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Geoeconomics: What can we learn from the end of the “real” Bretton Woods system of fixed exchange rates?

February 26, 2005

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Dan Drezner started a post with the Triffin dilemma, so I figure I too can digress into the realm of history.

The Bretton Woods system of fixed exchange rates (Bretton Woods 1) collapsed, in some sense, when Western Europe decided it was no longer willing to hold its reserves in dollars, and demanded gold instead.

The Bretton Woods system was based on the gold-dollar standard: the world, or at least the free-world, pegged to the dollar, and the dollar was pegged to gold. Initially, the system worked because the US held most of the world’s gold at the end of World War 2. But dollar reserves grew quickly along with an expanding global economy, and dollar reserves exceeded the US gold stock by 1966.

No problem. The world’s central banks agreed that they would not convert their dollars into gold, and the system kept going. After all, the countries holding dollar reserves were also, by and large, allies of the United States military allies, and no one was all that keen to end an international monetary system that had underpinned Europe and Japan’s spectacular recovery from World War 2.

Alas, though, the alliance (or coalition?) supporting Bretton Woods 1 eventually frayed: the countries that defected from the financial coalition propping up Bretton Woods 1 tended to be countries that concluded their broad national interests would be better served with a higher degree of political independence. West Germany held on to its dollar until the end. De Gaulle’s France, famously, moved out of NATO’s integrated military command, and if not NATO per se; worried about the "exorbitant privilege" the US got by virtue of issuing the international reserve currency, and converted its dollar reserves into gold before Germany and the UK.

Fast forward thirty years. An influential group of economists argue that a new Bretton Woods 2 ties together the countries of the Asian-Pacific to the US. Critics challenge parts of the analogy: there are fewer constraints on the anchor currency in Bretton Woods 2 than in the Bretton Woods 1, since the dollar is no longer tied to gold; many Asian countries do not formally peg to the dollar, even if they intervene heavily; etc. But even critics of the analogy -- and critics of the argument that Bretton Woods 2 provides a stable international monetary order -- recognize than Asian reserve accumulation has played a critical role in the financing the US current account deficit -- hell, even the AP now has noticed.

Can we also learn something from the political events that defined the end of Bretton Woods 1? After all, the system came apart because key members of the alliance supporting the dollar eventually concluded that the broader US-led system was no longer serving their political as well as economic interests.

Asian central banks, fortunately, cannot demand that the US exchange their dollars for gold -- or even for another reserve currency. The US has not promised to maintain the dollar’s value vis a vis the euro, or supply euros or any other asset on demand. On the other hand, just as every individual central bank had an incentive to convert its dollars into gold before other central banks, central banks now -- at least the smaller central banks -- have an incentive to be among the first, not among the last, to shift the composition of its reserves. Any country that stops adding to its dollars reserves as rapidly, whether because it is diversifying its reserves or intervening less, effectively shifts the burden of financing the US onto the other members of the cartel. So there are certain parallels.

That is where things get interesting.

Japan and Taiwan are presumably the Germany and UK of this game. Tied to the US through a system of alliances, they have a strategic interest in preserving the system.

South Korea might be the new France. It is a long-standing ally of the US, but Korea and the US also seem to be drifting apart. South Korea is next to North Korea, and is a lot more vulnerable to rain of North Korean artillery shells than the US. South Korea worries that it would bear the brunt of North Korean retaliation for any US strike against the North -- and their also is lingering resentment, I suspect, over Bush public dimissal of Korea’s Sunshine policy toward the North.

Russia is a bit of a wild card. It is adding to its reserves at a significant clip. Putin is no longer W’s best fried -- even if they share a concern with Islamic terrorism. The US no longer seems to be following Condi’s old adage to "punish France, forget Germany and forgive Russia." Russia and France sort of traded places. And Russia was one of the first to increase its euro holdings.

The biggest wild card of all, though, is China. It anchors the Bretton Woods 2 system, both by providing enormous amounts of financing to the US and by "punishing" any country that defects from the coalition. Opting out of the dollar financing cartel means, more than anything else, ending currency intervention and letting your currency appreciate against the dollar. But so long as China pegs to the dollar, that has an immediate cost. Changing your reserves from dollars to gold was a lot easier ...

Yet if China anchors the system, along with the US, through its willingness to build up its dollar reserves to keep the renminbi-dollar stable, and to keep the renminbi weak, it hardly does so because it is a strategic ally of the US. Economically, China is the West Germany of Bretton Woods 2, but politically, China is clearly not the West Germany of Bretton Woods 2. The US -- or at least some in the US -- talk of the China as a strategic rival, and at least some in China think of the US in a similar terms. The analogy to France does not quite work either -- France and the US were allies drifting apart, in part because French fears of Germany were waning, and it is not clear that China and the US ever fully transitioned from Cold War adversaries to allies.

That makes for an unusually strange mix. Two potential strategic rivals, at least in the Pacific, anchor two ends of an unbalanced economic relationship. Yet both would face significant economic costs if the unbalanced economic relationship broke down - or if an unbalanced relationship had to suddenly become a balanced relationship. Both think the current unbalanced relationship is increasing their strategic position: China sees its industrial might growing, its influence in Asia growing and its influence in resource rich economies growing. The US gets to finance the global war on terrorism on the cheap.

Beware, though, if either side starts to begin to seriously question the positive impact of the current unbalanced economic relationship on its global strategic position. China might read Stephen Roach and conclude that can only sustain its global hegemony on the back of the interest rate subsidy provided by the People’s Bank of China. The US might begin to view China’s willingness to do business with anyone who has oil as an impediment to its broader efforts to transform the world ...

Brad DeLong consistently makes the classic economic liberal case on China. He has articulated a simple US strategic interest: the US should not take steps that impede China’s economic development. Rather, the US should be to China as Britain was to the United States after 1870. I would feel a lot more comfortable, though, if the US was financing China’s development in the way Britain helped finance the United States’ development after the Civil War. Right now, of course, the money is flowing the other way ...

One asides. David Altig of Macroblog has argued central banks do not maximize their investment returns (or seek to minimize their financial losses), but rather focus on maximizing other goals -- whether domestic or global macroeconomic stability. They are willing to take losses on reserves to achieve their broader objectives. That is a fair point. On the other hand, central banks are "banks" and they cannot be entirely indifferent to prospective losses either -- particularly given the sheet size of the potential losses some Asian countries face and the fact that these losses ultimately will be passed on to the rest of the government. Moreover, large scale reserve accumulation can make it more difficult for the central bank to achieve their other goals -- rapid money growth from reserve accumulation that is not fully sterilized is not obviously conducive to either domestic monetary and financial stability. But this is a debate for a different time ...

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