Toward Bretton Woods 3?

Back in 2007 we used to refer to the current crisis as the "U.S. subprime crisis". But while it was the area where troubles first emerged, the subprime mortgage sector turned out to be only the tip of the iceberg. Today, the Lehman crisis of mid September 2008 is still widely seen as the critical blunder that pushed the U.S. and world economies off the cliff. And yet, the Lehman bust may have been no more than just the trigger of an implosion of underlying financial structures that had built-up to reach a cracking point many years before.

In assessing the roots of the ongoing crisis and also the prospects for a global rebalancing and sustained recovery, due account has to be taken of the center role of the U.S. dollar in the world economy. The world monetary and financial order - with the U.S. dollar as its hub - conditioned and induced particular macroeconomic policies in the rest of the world and at home, policies that led to the built-up of "global (and domestic) imbalances" and underlying international (and domestic) credit structures. We are currently witnessing their malign unwinding, as we grope for suitable policy responses. In weighing domestic policy options at the current juncture, it is important also to consider the future role of the dollar in an evolving and increasingly integrated world economy.

The U.S. economy has become more "open" in terms of trade and investment flows, with correspondingly heightened vulnerabilities to external events that global linkages and interdependencies inevitably bring with them - a tendency called globalization that the U.S. shares more or less equally with much of the rest of the world. Even more important, the U.S. is not only unique in the world, but also uniquely important for standing at the top of the international pecking order of currency and finance. Because the world monetary order is dollar-centered, U.S. financial institutions have for long enjoyed a supreme position in global finance. It is thus noteworthy that this order is asymmetric in that one player is more equal than everyone else - a special status that comes along with both special benefits and responsibilities. The behavior of the country at the hub of the order is of the greatest systemic importance, but remains conditioned by other players' conduct as well.

In much of the rest of the world, rising globalization under the asymmetric dollar-centered order has induced governments to pursue defensive macroeconomic policies. The world financial system has become increasingly globalized in its reach and operations. However, regulation and supervision of financial institutions engaged in cross-border activities have remained predominantly national. This mismatch creates a highly unsafe environment, especially for countries further down the currency hierarchy. The resulting loss in economic sovereignty through global integration has put a premium on policies that help preserve whatever little control and room of maneuver individual countries may have left. In general, seeking protection has taken the form of maintaining a competitive exchange rate vis-à-vis the U.S. dollar, running up current account surpluses, and accumulating soaring foreign exchange reserves, predominantly denominated in U.S. dollars, as self-insurance.

A common tendency among countries that pursue policies of this kind has important systemic implications: if everybody pushes exports and aspires to accumulate dollar reserves, strong deflationary forces arise in the system as a whole. In fact, under a 1930s gold standard system that was characterized by a given amount of gold reserves available for hoarding, such rising systemic pressures would have led to a severe tightening of financial conditions, bank runs, and ultimately deflation and financial meltdown. While individual countries could chose to get off gold or depreciate their currency relative to gold, the gold standard order as a whole lacked a mechanism to offset systemic deflationary pressures by augmenting the system's reserves correspondingly. That factor contributed to the severity of the Great Depression.

Today's world monetary order is not a gold standard, but a U.S. dollar standard. The amount of U.S. dollars available to be held as reserves by other countries is not physically constrained as in the case of gold, but generally depends on the evolution of the U.S. balance of payments over time and on U.S. macroeconomic policy decisions at critical junctures in particular. Systemic deflationary forces can develop in this system too, but they can more easily be offset by a flexible U.S. macroeconomic policy response, so the ultimate outcome of the current crisis may be less horrific than the Great Depression.

The country issuing the system's key reserve currency has a special responsibility under crisis conditions. Under more normal conditions, too, meeting the key reserve currency's systemic role may also come about quite naturally and in full accordance with the national interest. The point is that a general desire among the rest of the world to export to the U.S. and accumulate dollar reserves produces strong deflationary forces in the domestic economy of the reserve currency issuer. Weakness in U.S. labor markets and downward pressures on wages and prices in general arise. These market pressures will normally convince U.S. policymakers to respond by more expansionary macroeconomic policies. It should not be overlooked that stimulating domestic demand sufficiently to offset deflationary forces reaching U.S. shores from abroad is made easier by the benefits enjoyed by the key reserve currency issuer en route: cheap imports and easy terms of finance - given that U.S. dollar reserves normally pay only low rates of interest (on top of offering top-safety as sought by their foreign official holders).

Bretton Woods 2

These general insights into the workings of the dollar-centered world monetary and financial order come in handy when investigating critical global developments that led up to the Lehman-triggered financial implosion of 2008, the global policy responses that have followed since, and the prospects for global rebalancing and recovery as they present themselves today. The point I am driving at is that the world monetary and financial order conditioned and induced particular macroeconomic policies in the U.S. and the rest of the world, policies that led to the built-up of "global (and domestic) imbalances" and underlying international (and domestic) credit structures. The future outlook for the U.S. and world economies continues to be contingent upon the dollar's role in the global order, even if a return to conditions and policies prevailing before the crisis seems unlikely.

To highlight some critical issues I will draw on the so-called "Bretton Woods 2" hypothesis as my framework of analysis. In 2003, Michael Dooley, David Folkerts-Landau, and Peter Garber hypothesized in their influential "Essay on the revised Bretton Woods system" (or: "Bretton Woods 2") that global imbalances featuring a quasi-permanent U.S. current account deficit may be sustainable. On their view global current account imbalances reflected a symbiosis of interests among deficit (U.S.) and surplus (developing world) countries. The developing world's interest is to sell its products in the large U.S. market as a way of stimulating employment growth and development. The U.S. economy, on the other hand, is flexible enough to tolerate the resulting quasi-permanent drag on U.S. income growth, given its comparative advantage in creating safe assets which the periphery wishes to accumulate for safety reasons.

Note that the global monetary and financial order stands right at the center of an analysis of global "imbalances" which are actually interpreted as a balanced situation by Dooley et al. Moreover, the chosen title "revised Bretton Woods system" signals that the authors seem to see a lot of continuity in post-war monetary arrangements, despite the fact that the world has moved away from the "Bretton Woods 1" system of pegged exchange rates in the 1970s. Dooley et al. suggest that a new "periphery" (China in particular) has emerged replacing the former periphery of Western Europe and Japan in relying on export-led growth strategies by pegging to the U.S. dollar - which has remained the currency at the center of the so "revised" global order.

In view of what I said above about the dollar-centered global monetary and financial order, it will come as no surprise that I principally agree with these general points of perspective. However, there is one factor conspicuous for its absence in the Bretton Woods 2 hypothesis that turned out to be rather critical to the supposed sustainability of these arrangements. I am referring to those "safe assets" the production of which the U.S. has a comparative advantage in. It is of course true that the official authorities of countries such as China have largely accumulated safe assets, U.S. Treasuries in particular. The point is that the assets that actually sponsored U.S. spending in excess of income growth were assets that have proven to be so lethally "toxic" as to cause today's global crisis.

The Bretton Woods 2 hypothesis ignores that the domestic counterpart to the U.S.'s external deficit was based not on (safe) public debts, but on (toxic) private debts, mortgage debt in particular. Skepticism regarding soaring household indebtedness and the implications for the solvency of lenders ended the party when underlying collateral values stopped rising in 2006. In essence, as foreign official authorities came to hold a rising share of the outstanding stock of U.S. Treasuries, U.S. consumer spending was fired by households taking on ever more debt relative to income. The rise in household indebtedness (leverage) saw the U.S. personal saving rate decline from about 10 per cent in the 1980s to little more than zero by 2007. While falling interest rates helped keep the private debt burden in check to some extent, trends like these can clearly not continue forever. To be sure, neither will U.S. households pay down debt forever. They will start borrowing again at some point. The point is that we are unlikely to see a return to and continuation of previous patterns of behavior featuring a continuous decline in the saving rate.

Let me highlight then how the world monetary and financial order nurtured the U.S. consumer in its role as "borrower and spender of last resort", the true engine of growth behind the Bretton Woods 2 system. Japan in the early 1990s was the first calamity in the world economy that created forces for over-spending in the U.S. Stuck in protracted domestic demand stagnation, Japan has become wholly reliant on exports for its meager GDP growth. Germany came next, following the Bundesbank-provoked recession in response to the country's unification. Ever since 1993 Germany, too, has relied only on its export engine. Germany's influence in the global economy became further magnified when its economic policy model was exported to Europe through the Maastricht Treaty on Economic and Monetary Union - effectively committing Europe to a mercantilistic model of growth. The detrimental effects of the spreading of the "German disease" have become most visible in "Euroland", the club of countries that have adopted the euro as their common currency. Domestic demand had stagnated for much of the 1990s and "between 2001 and 2005, the eurozone was the sick giant of the world economy" (Martin Wolf, FT, 27 Mar 2007).[i] Note that these countries are all industrialized competitors of the U.S. According to the Bretton Woods 2 hypothesis these countries should have long matured and no longer be part of any export-led growth "periphery".

A new periphery really only came to emerge in the aftermath of the 1997-8 Asian crises, events which seem to have convinced increasing numbers of developing countries to seek safety in pursuing current account surplus rather than deficit positions. China, which had already pegged to the dollar in 1994 and maintained a competitive exchange rate ever since, represents one prominent example in this group, but China's current account surplus has really only soared since 2003.

Recall that in a world which becomes ever keener to export and accumulate dollars, systemic deflationary forces mount that hit the domestic economy of the key reserve currency issuer by putting downward pressure on wages and prices in general. In fact, without any offsetting forces forthcoming from U.S. macroeconomic policies U.S. and world economies would have faced the prospect of deflation. In the event, U.S. macro policies have responded flexibly to the above external developments since global imbalances started to emerge in the early 1990s, with monetary policy as first line of defense and recourse to active fiscal policy restricted to outright recessions. The Federal Reserve's mandate features maintaining price stability and high employment. Monetary policy encourages private spending by lowering interest rates, easing credit, and boosting asset prices. The Fed would have failed on both counts if it had not eased its policy stance sufficiently.

It is easy today to blame the Fed for causing bubbles. It is harder to see how the Fed could have otherwise fulfilled its mandate when global conditions were such that deflationary forces arriving from abroad required an offset from U.S. domestic demand that was not provided by public spending. The emergence of global imbalances, featuring a rising U.S. current account deficit, was thus inherently entwined with the emergence of domestic imbalances: debt-financed consumer spending and rising household indebtedness in particular. In 2006 projections by the IMF and OECD still showed a continued rise of the U.S. current account as a share of GDP. I argued above that the internal trends required to meet such projections were unsustainable - the aspect ignored in the Bretton Woods 2 hypothesis. Bretton Woods 2 was doomed long before Lehman hit the wall, the bank's failure merely delivered the regime's death blow.[ii]

The Emergence of Bretton Woods 3?

But the Lehman crisis has also triggered important policy responses across the globe together with some rebalancing of global demand. Interestingly, while Bretton Woods 2 is certainly dead, a new "Bretton Woods 3" regime might be in the process of emerging in its stead.

Under Bretton Woods 3 public debt replaces private debt, which may in principle prove more sustainable. The change of guard from monetary policy to fiscal policy has come about in the first place by the sheer severity of the crisis. With monetary policy short on ammunition, and important parts of the financial system dysfunctional, the only way to support domestic demand is to cut taxes in support of private incomes and spending or to boost public spending itself. As the private sector retrenches brutally, the public sector has to carry the torch; or else witness the economy sink into the abyss. In the winter of 2008-9 the world economy and world trade experienced a freefall comparable to the Great Depression of the 1930s. In contrast to that earlier episode, however, governments around the world initiated fiscal stimulus programs, although with some regional variation in magnitude. The rebalancing of global demand saw the U.S. current account deficit shrink from its peak of 6 per cent of GDP in 2006 to below 3 per cent in the first half of 2009. The question is whether the current global rebalancing and unwinding of imbalances is really going to continue, vindicating White House economics director Larry Summer's recent call for the U.S. to switch its consumption-based growth model for an export-oriented one.

I argued above that U.S. macroeconomic policies are conditioned by policies pursued in the rest of the world. If the U.S. were to merge in the export-led growth lane already overcrowded by the rest of the world, this would set the world on collision course, a sure recipe for disaster. It would also mean a refusal by the U.S. to play its role as key reserve currency issuer. If the rest of the world resumes its previous policy patterns of aspiring current account surplus positions and dollar reserve accumulations, the real choice facing the U.S. as key reserve currency issuer is to take recourse to fiscal policy and public debt rather than trying to rekindle the emergence of private sector imbalances. While we currently view fiscal policy as providing no more than a temporary emergency boost to restart private spending, Bretton Woods 3 would actually imply a more lasting role for fiscal policy in sustaining domestic demand.

To be sure, I do not mean anything like the current deficits, in double digits as a share of GDP. These stunning numbers reflect, first and foremost, the magnitude of ongoing private sector retrenchment. Public deficits will shrink as the private sector rebalances over the next few years. But even beyond this short-term rebalancing more permanent budget deficits may be needed, if the rest of the world were to resume previous policies. National income accounting implies that if the private sector's financial balance were balanced again, any U.S. current account deficit would require a corresponding public sector deficit. While a return to rising current account deficits of 6 per cent of GDP or so would likely quell renewed troubles not too far down the road, deficits of, say, 3 per cent may be perfectly manageable. Assuming 6 per cent nominal GDP growth, the U.S. net international investment position would converge to minus 50 per cent of GDP in the long run.

With rising external indebtedness, a crucial issue concerns U.S. external financing costs. And it is in this regard that the comparative advantage of the U.S. in producing low-yielding safe assets comes in handy. But in contrast to Bretton Woods 2 the safe assets acquired by foreign official authorities would also be the very assets that actually sponsor U.S. spending in excess of income: public debt (or government guaranteed securities) rather than private debt. Under BW2 Fed monetary policy played the lead role in keeping interest rates low, credit easy, and asset prices high and rising to induce sufficient private spending fired by private debts. Under Bretton Woods 3 Fed policy would still be important in keeping interest rates and U.S. external financing costs low, while a rebooted Wall Street could find its supplementary part in keeping the U.S. income balance on the current account in check. In any case, fiscal policy would take on the lead role - a change of guard in macroeconomic policy.

A Future Bretton Woods 4?

Importantly, as under BW2, the need and scope for Bretton Woods 3 "imbalances" (i.e. the size of the "equilibrium" U.S. current account deficit) largely depends on macro policies in the rest of the world. If, finally, Japan and Germany were really to mature from the mercantilistic periphery and generate domestic demand-led growth this would take important pressure off the U.S.'s shoulders. The same effect would occur if developing countries decided that globalization has become safer - perhaps due to reforms to global finance and the IMF with greater provision of "collective insurance." Finally, if China learned from its own ongoing rebalancing in the context of massive fiscal stimulus measures that a greater reliance on domestic rather than external demand is in its own national interest, this too would reduce the need and scope for Bretton Woods 3 accordingly.

One may therefore also venture some speculations about longer term prospects for the world monetary and financial order. At some point in the future, all major regions and players might mature and pursue domestic demand-led growth while exchange rates are adjusted so as to keep global trade in balance, and without any key reserve currency playing the crucial role currently occupied by the dollar.

The dollar is unlikely to retain its current special status forever. Bretton Woods 3 may however offer a more stable and sustainable system for the transition towards a more balanced "Bretton Woods 4" system of equal partners. As alternative arrangements along these lines would correspond to Keynes' original vision for the post-war order developed in the early 1940s, we could also call them "Bretton Woods 0" for that reason; the global order that never came to be as the actual "Bretton Woods 1" order was dollar-centered from the beginning.

Even without any official "new Bretton Woods" agreement, the alternative arrangements just sketched may still come about by market evolution and policy adaptation as China, India, and perhaps even Europe mature to a more equal global status. But this prospect still seems a matter of decades. In the interim period, Bretton Woods 3 might provide a more sustainable regime than Bretton Woods 2 could have ever become. If other countries do not like the prospect of continuous - though much smaller than today's - U.S. budget deficits, they can let their exchange rates appreciate, wean themselves off U.S. sponsored export growth and adopt domestic demand-led growth on their own. This is the real choice countries such as China are facing.

The U.S. cannot force other countries' policy choices, but in fulfilling its role as reserve currency issuer the U.S. should design its own macroeconomic policies in ways that best serve the national interest. There is no obvious economic reason why yet another private debt-financed HD television should be more beneficial to long-term U.S. growth than a public debt financed upgrade of U.S. infrastructure. Apart from boosting U.S. growth, particular infrastructure initiatives might also raise U.S. energy security, for instance. This would at the same time help to contain a re-surging U.S. energy (import) bill, a factor that inflated the U.S. current account deficit in the last boom. Flexibility, open-mindedness, and creativity are needed in filling the proper role for infrastructure investment in Bretton Woods 3.

To sum up, today's global crisis is ultimately rooted in the world monetary and financial order and the macroeconomic policies and global imbalances induced by that global order. Bretton Woods 2, featuring private debt financed consumer spending as the counterpart to the U.S.'s external deficit, is dead and cannot easily be revived, but a Bretton Woods 3 regime may come to take its place, featuring continued U.S. current account deficits, albeit this time driven by public spending and public debt. Unlike under Bretton Woods 2, under Bretton Woods 3 the safe assets accumulated by the periphery's official authorities would also be the very assets actually sponsoring U.S. spending in excess of income. Policy choices in the rest of the world would determine the need and scope for the U.S. to operate along Bretton Woods 3 arrangements for as long as the U.S. dollar remains the world's key reserve currency. Alternative arrangements under which the U.S. dollar would lose its special status as other key countries mature are conceivable but - absent any such official agreement - may still take decades to come about by evolution. In the interim, Bretton Woods 3 might actually offer more sustainability and greater benefit if the United States were to adapt macroeconomic policies accordingly and focus on upgrading U.S. infrastructure.

[i] See Joerg Bibow, "The American-German Divide: Macro Policy and International Co-operation", New American Contract Policy Paper, New America Foundation, 8 July 2009.

[ii] These issues are investigated in more depth and detail in my recently published book "Keynes on Monetary Policy, Finance and Uncertainty: Liquidity Preference Theory and the Global Financial Crisis", Routledge.