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Bretton Woods 2 and the current crisis: any link?

December 1, 2008

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Last week, I attended a conference on international financial reform. These kinds of conferences don’t really produce consensus; there is no need to agree on anything. But there was a sense -- at least I thought -- among the speakers that the recent crisis was a financial crisis plain and simple, not a financial crisis linked to the Bretton Woods 2 system of managed exchange rates. That implied, among other things, that current efforts to reform the international financial system should focus on reforming financial regulation -- not, say, reforming an international monetary system where the currencies of key surplus countries are pegged to the currency of the big deficit country.

And there is no doubt that the current crisis certainly isn’t the dollar crisis that many -- myself included -- long worried about. The sense that the current crisis isn’t an exchange rate crisis contributed to the sense that the loci of international effort should be regulatory reform. I nonetheless still believe that that the origins of the credit crisis cannot be entirely separated from the Bretton Woods 2 system -- a system where many emerging markets pegged (or managed) their exchange rates at levels that implied large ongoing current account surpluses and the resulting reserve growth financed large external deficits in the US and to a lesser degree in Europe.

Central banks didn’t take on a lot of credit risk directly, or directly finance the most risky loans to American households. Central banks bought Agencies to be sure -- but they were betting on the implicit government guarantee more than the Agencies exposure to US households and the Agencies themselves didn’t have the same appetite for risky mortgages as private banks and broker-dealers. Some central banks no doubt reached for yield and took on more risk that they should have in 2006 and early 2007 -- but in general they were far larger buyers of Treasuries and Agencies than "private" mortgage-backed securities. But central bank demand for safe debt nonetheless reverberated through the market. It helped keep US long-term rates down even as short-term rates rose. That in turn encouraging (myopic) private actors to take on more risk to keep their returns up.

Of course, private actors didn’t have to do this; they could have said that the risks were too high, and scaled back. Regulatory failures in the US and Europe played a role in the buildup of vulnerabilities that led to such a severe crisis. At the same time, if central banks hadn’t provided so much financing to the US for so long -- and kept lending to the US in dollars at low rates even as the United States (gross) external debt rose -- the US wouldn’t have built up the same kind of vulnerabilities either. Remember, private investors, by and large, weren’t willing to lend to the US on anything like the same terms as central banks. Without large dollar-denominated flows into the US, the US would have been forced to scale back -- and, in the process, delivered a bit less impetus to global demand growth.*

The large surpluses of the oil-exporters and Asian emerging economies could only last so long as someone in the US or Europe borrowed -- and borrowed in scale. When the US government stepped down (after 2004), private borrowers -- aided by a risk-risking financial sector -- stepped up, helped by a financial two step where emerging market central banks were willing to take dollar risk and leveraged financial intermediaries were willing to take credit risk. At least for a while. The game could only last in that form so long as emerging market governments were holding their exchange rates down and pushing up their countries national savings and private financial intermediaries were willing to lend to ever more indebted US households. That allowed say the rise in the oil exporters surplus to be offset globally by a rise in the combined deficit of the US and Europe, not a fall in Asia’s surplus. While the dollar’s rise and the resulting real appreciation of the renminbi has taken some of the urgency out of the debate over exchange rate, it would be a mistake, in my view, to limit the current debate over reforming the international financial system to regulatory issues -- as important as such reforms are.

In late October, at the prodding of a newspaper’s features section, I wrote a piece laying out why the current economic and financial crisis is a crisis of the Bretton Woods 2 system even if it isn’t a dollar crisis. In the end, the newspaper went in another direction, no doubt in large part because I haven’t mastered the art of reducing my argument to a few easily distilled points. My draft -- which is a bit longer and a bit less technical than my usual posts here on this blog -- follows. I hope it is still of some interest.

The current financial crisis has produced its share of surprises even to those who doubted the long-term health of a housing-centric US economy. International economists – at least some of them – have long worried about the risk of a breakdown in what former Treasury Secretary Summers labeled the balance of financial terror and what others have called the “Bretton Woods 2” system of fixed exchange rates -- a system where the rapid growth of central bank reserves in China and the oil-exporting economies financed large deficits in the US. They expected a crisis that marked by a fall in the dollar, a loosening of China’s peg to the dollar, a rise in the currencies of key emerging economies and higher interest rate on the US governments borrowing. The current crisis has not followed script: it has been defined by a a rise in the dollar, a tightening of China’s peg, a sharp fall in emerging market currencies and fall in the US governments borrowing costs.

Rather than dollar crisis that triggered a sell off in the Treasury market, a US banking crisis has turned into a crisis for most emerging market currencies. The dollar soared even as the US economy stalled. The yield on short-term Treasury bills has been close to zero for almost a month; the yield on the long bond just touched a record low. So much for even doomsday forecasts.

But in a deeper sense, the current crisis has been a crisis in an international financial system defined by the buildup of large surpluses among emerging market governments, a buildup that financed heavy borrowing by American and European households. Defenders of this system argued that it was win/ win. China could develop on the back of its exports. The US and Europe benefited from low and stable interest rates – a constellation that justified heavy borrowing by households and high prices for a host of risky financial assets. Unbalanced world need not be a risky world. China (and the Gulf) saved so that the US didn’t have to. Conversely, the US households spent so that China’s government didn’t have too – Menzie Chinn of the University of Wisconsin has accurately noted that the great puzzle of the past few years is why China preferred subsidizing US consumption to subsidizing Chinese consumption.

Crises have a way of clarifying the weak links in any financial arrangement. This crisis is no different. In retrospect, the stability of this system hinged on more than the willingness of China – and Russia and Saudi Arabia – to accumulate dollar reserves. China didn’t actually finance US household borrowing directly. Rather China bought US Treasury and Agency (Fannie Mae, Freddie Mac, and Ginnie Mae) bonds. Contrary to what some have argued, Freddie and Fannie weren’t the major sources of subprime, alt-a and other kinds of risky mortgages in 2005, 2006 and the first half of 2007. Consequently, China wasn’t directly making loans to the most risky borrowers in the US – or actually lending to those who were buying Chinese goods. But the inflow from China was still central to the process that allowed the extension of credit in an economy that itself wasn’t saving, and thus wasn’t generating new funds to lend. Think of it this way: when China bought a Treasury bond from an American insurance company or bank, if provided the pension fund or bank with funds to invest in riskier assets that offered a higher yield than Treasury bonds. Wall Street proved more than capable of churning out ever more complex kinds of mortgage backed securities – and securities composed of parts of other mortgage backed securities – to meet this demand.

The flow of credit that allowed American households to keep buying Chinese goods even as they were spending more on imported oil hinged on the willingness of China’s government to take currency risk – converting China’s domestic renminbi savings into demand for US government and agency bonds – and the willingness of Americans to trade their holdings of safe government bonds for riskier, and higher yielding, mortgage backed securities. That meant that American (and, as it turned out European) financial institutions took on ever increasing amounts of credit risk even as China allowed an ever rising share of its national savings to be denominated in dollars. Economists worried that the first leg of the trade might not be stable – China and others might not always be willing to buying depreciating dollars. It turned out though that the second leg of this trade was even more unstable - -and even more risky. China’s Treasuries aren’t likely to hold their value in terms of China’s own currency – but China will get more back than those who bought CDOS composed out of subprime mortgages – or the holders of Lehman’s bonds.

The collapse of confidence in US and European financial intermediaries consequently has brought down a key pillar of a global system that allowed emerging markets to grow on the back of American and European demand for their products. American households cannot borrow against their homes – and thus cannot continue to consume more than they earn. In September, US consumption fell sharply – and it would take a brave man to forecast a different outcome for October. China no longer can rely on US and European demand for its exports to drive its own economic development. Unusually strong global growth over the past few years may be offset by an unusually strong global slowdown. The entire global economy is now slowing sharply.

It almost goes without saying that those who bet that an unbalanced global economy could sustain high valuations for risky financial assets have lost large sums of money. That leads to the second surprise of this crisis: a fall in US home values and a likely severe US recession has turned into a emerging market crisis, with money now flowing out of emerging economies at a pace comparable to that of the Asian crisis of 97-98.

Why? Big banks weren’t just lending dollar to American households. They were also lending to banks and firms in the emerging world. Even as emerging market governments were building up their holdings of dollars and euros, emerging market companies were borrowing in dollars and euros. This is most obvious in a country like Russia: at the end of June 2008, Russia’s government has about $600 billion in foreign assets and less than $50 billion in foreign debts. Russian banks and firms by contrast had about $450 billion in foreign debts. The big US and European banks are now in trouble. They want their money back from borrowers in the emerging world – forcing emerging market banks, firms and governments to scramble to come up with the needed foreign exchange. A global banking crisis is creating problems for anyone who had relied on banks for to financing: US households that borrowed to spend more than they made, exuberant real estate developers in Moscow, Mumbai and Dubai, or a Brazilian firm looking to expand its iron ore production. Actually, it has caused more trouble for those who relied on shadow banks -- institutions that raised money by borrowed short-term funds in the capital market rather than from depositors – than for banks –but that is another story.

What then should be done?

In the short-run, the core challenge is to avoid a downward spiral of confidence and cascading defaults. The governments of the US and Europe have acted decisively to avoid the collapse of additional large financial institutions (in the process exposing US and European taxpayers to consider risks, but in the context there was little real choice). A similar effort is needed to limit the fallout from the current run on many emerging economies – and to limit the depreciation of their currencies. This isn’t altruism either: the dollar’s current strength will cut into the United States’ exports at time when the US would like to be exporting more not less.

In the medium term, the challenge is to prevent expanding financial distress from fueling a self-reinforcing downward cycle of contraction, one where consumers cut back leading firms to cut back – and one where governments respond to falling revenues by cutting back as well. This isn’t the time to allow concerns about the long-term health of government’s balance sheets to drive policy: governments around the world need to stimulate their economies to offset what now looks likely to be a severe global slump. That advice applies with particular force to those countries with large external surpluses and lots of external assets: China can help the world right now by spending a lot more at home; the Gulf can also help by drawing on its accumulated stockpile of foreign assets to keep spending at home up. Such a stimulus won’t avoid a contraction; the goal is to keep the contraction from morphing into something far worse.

In the long-run, the challenge will be to find a more sustainable basis for global growth. The last few weeks have once again illustrated the difficulties emerging economies looking to finance fast growth by borrowing from the international banking system face. But the past few months have also highlighted the costs of a world where rapid reserve growth in the emerging world finances heavy borrowing by US and European households. US and European taxpayers have been hit with the bill created when their banks lent against inflated home values; Chinese taxpayers will eventually be hit with the bill for borrowing in a currency that is going up (the RMB) to buy currencies (the euro as well as the dollar) that are going down. No one is going to win. The policies of the past few years have not worked; it is time to try something new.

If nothing else, my short-term policy prescriptions don’t seem that far from Dr. Krugman’s own policy prescriptions.

* Alternatively, slower growth in the US might have put downward pressure on the dollar -- and all the emerging economies tied to the dollar. Additional inflows to these economies would be recycled back to the US, so the overall result could have been lower global rates -- which ultimately would have had to induced someone to borrow more or key surplus countries to take steps to stimulate their own economies to support their growth and in the process reduce their surpluses. If China say remained pegged to the dollar, the overall result could have been an even weaker RMB against the euro, an even bigger swing in China’s trade balance with Europe and a bigger EU wide deficit rather than a smaller Chinese surplus.

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