NS3040 Winter Term 2014

Issues With Bretton Woods II

Bretton Woods II Issues I

• Bretton Woods II is one way of describing the current global financial system.

• Not a pure fixed exchange rate system like Bretton Woods I, but many countries do maintain fixed rates

• Fact: no one is happy with the current system

• Three broad complaints

• First – the dominance of the dollar as a reserve currency and America's management of it

• Bulk of foreign exchange transactions and reserves are in dollars even though the US accounts for only 24% of global GDP

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Bretton Woods II Issues II

• Based on figures in chart, current system fails to reflect realities of the world economy

• Finally it leaves others vulnerable to America’s domestic monetary policy

• Second – system has fostered the creation of vast foreign exchange reserves especially in emerging economies

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Bretton Woods II Issues III

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• Global reserves increased from $1.3 trillion (5% of world GDP in 1995 to $8.4 trillion (14%) by 2010

• Emerging economies hold two thirds of the total

• Most has been accumulated in the 2000s

• Huge reserves run counter to economic logic

• Mean poor countries which should have abundant investment opportunities are lending cheaply to richer ones, mainly America

• Such lending helped create the 2008 financial crisis by pushing down America’s long term interest rates

• Today with Americans saving rather than spending, reducing global demand and recovery

• Third complaint: the scale and volatility of capital flows

• Financial crisis have become fore frequent in the past three decades

• Emerging countries often have floods of capital or sudden droughts – not best basis for long-term growth

Bretton Woods II Issues IV

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• Fundamental question: What improvements are feasible?• Any monetary system will be constrained by the so-called

trilemma.

• If capital can flow across borders, countries must choose between fixing their currencies and controlling their domestic monetary system – cannot do both

• Classical 19th century gold standard – currencies tied to gold

• System collapsed because it allowed countries no monetary flexibility

Bretton Woods II Issues V• In Bretton Woods regime currencies pegged to dollar which in

turn tied to gold

• Capital mobility limited so that countries had control over their monetary conditions

• System collapsed in 1971 because US would not subordinate its domestic policies to the gold link

• Today’s system – no tie to gold or other anchor

• Contains a variety of exchange regimes and capital controls

• Capital controls were lifted three decades ago and financial markets are highly integrated.

• On paper emerging economy exchange regimes becoming more flexible

• But most floats highly managed

• Most are export-oriented and need competitive exchange

• Countries don’t like to have their currencies strengthen when capital flows in so they buy foreign exchange to stem tide builds up reserves.

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Bretton Woods II Issues VI• Countries have also found that a strong reserve position

creates stability during times of uncertainty – Asian Crisis in the late 1990s

• Question – what is a safe level of reserves?• China’s are no doubt excessive• The country’s behavior also affects others:• Many emerging economies especially in Asia are reluctant to

risk their competitiveness by letting their currencies rise much• Their currencies shadow the dollar creating Bretton Woods II

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Bretton Woods II Issues VII

• History Lessons• Similarities between Bretton Woods II and the original Bretton

Woods mean many of today’s problems have historical parallels

• Demand of emerging economies for dollars and fear that dollar may lose it value – problem in Bretton Woods

• Triffin paradox – reserve country must issue lots of assets (usually government bonds) to expand world liquidity

• But the more bonds it issues – more questions about serviceability

• IMF estimates that at current rate of global reserve accumulation global reserves would rise from

• 60% America’s GDP in 2010 to

• 200% in 2020 and

• 700% in 20358

Bretton Woods II Issues VIII• Possible Alternative Systems• SDR

• Favored by China

• Would still be heavily weighted by dollar

• Not much of a SDR bond market – why hold them?

• IMF would have to be a World Central Bank – not much chance countries would give up sovereignty to IMF

• China Yuan

• Country still has capital controls – limited bond market

• Currency not used much internationally

• System may evolve in this direction as dollar and British pound did before dollar dominance – perhaps by 2030

• Greater role of IMF in providing reserves

• Countries would have a line of credit, so no need for large reserves

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Bretton Woods II Issues IX

• Keynes idea of putting caps on balance of payments surpluses and deficits

• Would force Asian countries to rebalance

• U.S. would have to increase savings, reduce government deficits

• Might eliminate need to maintain week currencies if economies more diversified.

• What if countries ignore limits as in Europe?

• In sum – system will continue evolving with no formal agreement in place -- unless a complete collapse occurs

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