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Bretton Woods 2, its Vulnerabilities, and What Next?

29 August 2010

Naphon Phumma

Bretton Woods 2, its Vulnerabilities, and What Next?
University of Utah

Even though the Bretton Woods system has collapsed since 1971, Dooley, Folkerts-Landau, and Garber (2003) influentially argued that the monetary system that is taking care of the current world economy is the ‘revived Bretton Woods’ system, which is now known widely as the ‘Bretton Woods 2.’ The name ‘Bretton Woods 2’ comes from the fact that the current world monetary system and the current world trade system behave very similarly to those under supervision of the original Bretton Woods, which was active during 1944 - 1971. However, the other fact tells that under the Bretton Woods 2, the pace of the increasing global imbalance seems very vulnerable. The USA has been in a chronic trade deficit for a long time while some emerging countries gain trade surpluses for many consecutive years. This leads people to realize the last fact telling that the original Bretton Woods has collapsed, so they further think whether or not the Bretton Woods 2 will collapse as did the original one. Then, if it will, when will the Bretton Woods 2 collapse? And, after it collapses, what will replace the Bretton Woods 2?
This paper is aimed to do survey on economic literatures in various perspectives that provide answers of the three questions above. The paper is organized as follows. First, it will starts with the explanation of the Bretton Woods 2 hypothesis relying mostly on its birthplace in the work of Dooley, Folkerts-Landau, and Garber (2003). Second, it will discuss vulnerable characteristics of the Bretton Woods 2, but, at the same time, it, looking from different perspectives, will point that these characteristics are not so vulnerable. Thirdly, it will discuss the Bretton Woods 3 and the Bretton Woods 4. And, the last point will be some concluding remarks.
The Bretton Woods 2
After the World War II, the United State gained the momentum of having the US dollar superior to any other currency in the world; this is called ‘dollar hegemony’ in Liu’s term (2002), or ‘quasi-world-money’ in Lapavitsas’s term (2006). So, the conference for the world monetary system at Bretton Woods set the US dollar as reserve currency for other countries. Japan and Germany that were severely destroyed by the World War II used the export-led strategy as a medicine to heal themselves. In the 1950s, the world was mainly composed of two types of countries: the center, the USA, which issued the dominant currency and consumed goods from export-led countries, and the periphery, focused mostly on Japan and Germany, which used export-led growth by fixing their currencies undervalued to the US dollar, controlled capital flows, and accumulated reserves. Meanwhile, the USA acted as financial intermediary; that is, it borrowed these peripheral countries in short term by issuing short-term assets, and made long-term investments into peripheral countries. This export-led strategy of those peripheral countries seemed very effective in healing their economies, because their capitals had been developed real fast. This relationship remained for decades until peripheral countries ‘graduated’ to the center. After this graduation, the new center, Japan and Germany, did not have their currencies fixed undervalued, and financial intermediation serviced by the USA was no longer necessary for their developments. As a result, the floating exchange rate and open capital markets turned to be a mainstream in the whole world, and original Bretton Woods system collapsed in 1971.
However, Dooley, Folkerts-Landau, and Garber (2003) argued that this was not a complete collapse of the Bretton Woods system, but it “was itself only a transition during which there was no important periphery.” Straightforwardly, the graduation to the center of Japan and Germany led to a vacant position of a periphery until a certain time. After the Asian Crisis in 1997-1998, the East Asian countries, especially China, the export-led strategy was used again. These countries tried to keep their currencies undervalued, and controlled the openness of their capital markets. That is, these countries turned to be a periphery. Meanwhile, the USA acted as a consumer of last resort who bought goods and services produced from these peripheral countries. Undervalued currencies then led to huge surpluses in trade accounts of these peripheral countries, and the US dollar flown to these peripheral countries, the same as during the era of the original Bretton Woods system, has been kept as a reserve currency. Some excess reserves, due to the open capital markets in the USA, were then returned to earn some profits in the USA by buying American assets. These short-term loans flown from the periphery countries then helped to finance American expenditures which again stimulated more imports from periphery countries. Since the balance of trade between countries is a zero-sum gain; trade deficit in one country means trade surplus in other. The USA has stayed with chronic current account deficit, while other peripheral countries have earned current account surplus for a long time. However, because this system, demand from the USA is the greatest market for products from the periphery countries. The East Asian countries could produce great amounts of goods to gain benefits from economy of scale, because they know that their products would be consumed due to great demands from the USA. Meanwhile, progress in labor skills and development in capital goods lifted up productivity, so goods from peripheral countries turned competitive and hence dominated the world market.
There might be a question; why have the USA allowed itself to have current account deficit for so long? The simple answer would be that because of money hegemony of the US dollar, which resulted in many privileges for the USA, this current balance deficit was just a “benign neglect at the core.” (Bibow, 2003 p.17) The privileges are as follows. First, importing from aboard with comparatively strong US dollars means that Americans could enjoy cheap products from all over the world. This can help the Federal Reserve control domestic price level in the USA, and, in the principle, it lead to higher welfare in the country. Second, the USA acting as a financial intermediary can earn some money inflows resulting from the gap between lower interest rates from its own liabilities and higher interest rates from its investment in other countries. The USA, by nature of the core, can set its interest rates lower than other countries, because the US dollar is widely accepted by the rest of the world so its value can be more stable than other currencies. Hence, the USA does not have to set interest rates very high in order to attract capital inflows. As a result, the US capital income account has been staying positive for many years. (Bibow 2010) Adding to this point, hence, there would not be any other country except the USA in the world that could be financed by its buyers by offering this low interest rate. Third, since the US borrowings are in US dollar, pressures on lower value of dollar due to current balance deficit can cause higher US wealth transfered from the rest of the world.
According to Dooley, Folkerts-Landau, and Garber (2003), this Bretton Woods 2 is desirable and sustainable, for both the center and the periphery, at least for another decade, in spite of the increasing US current account balance deficit. In the view of the periphery, export-led growth under the Bretton Woods 2 leads to development of domestic economies. The pressure of higher inflation from rapid export-led growth seems not strong, because these peripheral countries, especially China, have a lot of capacity to absorb this pressure. Meanwhile, the concerns regarding US current account deficit will be alleviated because the USA would easily borrow from other countries by issuing assets in order to finance her spending. Peripheral countries who accumulate a lot of reserves from their trade surplus then will underwrite the USA by buying these assets. However, there might be a question; why do peripheral countries buy US assets which yield low interest rates compared to assets from other countries? The answer is so simple; that is, they know that this money will boost US demands for their products, so lending money back to the USA can, in turn, stimulate their economic growths. Thus, there is no reason for them to lend to other countries. This recycle of money is beneficial for both the center and the periphery, as said by Dooley, Folkerts-Landau, and Garber (2003).
Its Vulnerabilities; Are They Really Vulnerable?
However, many economists think that this global imbalance and the Bretton Woods 2 are very vulnerable. The vulnerabilities of the Bretton Woods 2 turned more obvious in many aspects, so economists think that the Bretton Woods 2 will be unraveling soon. These vulnerabilities can be explained as follow.
1. Devaluation of the US Dollar
One characteristic of the Bretton Woods 2 is that peripheral countries’ currencies are set undervalued to encourage exports, and their current account surpluses have pressures on their currencies to appreciate. Meanwhile, the USA have trade deficit, so the US dollar has a tendency to depreciate. Eichengreen (2004) considers that the bloc of peripheral countries that hold the US dollar as reserve currency is similar to a cartel of countries that collectively accept the US dollar. Of course, these countries are aware that US dollar reserves, US treasury bonds, and other US-dollar-dominated assets held in their hands will lose their values when their currencies appreciate, and this will be harmful to their balance sheets, so it is unwise to keep most types of assets in the form of the US dollar. Therefore, in the near future, they will have incentives to break the cartel by diversifying their portfolios and holding other currencies and assets in other currencies. Hence, they will not try to earn huge trade surpluses by exports to the USA, which is the way they are doing right now, and, hence, the pattern of the Bretton Woods 2 will be soon broken down because the US dollar is not desirable as the main reserve currency for exporting countries.
However, Thomas Palley (2006) argues that there are two objections on Eichengreen’s argument. For first objection, to diversify their portfolios, it is likely that peripheral countries may choose the Euro as the first choice. When peripheral countries buy the Euro by using the US dollar, the value of the Euro will appreciate compared to the US dollar, while the exchange rate between their currencies and the US dollar remains the same. For this case, exchange rates between the USA and peripheral countries has no strong incentive to change, so exports to the USA should remain as a major policy and this can maintain the position of the Bretton Woods 2. For second objection, Palley argues that it is not necessary for peripheral counties to suffer capital losses, but, instead, they can even gain capital gains from gradually opening capital markets. When peripheral countries try to diversify their portfolios by using the US dollar to buy other currencies, the pressure on appreciation of their currencies will gradually reduce. From this opening capital market, the same as in the first objection, the exchange rates of these peripheral currencies in relation to the US dollar will remain the same. So, at this point, Palley argues that Eichengreen’s idea on the point that the cartel will be broken because of devaluation of the US dollar may not be always correct.
However, from this point, we can see that although the value of the US dollar in relation to peripheral currencies remains stable, money does not flow back to finance the USA because peripheral countries diversify their risks by holding other currencies as reserves. If this incomplete circulation of money occurs, will this still be vulnerable to the Bretton Woods 2?
2. US fiscal deficits, US current account deficits, and their financings
According to the characteristic of the Bretton Woods 2, the USA has a privilege to borrow money to finance its current account deficit from peripheral countries at low interest rates. According to Roubini (2008), the large portion of this deficit is financed by peripheral countries’ central banks who collect a lot of US dollar reserves, and demand for this deficit becomes higher and higher through time. Meanwhile, as explained elsewhere (Feldstein (2008), Roubini, (2008)), a shortage of saving is the major problem in the USA. This shortage of saving combining with current balance deficits leads to the problem of government deficit; thus, twin deficits, deficits in balance of payment and in government budget, exist in the USA. In addition, treasury bonds issued to finance this fiscal deficit have also been purchased mostly by foreign central banks, especially the People Bank of China and the Bank of Japan, while private investors buying US assets take some parts to finance the USA. From these increasing foreign financing and chronic fiscal deficits, it seems that other countries may not want to lend to the United States because of the increasing default risks. These increasing risks turn to be more obvious especially after the financial crisis in 2008 which is said to be a result of global saving glut and foreign capital inflows to finance a housing boom. (Economic Report of the President, 2009 p.61-98) Financial problems of US financial institutions can destroy confidences of foreign investors. So it seems that peripheral countries may divert from the US assets to other assets to avoid these risks. And, if money does not flow back to the USA, it seems that the Bretton Woods 2 must be unraveling.
However, after the financial crisis in 2008, although demand for private US assets has declined, demand for US government securities has been quite stable. Recent news (Johnson, 2010) tells that while the confidence on the US assets gradually increase due to the recovery of the economy from the crisis, Greece’s debt crisis and a tendency of debt crises in other European countries warn investors to be aware of investing in Europe and implicitly tells that the USA may still be the best place to invest. This is the same as Dooley, Folkerts-Landau, and Garber (2009) who claim that capital will still flow to the USA after the financial crisis. The financial crisis tells peripheral countries that “(T)he world is obviously a dangerous place than we previously realized...” Hence, it will be certain for them to keep piling US dollar reserves, and invest in the safe place like the US treasury bonds. So it seems that the problem in the previous paragraph; that is, no one is willing to lend to the USA soon is most likely to be postponed from the facts in this paragraph.
At this point, although there are some evidences confirming that foreigners are still willing to lend to the USA, readers may question on stability of the twin deficit. How many more years will the USA be able to have this twin deficit? According to mainstream perspectives, the significant threat of the twin deficit is that it can leads to depreciation of the US dollar and the US insolvency, so the mainstream solution (e.g. Feldstein 2008) is the increase in domestic saving in the USA to finance domestic investment, and the reduction of the government spending. This then leads mainstream economists to think that the Bretton Woods 2 must be unraveling, because the USA will soon no longer depend on peripheral capital inflows. But, in heterodox perspectives (e.g. Wray 2006), economists that money is a creature of the state, the main source of vulnerability that comes from this twin deficit is not US insolvency, because the US government, in fact, can at least print money to pay back its debts. However, the global imbalance and the Bretton Woods 2 can be unstable because of the fragile demand side of the USA. This idea is very similar to that of Palley (2006), and more details are in the next section.
3. US demand
In the Bretton Woods 2, the USA acts as a consumer of last resort, so demand for goods from peripheral countries is a necessary condition for the existence of the Bretton Woods 2. However, Palley (2006) argues that there are several factors that can reduce US demand for imports. First, the Federal Reserve may run the tightening monetary policy by sharply increasing interest rate, and this will slow down economic growth that reduces demands for imports. Second, US local banks may tighten their credit issuing policies, because they observe that many customers overspend. Third, US customers may voluntarily reduce their consumptions due to slow economic growth. Obviously, we can see that the financial crisis and the burst of the housing price bubble can really make Palley’s second and third possibility real. Banks require some extra conditions from customers before making loans, while the falls of assets’ prices have negative wealth effect to people’s consumption. This idea can be more obvious if the US government tries to launch campaigns to encourage saving from people to solve twin deficit mentioned above. Increasing amount of saving, instead of increasing investment as argued by mainstream economists, will lead to a Paradox of Thrift which cuts down national income and hence US demand for imports. (Wray 2006) This then shortens the lifetime of the Bretton Woods 2.
Bibow (2009, and 2010) argues that US demand for foreign products is not going to be exhausted soon, because US government spending is going to play more active roles in activating the US economy. He argues that high ratio of private debt over GDP has been the main engine of running US demand for exports. Similar to what Palley says, these debts led to the current financial crisis, and this crisis, leading to banks’ strict lending policy, can cut US demand. But the point is that the US fiscal revenues, turning deficits since the late 1990s, have been used just to rescue these private debts and, hence, to postpone the crisis from the early 2000 to 2008. Even after the financial crisis occurred in 2008, US fiscal policies such as tax cuts and fiscal stimulus apparently show that the purposes of US fiscal budgets are to repair the slow economy, not to lead economic activities and the economis growth. Therefore, Bibow sees that, in the future, if US fiscal policy is mainly used to stimulate economic growth, US demand for exports will not be exhausted in the near future. He also argues that this kind of fiscal policy is not going to increase the ratio fiscal deficit over GDP, because growth rate of GDP can be higher than that of fiscal deficit. As a result, the ratio of fiscal deficit over GDP can be at the manageable level, and the center-periphery relationship of the world economy by the USA acting as a center can be maintained. Bibow calls this kind of relationship the ‘Bretton Woods 3,’ and it will be discussed more below.
4. Impact on the Financial System of the periphery
Roubini and Setser (2004) and Goldstein and Lardy (2005) argue that the pattern of the Bretton Woods 2 leads to a tendency of inflation and hence high costs of sterilization of peripheral countries. Huge current account surplus of peripheral countries force these countries to sell domestic bonds in order to mop up the liquidity flowing in the system in order to prevent inflation. However, this more bonds supplied in the market also lead to higher interest rate, and this tendency to have higher interest rate, again, attracts more speculative capital inflows to the countries. From this point, Goldstein and Lardy think that even though governments issue bonds to sterilize the flood of liquidity, inflation problem still appears as a major threat for peripheral domestic economies. Also from more speculative inflows, it has a tendency that domestic credits can be expanded to those who have inferior credit history which tends to cause higher NPLs, so peripheral governments may have to impose some controls on bank loans or credit approvals. Plus, they may encounter higher administrative costs from changes for required reserve ratio to prevent these consequences. These all are costs on monetary policy that tends to be more severe for peripheral countries.
The major beginning point of this argument is regarding the Quantity Theory of Money claiming that inflation caused by increasing money supply. This is in fact the standard monetarist argument used by monetarist economics. And, surely, there are many critiques on this notion. For example, Keynes (1991, p.292-309) claims that quantity of money does not have clear relationship with inflation, and considers that some portions of total money supply may not be circulated to create inflation. Furthermore, Keynes tries to point that increasing money supply can cause inflation via lower interest rates that then increase effective demand, and this increasing effective demand will further cause increases in wages and prices of production. So in the case of high unemployment, it is possible that increasing money supply may not cause inflation at all. In addition, he even adds, in my view, a more crucial critique on the Quantity Theory of Money used in this case by claiming that velocity of money may fluctuate. Changes in money supply may directly affect velocity of money, so their effects on inflation may be quite vague. In addition, Palley (2006) also claims that empirical evidences on this are not strong enough to support the positive relationship between inflation and money supply. Plus, he also argues that, in case of China, all administrative controls, which are claimed to be another cost of sterilization in Goldstein and Lardy (2005), have been working well, and seem to work well in the future.
5. The institutional infrastructure of the Bretton Woods 2
Roubini and Setser (2004) argue that the instutional infrastructure of the Bretton Woods 2 is too weak in two major points. First, unlike the original Bretton Woods, in which the US dollar was anchored to gold, the Bretton Woods 2 does not have any sustainable anchor for the US dollar. That is, the Bretton Woods 2 does not impose limits on the US policy, and, hence, current US fiscal deficits tend to devalue the US dollar quite easily. Second, in the original Bretton Woods, all parties are bonded by a formal commitment to follow the certain policies set as rules for the global monetary system. But, the Bretton Woods 2 does not have any formal commitment between parties; fixed undervalued currency or holding the US dollar as a reserve is actually a pursuit of highest interest for both the USA and peripheral countries. This leads to a tendency that peripheral countries will give up to hold the US dollar as a reserve, or the USA will force peripheral countries to increase their currencies’ values in the near future. Taking Eichengreen’s term, the cartel is too weak in the Bretton Woods 2. (2004)
To me, the argument above concerns only the economic perspective of US dollar hegemony. That is, peripheral countries will no longer hold the US dollar as a reserve, because the US dollar will lose its value; in other words, economic benefits will be disappeared soon. But, this may be not true if we consider institutional and political factors e.g. the US dollar is the most widely acceptable and reliable currency. As Lapavitsas (2006) says that “managing the dollar as quasi-world-money requires systematic use of political and economic power.” The rise of dollar hegemony results from the fact that the USA tries to develop and maintain its hegemonic powers since the end of the World War 2. During the time, the USA set up the crucial role for the US dollar, and played major roles in almost major superpower institutions, such as, the UN, the World Bank, etc., so it turns to be the most powerful country in the world. US interventions in the Bank of International Settlements which regulates international banks in the financial market and that in the IMF which provides funds and influences members’ monetary pattern are obviously the attempts to promote the US dollar as quasi-world-money. However, many people argue that the hegemonic power, including US dollar hegemony, of the USA fades down, and it will lose this power soon. However, though agreeing that it fades down, I disagree that the USA will soon lose its hegemonic power. I think, due to its strength in military power, the US military intervention can ensure the status of the USA as a Big Brother of the world for, at least, another decade. Adding this US dollar hegemony into account, peripheral countries know that they can hold the US dollar as a reserve and also can use export-led strategy for a long while, so the weak institutional infrastructure of the Bretton Woods 2 may not fade down soon.
The Bretton Woods 3 and Further.
As mentioned before, the Bretton Woods 3 is the center-periphery relationship of the world economy where the USA still acts as the center but its (safe) fiscal debts replaces (toxic) private debts to stimulate demands for exports. According to Bibow (2009, 2010), the turning point from the Bretton Woods 2 to the Bretton Woods 3 is the current financial crisis. As a result of the financial crisis, financial institutions in the USA, as well as those in other peripheral countries, due to government restrictions and/or their own awareness, tend to have stricter lending rules, so growth rate of private debts should be at the limited level. Because of this credit crunch, economic growth driven by financial sector should be viewed as unwise policies for all countries. Private debts that stimulated domestic demands and hence economic growth no longer play a role as the main engine of the US economy. Meanwhile, peripheral countries then will stick with their export-led strategy in real sectors as an engine for their economic growth. Bibow argues that the USA is conditioned by this strategy pursued by peripheral countries, so it is impossible for the USA to turn to be export-led growth because the lane of export-led growth is packed with many peripheral countries. The only way out for the USA after the crisis is to the use of fiscal debts to stimulate its economic growth. From this position, safe US government securities play a big role in running the economy forward without being fragile in the financial sector due to lower amount of toxic private debts. Meanwhile, US economic growth from this policy should be able to control the ratio of fiscal deficits over GDP at a manageable level. In addition, the Federal Reserve’s policy that sets interest rate very low helps reducing the US government’s burden of paying interest rates to foreign investors who are holding US government securities. From this low interest rate, Bibow (2010) shows that the USA can earn surplus in investment income account, interests paid to foreign holders are lower than interests received from holding foreign assets, and this surplus can partially help the US government to be able to manage its fiscal deficits. This point also implies that the US dollar still hold hegemonic power over other currencies, and US dollar will be highly demanded from other countries for a long while. From this point of view, the relationship in world economy will turn to be the Bretton Woods 3, led by US public debts.
The conditions of the valid Bretton Woods 3 can be separated into two parts; first, peripheral countries are still in love with export-led strategy and, second, the USA is able to act as a consumer of last resort. Bibow (2009, 2010) says that the USA and the US dollar are not likely to hold this privilege forever and current peripheral countries, especially China, are not going to stay peripheral forever. So, whenever the USA and its currency lose their positions and current peripheral countries no longer needs export-led strategy as engines of their economic growth, the Bretton Woods 3 will collapse. However, that should be long enough for other countries to replace these conditions. According to Bibow (ibid.), European countries and their Euro, Japan and its Yen, or even China and its Yuan should be mature enough at the time the Bretton Woods 3 collapses to replace the USA as a center, while India should be ready to pursue export-led strategy and be a major peripheral country. Therefore, the center-periphery relationship will still exist as Bretton Woods 4 in the world economy.
My Opinion and Conclusion
In my opinion, Bibow’s Bretton Woods 2 and Bretton Woods 3 are very similar and it may be difficult for us to observe the real collapse of the Bretton Woods 2 and the rise of the Bretton Woods 3. In fact, I do not see any point to distinguish these two, because it is the USA that is still a center. However, I very much agree with him on other parts of his idea. I agree that the USA will play a role as a central country, while China and other emerging countries will be peripheral countries for, in my view, perhaps, a decade. The US fiscal policy will play a very crucial role to keep privilege of being a center. In addition, as discussed above, my reason may be regarding the USA’s military power and its political power to maintain its hegemonic power to keep its position in the world economy. Ones may argue that the current status of the USA is very similar to the Netherland and UK when they lost their hegemonic powers during the late 17th century and the early 20th century, respectively. However, in my opinion, globalization, facilitating the USA to easily contact with the rest of the world, and the USA’s current position in military allow the USA to have more power than what the Netherland and UK ever had. As a result, my approximate time of the US dollar hegemony at about a decade may be even too less, because these powers seem quite stable for the USA. Furthermore, since the USA will be able hold its position for a long while, I still agree with Bibow that, at the time the USA lose this privilege, there will be other countries replacing its position as a center. At the same time, again due to globalization, facilitating the development of technology in the rest of the world, other countries, not only India as argued in Bibow but also other countries in the Indian subcontinent and some African countries which possess an abundance of resources, will be more ready to pursue export-led strategy immediately after China hits its limitation to act as a periphery. Therefore, it seems to me that the Bretton-Woods-type relationship will be active in the world economy for, say, at least 20 years.

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