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Does Bretton Woods 2 end with a bang or with a wimper — a dialogue

June 20, 2007

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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What follows is a bit of an experiment.   I am posting -- with permission -- a lightly edited version of an email exchange that I had with a global equity portfolio manager a few days ago.  

Like all good conversations, it evolved.  What started out as a conversation about China's economic cycle -- or more precisely, the absence of much recent macroeconomic volatility in China -- developed into a  broader discussion of US competitiveness, global capital flows and the conditions that might bring today's relatively stable equilibrium to an end.    Enjoy.

Global equity portfolio manager: 

The growth rate of China's exports and construction & mfg in general raises another question. US history suggests that high growth regions have greater economic volatility since so much of their economy  represents growth industries. A slowdown in growth rate creates powerful "feedbacks" (not the right word), since getting to a  steady-state economy requires substantial restructuring.

Might this be true of China, even as a short-term effect? If US export  growth goes to zero, what about all their internal business devoted to generating increased growth? This is not clearly stated in most articles discussing global rebalancing. 

Brad Setser:

Your point on China is a good one. In the 90s Chinese growth (overall  and in exports) was high but very volatile. Some of that was external  -- Asian crisis/ tech bust (and impact on demand for computer assembly). Some was internal (inflation & over investment in early 90s  restructuring of state-owned enterprises in late 90s). From 02 on though Chinese growth has been high and lacked volatility.  The same is true of exports. You could argue this is just storing up future volatility in both... 

Tend to agree with you re: lack of US investment in real economic capacity in the US. It is a problem. I tend to think the exchange rate is a  solution (right now it makes sense to invest in tradables production in China than in the US). But I tend to always think the exchange rate is the solution, so I may be blind to other factors.

Continues below the fold.

Global equity portfolio manager:

Given today's global imbalances, I too suspect fx is the key variable.   But USD deval is an awful solution. Rebuilding export capacity -- skills, mfg, sales and then slowly gaining mkt penetration -- is a slow process.  The J-curve from Hades.

Consumption declines, inflation, foreign purchase of US assets -- wouldn't there be a host of earlier macro impacts from USD deval before we entered the promised land of renewed export competitiveness? 

Brad Setser:

Yes, both on taking time to rebuild skills & the need to deal with an  ugly period of adjustment.  That is why I long thought change now is better than change later, but well, I have been saying that since 04 and since then Chinese exports have doubled (at least). 

Hopefully the adjustment in the US will be far less extreme than in Argentina in 02 (which had to deal with financial consequences of “liability dollarization” – i.e. the use of the dollar in domestic contracts – in the face of a necessary depreciation of the peso.

It is amazing though how investment in tradables (and tourism) in Argentina soared after the depreciation, though the rise in resource prices also clearly helped.

Global equity portfolio manager:

Agreed. Devaluation is usually great for growth assets, like equities. However I wonder about scale effects. Engineers say that every 10x change in scale radically changes the dynamics. We've never had a deval like the USD, including loss of reserve currency status.  That is, not just a change in flows -- but likely movement in "stocks" (holdings of US debt) that dwarfs the usual flows. 

I'll bet the unexpected consequences would be far larger than the expected ones.

This could be much larger than the usual flows of US debt (e.g., debt  creation of US issuers, c/a deficits, interest).  As you know better than I, loss of reserve currency status suggests -- at the very least -- foreign private holders become less interested in holding USD debt. 

I don't see how any global re-balancing involving USD deval avoids massive changes in who holds our debt -- which might be difficult to arrange in an orderly manner (no global equivalent of NYSE specialists for these order imbalances).

Plus, of course, during this transitional period we'll still be running a large current account deficit. Not only will the transition to a low c/a take  time, AND any currency flight (by foreign & domestic investors) be financed, BUT ALSO the c/a could rise during the j-curve period. Scenarios in which the US regains export competitiveness seems path-dependent, and many of these paths seem "difficult."  As a fringe

observation, this transitional period seems to get little attention by those recommending solutions. 

Who moves first to spark rebalancing?  Central banks’ tend to be slow moving, incremental, reactive, usually counter-cyclical, decision-makers. Private actors are the opposite, in aggregate.

My guess is that at some point private holders (both foreign and domestic) will be motivated sellers of USD - whether increasing gradually or suddenly depends on events.  Coordinated action by central banks' will be required to avoid chaos or worse. 

I see no other likely scenario. That is, I can imagine scenarios in which one or more central banks' initiate or jump on a downward USD move - but consider these a low probability group.

Going one more step, I suspect (with no evidence) there has been informal discussion by central banks' about these scenarios. Things get interesting at that point. Are you familiar with the Stephen Jay Gould & Niles Eldredge theory of "punctuated equilibrium." I believe this applies well to geo-political affairs, which is what this becomes. 

Brad Setser:

"of course, during this transitional period we'll still be running a large current account (c/a) deficit.  Not only will the transition to a low c/a take time, AND any currency flight (by foreign & domestic investors) be financed, BUT ALSO the c/a could rise during the j-curve period." 

Actually, that was more or less what I have been arguing.  Suppose private markets lose confidence in $ before central banks.  The net result -- given US financing needs during an adjustment -- is that central banks need to intervene more, and they will end up providing most of the financing to the US that in some sense allows the US to avoid a truly wrenching adjustment. They do this in part b/c of inertia (dollar pegs and the dollar share of their portfolio are often fixed in the short-run by policy decisions and cannot easily be changed), and in part b/c they aren't motivated solely by financial gain.

You can argue this is what happened in q4 and q1 -- global reserve growth spiked to around $250b then, with dollar reserve growth probably rising to around $200b a quarter – enough to basically cover the US CAD at a time when private markets didn't want to finance this US deficit. 

The interesting thing is this happened w/o outright overt coordination and it happened automatically as a byproduct of central bank inertia. Private flows to the emerging world picked up. Emerging market central banks intervened more, basically sending the money private investors were taking out of the US back to the US. The net result: the US deficit was still financed, despite less willingness by private us investors to keep their dollars in the US & smaller private flows from the rest of the world.  At least that is my interpretation of the data.

The problem is that central banks right now seem to be as much in the business of blocking adjustment as they are in the business of financing adjustment. 

Global equity portfolio manager:

So what happens if we get substantial capital flight, with flows 5x or 10x greater from today -- the scenario I was considering? That might snap CB's out of their inertial state! 

One item on the "one step more" speculation: will CB's intervene without the usual drill of setting conditions (e.g., fiscal, monetary) for the miscreant? I suspect not.

Brad Setser:

So far emerging market central banks have provided the US with unconditional liquidity support.  The US Treasury was never as kind to emerging markets back in the 1990s. 

The day this changes and emerging market central banks start acting like the US Treasury, the world changes.

Global equity portfolio manager: 

Agree. The concept of punctuated equilibrium is non-consensus for reasons unclear to me. The historical record shows periods of stasis then rapid change. IMHO, Bretton Woods II is an attempt to project current stasis into the future -- rather than consider that pressure might be merely accumulating unseen.

From Wikipedia: 

Punctuated equilibrium (also called punctuated equilibria) is a theory in evolutionary biology, which states that most sexually reproducing species will show little change for most of their geological history. When phenotypic evolution occurs, it is localized in rare events of branching speciation (called cladogenesis), and occurs relatively quickly compared to the species' full and stable duration on earth.

Punctuated equilibrium is commonly contrasted against the theory of phyletic gradualism, which states that most evolution occurs uniformly and by the steady and gradual transformation of whole lineages (anagenesis). In this view evolution is seen as generally smooth and continuous.

In 1972 paleontologists Niles Eldredge and Stephen Jay Gould published a landmark paper developing this idea. Their paper was built upon Ernst Mayr's theory of geographic speciation, I. Michael Lerner's theories of developmental and genetic homeostasis, as well as their own empirical research. Eldredge and Gould proposed that the gradualism predicted by Charles Darwin was virtually nonexistent in the fossil record, and that stasis dominates the history of most fossil species.

Brad Setser -- but after the end of the initial conversation

The pressures on Bretton Woods II are actually rather visible.   The recent acceleration in reserve growth isn't all that hidden -- and from the point of view of the world's emerging economies, the scale of reserve growth is one measure of the costs that they are incurring to sustain the current system.  Evidence of a backlash against "globalization" also isn't hard to find in the US. That backlash is driven by weak median real wage growth more than anything else, though the sense that China's allocation of its reserves is helping to decide who wins and who loses in the US economy presumably doesn't help. 

What is far harder to determine is whether such pressures are building to the point where the system is close to a breaking point.

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