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Authors for macroblog are Dave Altig, John Robertson, and other Atlanta Fed economists and researchers.

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February 25, 2005

The Bretton Woods II Red Herring

Daniel Drezner's latest post cleanly lays out the the state of the debate on the dollar, U.S. current account imbalances, and the prospects for global financial stability.  On the one side are the proponents of a renewed system of more-or-less fixed exchange rates tied to the dollar.  Here Drezner quotes David Levey and Stuart Brown:

In a series of recent papers, economists Michael Dooley, David Folkerts-Landau, and Peter Garber maintain that Asian governments--pursuing a "mercantilist" development strategy of undervalued exchange rates to support export-led growth--must continue to finance U.S. imports of their manufactured goods, since the United States is their largest market and a major source of inward direct investment. Only a fundamental transformation in Asia's growth strategy could undermine this mutually advantageous interdependence--an unlikely prospect at least until China absorbs the 300 million peasants expected to move into its industrial and service sectors over the next generation.

On the other side are Nouriel Roubini and Brad Setser, who have been consistently argued that chickens will soon come home to roost.  This, from Nouriel, is representative of their conclusions:

Essentially, there is a fundamental contradiction between the large and growing US financing needs for its twin current account and fiscal deficits and the shrinking willingness over time of the rest of the world - both central banks and private investors - to provide such massive and growing financing.

- We argue that the likely collapse of this regime in the next couple of years would result in a Hard Landing scenario: the dollar would sharply fall, US long term interest rates would sharply increase, the price of most risky assets - equities, housing, high yield debt, emerging market sovereign debt - would significantly fall, and a sharp US and global economic slowdown - if not outright recession - may ensue. The probability of such hard landing is increasing.

As I've said (or at least implied) on many occasions -- the latest being here --  these polar models don't strike me as a productive way to frame the discussion. In other words, the non-Hard Landing scenario does not require the extreme assumption that foreigners are willing to finance an unending amount of American consumption.

My thinking on this is driven, in part, by my sense that Drezner's description of the dilemma...

The dollar's fall in value relative to the euro is costly for the central banks holding large amounts of dollar-denominated assets. In purchasing so many dollars, these banks have a powerful incentive to ensure that their investment retains its value -- but they an equally powerful incentive to sell off their dollars if it appears that they will rapidly depreciate. This cost creates a dilemma for these central banks. Collectively, these central banks have an incentive to hold on to their dollars, so as to maintain its value on world currency markets. Individually, each central bank has an incentive to sell dollars and diversify its holdings into other hard currencies. This fear of defection leads to a classic prisoner's dilemma, and the risk that these central banks will simultaneously try to diversify their currency portfolios poses the greatest threat toward a run on the dollar.

... misses the mark on one important dimension.  It is not the business of central banks to maximize the return on their portfolios.  It is the business of central banks to protect and enhance the stability of domestic financial markets and, in the case of the large central banks, global financial stability.   This is what we were created to do.  This is what we do.  (I know you will be able to provide all sorts of counterexamples, but let me take a preemptive strike by asking you to think back to 1987 and 1997-98.)

I will grant I don't know a lot about the internal functioning of monetary authorities outside the United States.  And the less independent the monetary authority in any particular country is -- that is, the more it is tied to the nation's fiscal operations -- the more likely it is that profit-maximization motives will come to dominate.  Further, it is true there is a limit to the losses on central bank balance sheets that smaller countries can sustain.  But I don't believe that these are the relevant consideration for the really big players in the current environment. 

If I am wrong on this, then let the evidence speak.  I think that would be a more productive next step in the debate than reiterating that the U.S. current account deficit is really big (we know that, and also know that means large capital account surpluses) or taking pot shots at the rather extreme vision of a new Bretton Woods monetary order (which looks a lot like a straw man to me).

February 25, 2005 in Exchange Rates and the Dollar , Trade Deficit | Permalink


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Tracked on Feb 27, 2005 10:21:07 AM



I must be forgetting my macro fundamentals.

But, one potentially important difference between Bretton Woods I and the current 'II' is that, in I, there was another reserve 'currency' behind the USD - gold.

Could someone please explain how system 'II' can be sustained indefinately when there is only one reserve currency, and it is a net debtor. That means that, without policy adjustment, the supply of the reserve currency must expand at an ever accelerating rate, no?

This question has puzzled me since the Korean reserve adjustment issue popped up this week. If there is only one reserve currency, and it's viability comes into question then, if the reserve currency country does not take action to arrest excess spending, isn't diversification of reserves the only alternative for other countries? If that's true, then this can only accentuate the underlying problem of an accelerating excess USD position.

What am I missing here?? Please help!

Posted by: Andres Drobny | February 25, 2005 at 01:40 PM

Isn't there a temporal element to your statement that "the business of central banks to protect and enhance the stability of domestic financial markets and, in the case of the large central banks, global financial stability?"

Creating stability in the short run seems to be adding to instability in the long run so it is not clear to me that their good intentions can solve the problem.

It also seems like we may be at a point where central banks powers to create liquidity (as in 87 and 97-98) could be limited by the private sectors perception of imbalances.

Posted by: Michael | February 25, 2005 at 02:26 PM

David -- How exactly does reserve accumulation of more than 10% of GDP (China in 04), reserve accumulation on a scale that cannot be effectively sterilized, contribute to "domestic financial stability"? I can see how it contributes to fast growth in the export sector, but not so easily how it is contributing to "domestic financial stability"?

And I guess you can make a case that financing US imbalances contributes to global financial stability in a certain sense, but by financing the absence of adjustment (in both the US and in Asia), you can also make a case that the Asian central banks are contributing to future global financial instability ...

Posted by: brad | February 25, 2005 at 03:48 PM

David -- I remain interested in the financial flows that accompany your non-hard landing scenario. It is certainly a possible scenario. But I am curious if you expect central bank reserve accumulation to continue during this scenario at its current pace ($450b),for it to gradually fall back to its historical norm (under $100b) and private flows to the US to gradually pick up? For it to fall back quickly/ offset by a surge in private flows.

Gross notes that foreigners bought $900b of the $1300b in net debt issuance in the US in 04 -- that is a pretty hefty chunk, and central banks bought maybe $400 b of it (assuming a 60 b increase in their bank deposits, so $400b increase in overall holdings of dollar securities and $460b or so overall increase in their dollar reserves); I can see a soft landing scenario where CBs keep up this level of reserve purchases, US fiscal starts to adjust, and gradual increases in the interest rates needed to attract private financing to fill the rest of the US external financing need lead to a gradual slowdown of growth. But it also seems to me that there are real risks to that relatively benign scenario.

Posted by: brad | February 25, 2005 at 03:53 PM

The economic points of view have been pretty well framed on both sides. It sems to me that: - everyone is agreed that the very large current account mis-alignements that we are observing are likely not optimal,
- forex accumulation at the rate it is going in some countries is not optimal,
people are essentially disagreeing (very difficult English word !)on whether the necessary adjustment will be sudden and un-controlled, thus disruptive or take place over a number of years such that it can be accomodated without too much damage to various economies. I personally would expect that the second scenario is more likely basically due to the identity and nature of the essential actors, namely Asian central banks. Perhaps I am an optimist, time will tell.

Now what strikes me in this situation is the following, not directly economic, observation.

We have on the one hand a country more powerful in relative terms than perhaps ever seen on earth, call it the empire. Setting aside the formerly sleeping giant, we have a number of small and medium size countries whose development, security, culture even is heavily influenced by the empire.

Strange things happen.

The empire benefits from cheap - undervalued exchange rate - imports of manufactures from these countries. These contribute to increase living standards for the lucky citizens of the empire ( even though they sometimes or all the time get confused about this).

The empire extracts massive capital from these countries as it runs a large current account deficit, and they run large surpluses. This helps the empire maintain a level of investment and research necessary to future increases in wealth, while simultaneously enjoying a somewhat lavish lifestyle - incidentally may I recommend a nice bottle of Claret, the 1989 Château Latour, though I'll have to check if they use Pinot Noir or Merlot.

Am I the only one reminded of Victorian UK (or colonial France for that matter)?

A colonial system is not a stable arrangement. It can however appear and remain stable for a very long time.

Posted by: godement | February 25, 2005 at 05:43 PM

Godement --

The historian Niall Ferguson has a paper circulating that plays off similar themes. I don't think it is on his web page, but presumably it will make an appearance soon.

Posted by: brad | February 25, 2005 at 08:37 PM


Many thanks for telling me about the coming Niall Ferguson paper. As I am not in academia, I would likely have missed it. I'll be watching for it.

Posted by: godement | February 26, 2005 at 04:34 AM

Greetings -- Outstanding comments as usual. A few notes.

Andres -- I am not sympathetic to the BWII metaphor, so I'm not the best person to ask. But I will say this. It is my sense that the gold standard really ceased to exist after WWII -- the cards being played in 1933 with the suspension of private gold ownership. So, in effect, Bretton Woods operated primarily as a world fixed exchange rate regime with the dollar as the universal (fiat) reserve currency. It broke down precisely because the US exploited its privileged role, and Nixon finally completely removed any pretense that we were operating under a true gold standard. In this sense, the invoking of Bretton Woods by Garber et al is not crazy, although the history of things favors the Roubini-Setser line (in my opinion). (Monetary historians should feel free at this point to correct any misinterpretations.)

Michael -- I don't think the issue is whether the world stands ready to absorb more liquidity. My position is that central banks are not likely to create counterproductive shocks. As I said, they will (and maybe should!) diversify away from dollar assets at the margin. But that is different thing than dumping large chunks of their portfolio. The former is the path to orderly adjustment. The latter the path to Roubini-Setser-land.

Brad -- First, let's not mix up central bank liabilities and general government debt. I think it is pretty clear that the accumulation of dollar-denominated assets (so far) is not because of excess monetary creation, but fiscal deficits. It is fundamental to my position that the Fed is going to behave and not exacerbate problems by inflating. (If you want to hear a higher authority on this see my post titled "Worried about the deficit? Here's one problem to cross off your list")

And -- Although it may seem the contrary is true, I do not dismiss the hard landing scenario out of hand. I just think it can work out otherwise (as do you, I think). But you and Nouriel are making perfectly good points -- I'm playing the role of loyal opposition.

Godement -- I briefly note Niall Ferguson's argument in a post on December 7 titled "Time for a little perspective on the dollar?" There I link to a book review by Ferguson in Foreign Affairs, where he lays out his general view of things. It is very much worth a look. Here is the link: http://www.foreignaffairs.org/20030901fareviewessay82512/niall-ferguson/hegemony-or-empire.html

Posted by: Dave Altig | February 26, 2005 at 07:23 AM

Dave -- To the extent that Asian central bank reserve accumulation is keeping a range of US interest rates lower than they otherwise would be (a point of some debate), it is keeping US monetary conditions looser than they otherwise would be for a given Fed funds rate. But that was not my main argument (and the Fed can always offset lowere long rates with higher short rates)

My concern was focused on the other side of the Pacific. All those reserves imply a growing domestic money supply in India, Thailand, Malaysia, Taiwan, Korea and China (I am leaving Japan out, b/c a bit of inflation would not be a bad thing there), unless the central bank sterilizes to keep the money supply from rising. Sterilization usually requires selling the central banks existing holdings of gov. bonds, or issuing new CB sterilization bonds. My general sense is that some Asian central banks are having trouble sterilizing reserve accumulation at the current rate. This is particularly true in China (see Lardy/ Goldstein). Right now, China is using other, administrative means to keep inflation under control, and perhaps to keep the financial system from continuing to fuel property/ investment bubbles (I remain to be convinced on this). So my argument is that continued reserve accumulation in Asia may eventually conflict with domestic monetary/ financial stability in Asia (the old imported inflation at the end of BW2 story) because of difficulties sterilizing reserves of almost 40% of GDP (now) heading toward 50% of GDP in a country like China.

Posted by: brad | February 26, 2005 at 12:17 PM

Brad -- On that we are agreed. Ironically, though, Chinese inflation, in the end, justifies the peg in that it devalues the nominal value of the yuan relative to the dollar (and everything else). Of course, the question is whether the imblance between the peg and the fundamental value of the real exchange rate will widen. If so, I agree the effects of attemtping to fix could utlimately prove destabilizing. I'm actually on your side in believing that the peg will go at some point.

One side note: I don't agree with the implication that low interest rates are prima facie evidence of easy policy. The stance of monetary policy depends on the relationship of the federal funds rate to the underlying market-determined real return to capital (the Wicksellian norm, if you will). The federal funds rate has been able to remain low for so long because the equilibrium real interest rate has been low. However, that situation, as you and I agree, has in part been delivered by the willingness of foreigners to finance our current account deficits.

Posted by: Dave Altig | February 27, 2005 at 08:47 AM

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