informal arrangement between the U.S. and the nations of the Asian savings bloc. Under the new 'system,' the Bretton Woods gold-dollar fixed exchange rate has in essence been replaced by an arrangement whereby the nations of emerging Asia either peg (China, Hong Kong, and Malaysia), or closely manage their respective currencies against the greenback. This new regime is based on structural current account deficits in the U.S. and structural current account surpluses in Asia; Asian current account surpluses are recycled to provide cheap financing for the US current account deficits, although under a classic monetary system it is doubtful that anything like the imbalances currently in existence would be allowed to develop. At the apex of this new Bretton Woods, the US Federal Reserve produces money supply that goes through the banking system to consumers, who then consume imported goods via the "fixed" exchange rate, a large portion of which are produced in Asia. Asia takes the money generated by these exported goods, and then purchases U.S. bonds - in other words, lends it back to the U.S. - and then the cycle repeats itself over and over again.

Implicit in the Bretton Woods II model is that the presumption is that the arrangement is symbiotic and mutually beneficial for everybody. According to its advocates, this new monetary regime allows the U.S. to finance its large current account deficit at a low cost for a long time; the U.S. has a huge savings shortfall, but offers tremendously high returns afforded for capital imports by virtue of the dynamism of its economy.

One can see the alleged coincidence of interests: America allows this arrangement to persist because it provides ample financing for its large and growing current account deficit. Indeed, the deficit itself is turned around: it is not a symptom of over-consumption, or a nation experiencing acute financial fragility, but rather a sign of economic virility because the deficit reflects the prospect of substantial returns to capital afforded within the American economy, in relation to the rest of the world.

Similarly, the nations of Asia agree to this arrangement because they presumably need to produce products for export to the U.S., in particular, and, in the specific case of China, to create jobs for their people who are migrating from the farm to industry.

If one accepts the thesis wholeheartedly, then the upshot is that America's growing external indebtedness poses few immediate concerns. So, the markets should just get over their fixation with the 'unsustainable' US current account deficit. By the same token, the vexed issue of whether Beijing should revalue its currency or not is simply a red herring that should be ignored.

Of course, just because one tries to put a respectable label on today's odd global financial arrangements, does not legitimize the system. Bretton Woods II, even if only an informal monetary arrangement, seems to make virtue out of necessity. It has nothing like the disciplines nominally offered by a proper functioning monetary system, whereby the debtor ultimately faces the consequences of its economic profligacy. In the case of a gold-based system, for example, the debtor loses gold (i.e. its monetary base) and thereby is forced to implement policies designed to curb the outflow. Its interest rates go up and its aggregate demand is accordingly slowed until the process begins to reverse itself.

BWII, as Paul Krugman has noted recently, offers no such symmetry and in fact foments further underlying financial fragility. In particular, he notes the central role that China now plays in underwriting current American financial profligacy:

'[T]he Chinese government. has kept the Yuan down by shipping the incoming funds right back out again, buying huge quantities of dollar assets - about $200 billion worth in 2004, and possibly as much as $300 billion worth this year. This is economically perverse: China, a poor country where capital is still scarce by Western standards, is lending vast sums at low interest rates to the United States.

Yet the U.S. has become dependent on this perverse behaviour. Dollar purchases by China and other foreign governments have temporarily insulated the U.S. economy from the effects of huge budget deficits. This money flowing in from abroad has kept U.S. interest rates low despite the enormous government borrowing required to cover the budget deficit.

Low interest rates, in turn, have been crucial to America's housing boom. And soaring house prices don't just create construction jobs; they also support consumer spending because many homeowners have converted rising house values into cash by refinancing their mortgages.'

So an undervalued renminbi propels spectacular growth in China's exports, and particularly its exports to the United States. But, so long as China maintains its current peg and resists letting its currency appreciate, it can happily continue to export to the US market, but equally important, US households can happily consume, little constrained by growing debt considerations. It's not so much a new monetary system as it is a huge global game of financial chicken.

The country that has the most to lose by abrogating this new arrangement is the US (in contrast to Bretton Woods I, where President Nixon's closure of the gold window essentially screwed the Japanese). So why on earth is the American government complaining so much? Why the recent very public demands for an immediate 10 per cent revaluation of the renminbi? For if China suddenly chose to abrogate its implied obligations under Bretton Woods II, the consequences would almost certainly include a dollar collapse, higher domestic prices, a jump in interest rates, a fall in prices of housing, a steep rise in household bankruptcies and, not least, a sharp US recession. The bigger and swifter the adjustment in the external accounts, the more drastic those impacts would be.

As Krugman notes, it is highly desirable for the US to break itself of this addiction to cheap capital and avoid a further explosive build-up of net external liabilities. However big the crisis if a sudden correction were to occur now, it would be nothing compared with what would happen after another decade of rising net liabilities. Better still, instead of choosing between a sudden correction now and a still more brutal sudden correction later, why not go for a smoother correction that starts now?

One would hope that in the unlikely event that the US went 'cold turkey' and sought to break its addiction to cheap Asian capital that there would be an offsetting growth impulse from Europe and Asia. The problem is that Europe in particular remains weak and mired by political uncertainty (particularly in France where consumer sentiment continues to be damaged by uncertainties over the fall-out of a possible French rejection of the new European Union constitution next week).

Furthermore, Europe remains caught in the crossfire of the arrangement between the Americans and Asians implied by Bretton Woods II. Given that the Asians have continued to insist on pegging their currencies or managing them closely against the greenback, most of the downward pressure on the US dollar has, until recently, been channeled towards the Euro. This is not politically sustainable. Euroland's policy makers have historically demonstrated considerably less willingness than their US counterparts to allow the EU's tradable sector to be hollowed out by Asian competition.

As for Asia in general, and China specifically, the region's investment ratios are so high and the capital stock is export oriented, largely as a consequence of the workings of this strange new monetary system. It may well be the case China and the emerging world must eventually revalue against the US dollar. In the past emerging Asia did it by inflating higher than the US. But today it is more problematic, given that so many economies - Japan, China, Thailand, Malaysia, and Korea - are seeking to restrain their own domestic credit bubbles, themselves ironically a product of this so-called 'Bretton Woods II' system. The effect of maintaining something close to a fixed parity rate against the dollar simply turned a US domestic credit bubble into an international one.

In the case of Japan, for example, author Richard Duncan notes: 'Intentionally or otherwise, by creating and lending the equivalent of $320 billion to the United States, the Bank of Japan and the Japanese Ministry of Finance counteracted a private sector run on the dollar and, at the same time, financed the U.S. tax cuts that reflated the global economy, all this while holding U.S. long bond yields down near historically low levels.'

The entire Asian region is now a repository of huge surplus savings, both because of rapidly rising trade surpluses and huge foreign direct investment (FDI) on the part of both Western and Japanese companies. Normally, this inflow of funds would be self-correcting because the magnitude of the fund flows would engender an appreciation of the region's respective currencies, making their exports less competitive and shrinking the trade surplus. But as Duncan and Krugman have both observed, Japan, China and others have largely resisted this process. Ironically, the very aspect of BWII lauded by exponents as introducing the virtues of an quasi-fixed exchange rate system has in fact propagated enormous international imbalances, the unwinding of which will almost certainly be hugely destabilizing.

To paraphrase the Irish poet, W.B.Yeats, the status quo cannot hold. Indeed, there are signs that the Bank of Japan (long a key player in perpetuating 'BWII') is hinting that enough is enough. The Bank of Japan last week said it would allow levels of liquidity to fall below its monetary policy target in what many have interpreted as the first step towards re-establishing a marginally more restrictive monetary regime after four years of unorthodox policy. Although the BoJ has described the action as a 'technical response' to the difficulty of creating enough liquidity, many suspect that last Friday's move reflects a desire on the part of Japan's monetary officials to return to an orthodox targeting of interest rates at the earliest opportunity. And wouldn't it be ironic if, just when all of the attention is being focused on China and its alleged 'currency manipulation', it was Japan which ended up pulling the plug on this perverse monetary regime, which is really more of an excuse than a true policy solution.