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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.
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).
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