Executive Summary
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The world economy is on the threshold of significant upheaval because of the substantial structural change in the global financial architecture, now popularly known as “Bretton Woods II.” Proponents of this so-called “Bretton Woods II” system argue that there is nothing inherently unsustainable about it. It simply represents the reemergence of a new Bretton Woods regime of global fixed exchange rates, based on structural current account deficits in the U.S. and structural current account surpluses in Asia, with the Asian current account surpluses recycled to provide cheap financing for the U.S. current account deficits. The U.S. gets to consume more than it produces and finance budget deficits cheaply, while strong export growth drives East Asian growth rates and rapid industrialization absorbs the labor surplus created by China’s underemployed rural population. In this view, this new BWII regime will allow the U.S. to finance its large current account deficit at a low cost for a long time; consequently, the United States’ growing external indebtedness poses few immediate concerns. In the paper below, we disagree.
In contrast to its forebear, BWII is not global in scope; nor does it retain any vestigial linkage to gold, nor any contractual obligations. It is less a monetary “system” and more monetary fiction, articulated to rationalize the dollar’s perverse resilience in the face of America’s increasingly parlous debt build-up and America’s seeming immunity to Third World style debt-trap dynamics. It artificially distorts risk premiums and encourages destabilizing financial practices such as the so-called “yen carry trade.” A misleading snapshot, it ignores the harmful impact of today’s exchange rate anomalies, rather than seeing them for what they are: the roots of a convoluted financial architecture, which have—and continue to create—great imbalances that ultimately threaten global stability and freedom.
All parties that have embraced the conventions of BWII have had good short-term reasons for doing so. The U.S. has acceded to this arrangement because it has served to boost U.S. asset prices and lower risk spreads, thereby helping to facilitate America’s “guns AND butter” foreign policy. In the absence of its Asian creditors acting as “dollar sub-underwriter of last resort,” it is hard to envisage a chronic debtor country like the U.S. mounting successive wars with little financial strain and an absence of tax increases.
Similarly, from the Asian perspective, BWII seems to make good short-term sense in that the consequent build-up of foreign exchange reserves has enabled them to avoid a repeat of the economic calamity that afflicted the region ten years ago. Virtually all of the governments in the region have sought to keep their currencies cheap, developing Asia’s total reserves have jumped from $250 billion in 1997 to $2.5 trillion this year. The desire to build up reserves is understandable in light of the Asian financial crisis of 1997 and is a direct result of the massive devaluations in the region at that time, but they are now excessive. Furthermore, they do not actually give the Asians the insurance they seek to avoid another disruptive financial crisis. On the contrary, they actually add to the potential for another one. By keeping their currencies artificially low, recycling the resultant current account surplus savings back into dollars, they are driving down risk premiums and subsidizing uneconomic lending. The creditor nations all face capital losses on their reserves as the dollar declines, while running the economy according to an exchange rate target means abandoning control of domestic policy. This is the price they are willing to pay to put otherwise idle resources to work to build investment internally from cash flow as long as current systems persist. But in contrast to 1997, the initiative rests with them, not the Americans.
Most analysis of the Asian financial crisis has tended to ignore the role played by China’s policy of “beggar thy neighbor” devaluations, which began in the late 1980s and later set the stage for the loss of East Asia’s export competitiveness. But it is the ongoing fear of losing competitiveness relative to China that has played a big role in these countries’ reluctance to allow their exchange rates to appreciate any more rapidly. If China allowed its currency, the Yuan, to rise, they would have less need to intervene. China, more than its neighbors, may have drawn the wrong lesson from the crisis. In effect, China created the crisis in the first place and learned the power of exchange rate manipulation as a development tool.
As China’s current inflationary pressures illustrate, the policy generates unsterilisable increases in foreign currency reserves, which in turn causes excess monetary growth, domestic asset price bubbles, overheating, inflation and the loss in competitiveness that governments had tried to prevent by suppressing the rises in nominal exchange rates. It distorts domestic financial systems, by pushing interest rates below equilibrium levels. It floods the market with an excessive supply of goods and then subsidizes purchases by subsidizing credit. It generates a waste of resources in accumulation of low-yielding foreign currency assets exposed to the likelihood of huge capital losses—losses on reserve which would not have existed if China had revalued its currency in the first instance. The benefit that accrued to China was a much more rapid development of its capital base, industry, and infrastructure. But retaining the policy today makes all Asian economies excessively dependent on demand from outside the region. It exacerbates U.S. protectionism.
A perpetuation of existing exchange rate policies, then, based on flawed economic analysis, is creating broadly similar conditions to those that prevailed before the Great Depression. History suggests great economic hardship will follow and that it will be proportionately borne greatest by the debtor nations. But the creditor nations will be afflicted as well as they suffer the loss of their largest export market, and the risk of an economically aggrieved America increasingly prone to resolve its difficulties through the embrace of military unilateralism.
Failure to implement policies that alter the otherwise inevitable expansion of these deficits will result in a very bad outcome—one whose form is impossible to predict. For context of the unpredictable, it is useful to recall Princeton economist Frank D. Graham’s 1943 essay titled, “Fundamentals of International Monetary Policy.” He states, “In international affairs we must therefore strive to reconcile the liberty of the individual, the sovereignty of states, and the welfare of the international community.” Graham understood that poorly crafted sets of economic policies and rules in a global economy would lead to great imbalances that threaten stability and freedom. His analysis and insights applied to the two world wars of the last century as well as to the Great Depression. They also apply to global circumstances today. More specifically, Graham argues that a poorly regulated fixed-exchange rate regime is inherently unstable. Countries will cheat by setting their currency at rates that promote national agendas, ignoring the instability imposed upon the global economy. They become “renegade nations” in effect practicing “renegade economics.”
Rather than capitulate to the false logic of Bretton Woods II, we propose a Japan-style zero interest rate policy (ZIRP) for the U.S. in combination with strategic and iterative fiscal tightening as a targeted response to global imbalances, creating a “synthetic” trade tariff for foreign exporters of capital, and effecting a redistribution of wealth from asset-rich savers to debt-laden consumers in the U.S. Along with this, a substantial revaluation of the Asian currencies, led by China is in order. The desired policy objective is to eliminate the U.S. twin deficits and reduce U.S. debt levels without inducing an asset-deflation driven economic recession, explicitly legislating protectionism or encouraging heightened militarism, all of which threaten to reverse the progress of globalization and rising global economic prosperity.1
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1 This paper is a sequel to “A Zero Interest Rate Policy (ZIRP): Remedy to Global Imbalances” by Chris P. Dialynas & Saumil H. Parikh, April 2006. The authors acknowledge the assistance of Saumil Parikh and Katerina Alexandraki.
The opinions expressed in this paper are the authors’ and may not reflect the viewpoint of PIMCO.