Tuesday, July 22, 2014
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The Bear of Bretton Woods

BERKELEY – This is the season for international monetary conferences. In March, national leaders assembled in Nanjing, China, to speechify on exchange and interest rates. And, in early April, leading thinkers and former policymakers met in Bretton Woods, New Hampshire, the birthplace in 1944 of the International Monetary Fund and our dollar-centered international monetary system.

The 1944 Bretton Woods conference was marked by a clash between the United States and the United Kingdom, represented by the economists Harry Dexter White and John Maynard Keynes, respectively. The UK wanted a system in which global liquidity would be regulated by a multilateral institution, while the US, for self-interested reasons, preferred a dollar-based system.

Given its immensely greater economic and financial power, America predictably carried the day. Keynes failed in his quest to endow the IMF with the power to create a new international reserve unit as an alternative to the dollar. And he failed to secure agreement on measures that might force surplus as well as deficit countries, and the issuer of the international currency as well as its users, to adjust.

The latter failing haunts us to this day. Countries that run chronic external surpluses, like China, and countries whose currencies are widely used internationally, like the US, do not face the same pressure as other countries to correct their policies when economic imbalances arise.

Policymakers at Nanjing promised to address this problem. They tasked the G-20 with developing a set of indicators that would signal when any country, including the US and China, was at risk of a crisis. They called for a process to ensure that when the warning lights flashed yellow, the country in question would be compelled to correct its policies.

Unfortunately, such early warning indicators are better at reflecting the last crisis than they are at preventing the next one. The nature of financial risk is constantly changing in ways that are difficult to predict using backward-looking indicators like those being devised by the G-20. In any case, the only process for acting on such indicators is “peer pressure,” which is unlikely to deliver results.

The other fashionable policy idea that will ultimately prove impractical is to transform the IMF credits known as Special Drawing Rights into an international currency to rival the dollar. The problem is that SDRs are used neither to settle cross-border transactions nor as a unit in which to denominate international bonds. That means that there are no private markets for SDRs, and creating such markets would be a long, hard slog.

In addition, in order for the SDR to become a true global currency, the IMF would have to be empowered to issue more of them in a crisis, much like the US Federal Reserve provided foreign central banks with $120 billion in emergency credits following the collapse of Lehman Brothers. In other words, the IMF would have to be given the powers of a global central bank. It seems unlikely that Ron Paul, the libertarian chairman of the US Senate Banking Committee, who doubts that even the US needs a central bank, would be inclined to agree.

Instead, what will ultimately replace today’s dollar-centric international monetary and financial system is a tripolar system organized around the dollar, the euro, and the Chinese renminbi. Despite all of the current wailing and gnashing of teeth in Europe about its future, the euro isn’t going anywhere. And China, for its part, is working energetically to internationalize its currency – and it is making faster progress than most people appreciate.

The world will be better off as a result. The existence of alternatives to the dollar will mean that the issuers of internationally used currencies will feel market discipline earlier and more consistently. When the US again shows signs of falling prey to financial excess, it will not receive as much foreign funding as freely as it has in the past. After all, central banks seeking to accumulate foreign-currency reserves will have alternatives to acquiring dollars, so foreigners won’t give America so much rope with which to hang itself.

The result will be a safer financial world. After all, the ultimate cause of the 2007-2009 financial crisis was the dangerous inconsistency between our multipolar global economy and its still dollar-dominated monetary and financial system.

The good news is that this will change over the coming decade, bringing international monetary arrangements back into line with economic realities. The bad news is that ten years is a long time. If recent history is any guide, salvation could still be three crises away.

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