Toward Bretton Woods 3?

Back in 2007 we used to
refer to the current crisis as the "U.S. subprime crisis". But while it
was the area where troubles first emerged, the subprime mortgage sector turned
out to be only the tip of the iceberg. Today, the Lehman crisis of mid
September 2008 is still widely seen as the critical blunder that pushed the U.S. and world
economies off the cliff. And yet, the Lehman bust may have been no more than
just the trigger of an implosion of underlying financial structures that had
built-up to reach a cracking point many years before.

In assessing the roots
of the ongoing crisis and also the prospects for a global rebalancing and
sustained recovery, due account has to be taken of the center role of the U.S.
dollar in the world economy. The world monetary and financial order – with the
U.S. dollar as its hub – conditioned and
induced particular macroeconomic policies in the rest of the world and at
home, policies that led to the built-up of "global (and domestic) imbalances"
and underlying international (and domestic) credit structures. We are currently
witnessing their malign unwinding, as we grope for suitable policy responses.
In weighing domestic policy options at the current juncture, it is important also
to consider the future role of the dollar in an evolving and increasingly
integrated world economy.

The U.S. economy has become more "open" in terms of
trade and investment flows, with correspondingly heightened vulnerabilities to
external events that global linkages and interdependencies inevitably bring
with them – a tendency called globalization that the U.S. shares more or less equally
with much of the rest of the world. Even more important, the U.S. is not only
unique in the world, but also uniquely important for standing at the top of the
international pecking order of currency and finance. Because the world monetary
order is dollar-centered, U.S.
financial institutions have for long enjoyed a supreme position in global
finance. It is thus noteworthy that this order is asymmetric in that one player
is more equal than everyone else – a special status that comes along with both
special benefits and responsibilities. The behavior of the country at the hub
of the order is of the greatest systemic importance, but remains conditioned by
other players’ conduct as well.

In much of the rest of
the world, rising globalization under the asymmetric dollar-centered order has
induced governments to pursue defensive macroeconomic policies. The world
financial system has become increasingly globalized in its reach and
operations. However, regulation and supervision of financial institutions
engaged in cross-border activities have remained predominantly national. This mismatch creates a highly unsafe
environment, especially for countries further down the currency hierarchy. The
resulting loss in economic sovereignty through global integration has put a
premium on policies that help preserve whatever little control and room of maneuver
individual countries may have left. In general, seeking protection has taken
the form of maintaining a competitive exchange rate vis-à-vis the U.S. dollar,
running up current account surpluses, and accumulating soaring foreign exchange
reserves, predominantly denominated in U.S. dollars, as self-insurance.

A common tendency among
countries that pursue policies of this kind has important systemic
implications: if everybody pushes exports and aspires to accumulate dollar
reserves, strong deflationary forces arise in the system as a whole. In fact,
under a 1930s gold standard system that was characterized by a given amount of
gold reserves available for hoarding, such rising systemic pressures would have
led to a severe tightening of financial conditions, bank runs, and ultimately
deflation and financial meltdown. While individual countries could chose to get
off gold or depreciate their currency relative to gold, the gold standard order
as a whole lacked a mechanism to offset systemic deflationary pressures by
augmenting the system’s reserves correspondingly. That factor contributed to the severity of
the Great Depression.

Today’s world monetary
order is not a gold standard, but a U.S. dollar standard. The amount of U.S.
dollars available to be held as reserves by other countries is not physically
constrained as in the case of gold, but generally depends on the evolution of
the U.S. balance of payments
over time and on U.S.
macroeconomic policy decisions at critical junctures in particular. Systemic
deflationary forces can develop in this system too, but they can more easily be
offset by a flexible U.S.
macroeconomic policy response, so the ultimate outcome of the current crisis
may be less horrific than the Great Depression.

The country issuing the
system’s key reserve currency has a special responsibility under crisis
conditions. Under more normal conditions, too, meeting the key reserve
currency’s systemic role may also come about quite naturally and in full
accordance with the national interest. The point is that a general desire among
the rest of the world to export to the U.S. and accumulate dollar reserves
produces strong deflationary forces in the domestic economy of the reserve
currency issuer. Weakness in U.S.
labor markets and downward pressures on wages and prices in general arise.
These market pressures will normally convince U.S. policymakers to respond by
more expansionary macroeconomic policies. It should not be overlooked that
stimulating domestic demand sufficiently to offset deflationary forces reaching
U.S. shores from abroad is made easier by the benefits enjoyed by the key
reserve currency issuer en route: cheap imports and easy terms of finance –
given that U.S. dollar reserves normally pay only low rates of interest (on top
of offering top-safety as sought by their foreign official holders).

Bretton Woods 2

These general insights
into the workings of the dollar-centered world monetary and financial order
come in handy when investigating critical global developments that led up to the
Lehman-triggered financial implosion of 2008, the global policy responses that
have followed since, and the prospects for global rebalancing and recovery as
they present themselves today. The point I am driving at is that the world
monetary and financial order conditioned
and induced particular macroeconomic policies in the U.S. and the rest of
the world, policies that led to the built-up of "global (and domestic)
imbalances" and underlying international (and domestic) credit structures. The
future outlook for the U.S.
and world economies continues to be contingent upon the dollar’s role in the
global order, even if a return to conditions and policies prevailing before the
crisis seems unlikely.

To highlight some
critical issues I will draw on the so-called "Bretton Woods 2" hypothesis as my
framework of analysis. In 2003, Michael Dooley, David Folkerts-Landau, and
Peter Garber hypothesized in their influential "Essay on the revised Bretton
Woods system" (or: "Bretton Woods 2") that global imbalances featuring a
quasi-permanent U.S.
current account deficit may be sustainable.
On their view global current account imbalances reflected a symbiosis of interests among deficit (U.S.) and
surplus (developing world) countries. The developing world’s interest is to
sell its products in the large U.S.
market as a way of stimulating employment growth and development. The U.S. economy, on the other hand, is flexible
enough to tolerate the resulting quasi-permanent drag on U.S. income
growth, given its comparative advantage in creating safe assets which the
periphery wishes to accumulate for safety reasons.

Note that the global monetary and financial order stands
right at the center of an analysis of global "imbalances" which are actually
interpreted as a balanced situation by Dooley et al. Moreover, the chosen title
"revised Bretton Woods system" signals that the authors seem to see a lot of
continuity in post-war monetary arrangements, despite the fact that the world
has moved away from the "Bretton Woods 1" system of pegged exchange rates in
the 1970s. Dooley et al. suggest that a new "periphery" (China in particular)
has emerged replacing the former periphery of Western Europe and Japan in
relying on export-led growth strategies by pegging to the U.S. dollar – which has
remained the currency at the center of the so "revised" global order.

In view of what I said
above about the dollar-centered global monetary and financial order, it will
come as no surprise that I principally agree with these general points of
perspective. However, there is one factor conspicuous for its absence in the
Bretton Woods 2 hypothesis that turned out to be rather critical to the
supposed sustainability of these arrangements. I am referring to those "safe
assets" the production of which the U.S. has a comparative advantage
in. It is of course true that the official authorities of countries such as China have
largely accumulated safe assets, U.S. Treasuries in particular. The point is
that the assets that actually sponsored U.S. spending in excess of income
growth were assets that have proven to be so lethally "toxic" as to cause
today’s global crisis.

The Bretton Woods 2
hypothesis ignores that the domestic counterpart to the U.S.’s external deficit was based
not on (safe) public debts, but on (toxic) private debts, mortgage debt in
particular. Skepticism regarding soaring household indebtedness and the
implications for the solvency of lenders ended the party when underlying
collateral values stopped rising in 2006. In essence, as foreign official
authorities came to hold a rising share of the outstanding stock of U.S.
Treasuries, U.S.
consumer spending was fired by households taking on ever more debt relative to
income. The rise in household indebtedness (leverage) saw the U.S. personal
saving rate decline from about 10 per cent in the 1980s to little more than
zero by 2007. While falling interest rates helped keep the private debt burden
in check to some extent, trends like these can clearly not continue forever. To
be sure, neither will U.S.
households pay down debt forever. They will start borrowing again at some
point. The point is that we are unlikely to see a return to and continuation of
previous patterns of behavior featuring a continuous decline in the saving
rate.

Let me highlight then
how the world monetary and financial order nurtured the U.S. consumer
in its role as "borrower and spender of last resort", the true engine of growth
behind the Bretton Woods 2 system. Japan
in the early 1990s was the first calamity in the world economy that created
forces for over-spending in the U.S. Stuck in protracted domestic demand
stagnation, Japan
has become wholly reliant on exports for its meager GDP growth. Germany came
next, following the Bundesbank-provoked recession in response to the country’s
unification. Ever since 1993 Germany,
too, has relied only on its export engine. Germany’s
influence in the global economy became further magnified when its economic
policy model was exported to Europe through the Maastricht Treaty on Economic
and Monetary Union – effectively committing Europe
to a mercantilistic model of growth. The detrimental effects of the spreading
of the "German disease" have become most visible in "Euroland", the club of
countries that have adopted the euro as their common currency. Domestic demand
had stagnated for much of the 1990s and "between 2001 and 2005, the
eurozone was the sick giant of the world economy" (Martin Wolf, FT,
27 Mar 2007).[i]
Note that these countries are all industrialized competitors of the U.S. According
to the Bretton Woods 2 hypothesis these countries should have long matured and
no longer be part of any export-led growth "periphery".

A new periphery really
only came to emerge in the aftermath of the 1997-8 Asian crises, events which
seem to have convinced increasing numbers of developing countries to seek
safety in pursuing current account surplus rather than deficit positions.
China, which had already pegged to the dollar in 1994 and maintained a
competitive exchange rate ever since, represents one prominent example in this
group, but China’s current account surplus has really only soared since 2003.

Recall that in a world
which becomes ever keener to export and accumulate dollars, systemic
deflationary forces mount that hit the domestic economy of the key reserve
currency issuer by putting downward pressure on wages and prices in general. In
fact, without any offsetting forces forthcoming from U.S.
macroeconomic policies U.S.
and world economies would have faced the prospect of deflation. In the event,
U.S. macro policies have responded flexibly to the above external developments
since global imbalances started to emerge in the early 1990s, with monetary
policy as first line of defense and recourse to active fiscal policy restricted
to outright recessions. The Federal Reserve’s mandate features maintaining
price stability and high employment. Monetary policy encourages private
spending by lowering interest rates, easing credit, and boosting asset prices.
The Fed would have failed on both counts if it had not eased its policy stance
sufficiently.

It is easy today to
blame the Fed for causing bubbles. It is harder to see how the Fed could have
otherwise fulfilled its mandate when global conditions were such that
deflationary forces arriving from abroad required an offset from U.S. domestic
demand that was not provided by public spending. The emergence of global
imbalances, featuring a rising U.S.
current account deficit, was thus inherently entwined with the emergence of
domestic imbalances: debt-financed consumer spending and rising household
indebtedness in particular. In 2006 projections by the IMF and OECD still
showed a continued rise of the U.S.
current account as a share of GDP. I argued above that the internal trends
required to meet such projections were unsustainable – the aspect ignored in
the Bretton Woods 2 hypothesis. Bretton Woods 2 was doomed long before Lehman
hit the wall, the bank’s failure merely delivered the regime’s death blow.[ii]

The
Emergence of Bretton Woods 3?

But the Lehman crisis
has also triggered important policy responses across the globe together with
some rebalancing of global demand. Interestingly, while Bretton Woods 2 is
certainly dead, a new "Bretton Woods 3" regime might be in the process of
emerging in its stead.

Under Bretton Woods 3
public debt replaces private debt, which may in principle prove more
sustainable. The change of guard from monetary policy to fiscal policy has come
about in the first place by the sheer severity of the crisis. With monetary
policy short on ammunition, and important parts of the financial system
dysfunctional, the only way to support domestic demand is to cut taxes in
support of private incomes and spending or to boost public spending itself. As
the private sector retrenches brutally, the public sector has to carry the
torch; or else witness the economy sink into the abyss. In the winter of 2008-9
the world economy and world trade experienced a freefall comparable to the
Great Depression of the 1930s. In contrast to that earlier episode, however,
governments around the world initiated fiscal stimulus programs, although with
some regional variation in magnitude. The rebalancing of global demand saw the U.S. current
account deficit shrink from its peak of 6 per cent of GDP in 2006 to below 3
per cent in the first half of 2009. The question is whether the current global
rebalancing and unwinding of imbalances is really going to continue,
vindicating White House economics director Larry Summer’s recent call for the
U.S. to switch its consumption-based growth model for an export-oriented one.

I argued above that U.S.
macroeconomic policies are conditioned by policies pursued in the rest of the
world. If the U.S.
were to merge in the export-led growth lane already overcrowded by the rest of
the world, this would set the world on collision course, a sure recipe for
disaster. It would also mean a refusal by the U.S. to play its role as key
reserve currency issuer. If the rest of the world resumes its previous policy
patterns of aspiring current account surplus positions and dollar reserve
accumulations, the real choice facing the U.S. as key reserve currency issuer
is to take recourse to fiscal policy and public debt rather than trying to
rekindle the emergence of private sector imbalances. While we currently view
fiscal policy as providing no more than a temporary emergency boost to restart
private spending, Bretton Woods 3 would actually imply a more lasting role for
fiscal policy in sustaining domestic
demand.

To be sure, I do not
mean anything like the current deficits, in double digits as a share of GDP.
These stunning numbers reflect, first and foremost, the magnitude of ongoing
private sector retrenchment. Public deficits will shrink as the private sector
rebalances over the next few years. But even beyond this short-term rebalancing
more permanent budget deficits may be needed, if the rest of the world were to
resume previous policies. National income accounting implies that if the
private sector’s financial balance were balanced again, any U.S. current
account deficit would require a corresponding public sector deficit. While a
return to rising current account deficits of 6 per cent of GDP or so would
likely quell renewed troubles not too far down the road, deficits of, say, 3
per cent may be perfectly manageable. Assuming 6 per cent nominal GDP growth,
the U.S.
net international investment position would converge to minus 50 per cent of
GDP in the long run.

With rising external
indebtedness, a crucial issue concerns U.S. external financing costs. And
it is in this regard that the comparative advantage of the U.S. in
producing low-yielding safe assets comes in handy. But in contrast to Bretton
Woods 2 the safe assets acquired by foreign official authorities would also be
the very assets that actually sponsor U.S. spending in excess of income:
public debt (or government guaranteed securities) rather than private debt.
Under BW2 Fed monetary policy played the lead role in keeping interest rates
low, credit easy, and asset prices high and rising to induce sufficient private
spending fired by private debts. Under Bretton Woods 3 Fed policy would still
be important in keeping interest rates and U.S.
external financing costs low, while a rebooted Wall Street could find its
supplementary part in keeping the U.S. income balance on the current
account in check. In any case, fiscal policy would take on the lead role – a
change of guard in macroeconomic policy.

A
Future Bretton Woods 4?

Importantly, as under
BW2, the need and scope for Bretton
Woods 3 "imbalances" (i.e. the size of the "equilibrium" U.S. current account deficit)
largely depends on macro policies in the rest of the world. If, finally, Japan and Germany
were really to mature from the
mercantilistic periphery and generate domestic demand-led growth this would
take important pressure off the U.S.’s
shoulders. The same effect would occur if developing countries decided that
globalization has become safer – perhaps due to reforms to global finance and
the IMF with greater provision of "collective insurance." Finally, if China learned
from its own ongoing rebalancing in the context of massive fiscal stimulus
measures that a greater reliance on domestic rather than external demand is in
its own national interest, this too would reduce the need and scope for Bretton
Woods 3 accordingly.

One may therefore also
venture some speculations about longer term prospects for the world monetary
and financial order. At some point in the future, all major regions and players
might mature and pursue domestic demand-led growth while exchange rates are
adjusted so as to keep global trade in balance, and without any key reserve
currency playing the crucial role currently occupied by the dollar.

The dollar is unlikely
to retain its current special status forever. Bretton Woods 3 may however offer
a more stable and sustainable system for the transition towards a more balanced
"Bretton Woods 4" system of equal partners. As alternative arrangements along
these lines would correspond to Keynes’ original vision for the post-war order
developed in the early 1940s, we could also call them "Bretton Woods 0" for
that reason; the global order that never came to be as the actual "Bretton
Woods 1" order was dollar-centered from the beginning.

Even without any
official "new Bretton Woods" agreement, the alternative arrangements just
sketched may still come about by market evolution and policy adaptation as China, India,
and perhaps even Europe mature to a more equal
global status. But this prospect still seems a matter of decades. In the
interim period, Bretton Woods 3 might provide a more sustainable regime than
Bretton Woods 2 could have ever become. If other countries do not like the
prospect of continuous – though much smaller than today’s – U.S. budget deficits, they can let their
exchange rates appreciate, wean themselves off U.S. sponsored export growth and
adopt domestic demand-led growth on their own. This is the real choice
countries such as China
are facing.

The U.S. cannot force other countries’ policy
choices, but in fulfilling its role as reserve currency issuer the U.S. should
design its own macroeconomic policies in ways that best serve the national
interest. There is no obvious economic reason why yet another private
debt-financed HD television should be more beneficial to long-term U.S. growth than a public debt financed upgrade
of U.S.
infrastructure. Apart from boosting U.S.
growth, particular infrastructure initiatives might also raise U.S. energy
security, for instance. This would at the same time help to contain a
re-surging U.S. energy
(import) bill, a factor that inflated the U.S. current account deficit in the
last boom. Flexibility, open-mindedness, and creativity are needed in filling
the proper role for infrastructure investment in Bretton Woods 3.

To sum up, today’s
global crisis is ultimately rooted in the world monetary and financial order
and the macroeconomic policies and global imbalances induced by that global order. Bretton Woods 2, featuring private
debt financed consumer spending as the counterpart to the U.S.’s external
deficit, is dead and cannot easily be revived, but a Bretton Woods 3 regime may
come to take its place, featuring continued U.S. current account deficits,
albeit this time driven by public spending and public debt. Unlike under Bretton
Woods 2, under Bretton Woods 3 the safe assets accumulated by the periphery’s
official authorities would also be the very assets actually sponsoring U.S. spending
in excess of income. Policy choices in the rest of the world would determine the
need and scope for the U.S. to operate
along Bretton Woods 3 arrangements for as long as the U.S. dollar remains the
world’s key reserve currency. Alternative arrangements under which the U.S.
dollar would lose its special status as other key countries mature are
conceivable but – absent any such official agreement – may still take decades
to come about by evolution. In the interim, Bretton Woods 3 might actually
offer more sustainability and greater benefit if the United
States were to adapt macroeconomic policies accordingly
and focus on upgrading U.S.
infrastructure.

[i]
See Joerg Bibow, "The American-German Divide: Macro
Policy and International Co-operation", New American Contract Policy Paper, New America
Foundation, 8 July 2009.

[ii]
These issues are investigated in more depth and detail in my recently published
book "Keynes on Monetary Policy, Finance and Uncertainty: Liquidity Preference
Theory and the Global Financial Crisis", Routledge.