NS3040 Summer Term 2018 Issues With Bretton Woods II Federal Reserve Bank of Chicago, Strong Dollar Weak Dollar

Bretton Woods II Issues I Bretton Woods II is one way of describing the current global financial system. Not a pure fixed exchange rate system like Bretton Woods I, but many countries do maintain fixed rates Fact: no one is happy with the current system Three broad complaints First – the dominance of the dollar as a reserve currency and America's management of it Bulk of foreign exchange transactions and reserves are in dollars even though the US accounts for only 24% of global GDP

Bretton Woods II Issues II Based on figures in chart, current system fails to reflect realities of the world economy Finally it leaves others vulnerable to America’s domestic monetary policy Second – system has fostered the creation of vast foreign exchange reserves especially in emerging economies

Bretton Woods II Issues III Global reserves increased from $1.3 trillion (5% of world GDP in 1995 to $8.4 trillion (14%) by 2010 Emerging economies hold two thirds of the total Most has been accumulated in the 2000s Huge reserves run counter to economic logic Mean poor countries which should have abundant investment opportunities are lending cheaply to richer ones, mainly America Such lending helped create the 2008 financial crisis by pushing down America’s long term interest rates Today with Americans saving rather than spending, reducing global demand and recovery Third complaint: the scale and volatility of capital flows Financial crisis have become more frequent in the past three decades Emerging countries often have floods of capital or sudden droughts – not best basis for long-term growth

Bretton Woods II Issues IV Fundamental question: What improvements are feasible? Any monetary system will be constrained by the so-called trilemma. If capital can flow across borders, countries must choose between fixing their currencies and controlling their domestic monetary system – cannot do both Classical 19th century gold standard – currencies tied to gold System collapsed because it allowed countries no monetary flexibility

Bretton Woods II Issues V In Bretton Woods regime currencies pegged to dollar which in turn tied to gold Capital mobility limited so that countries had control over their monetary conditions System collapsed in 1971 because US would not subordinate its domestic policies to the gold link Today’s system – no tie to gold or other anchor Contains a variety of exchange regimes and capital controls Capital controls were lifted three decades ago and financial markets are highly integrated. On paper emerging economy exchange regimes becoming more flexible But most floats highly managed Most are export-oriented and need competitive exchange Countries don’t like to have their currencies strengthen when capital flows in so they buy foreign exchange to stem tide builds up reserves.

Bretton Woods II Issues VI Countries have also found that a strong reserve position creates stability during times of uncertainty – Asian Crisis in the late 1990s Question – what is a safe level of reserves? China’s are no doubt excessive The country’s behavior also affects others: Many emerging economies especially in Asia are reluctant to risk their competitiveness by letting their currencies rise much Their currencies shadow the dollar creating Bretton Woods II

Bretton Woods II Issues VII History Lessons Similarities between Bretton Woods II and the original Bretton Woods mean many of today’s problems have historical parallels Demand of emerging economies for dollars and fear that dollar may lose it value – problem in Bretton Woods Triffin paradox – reserve country must issue lots of assets (usually government bonds) to expand world liquidity But the more bonds it issues – more questions about serviceability IMF estimates that at current rate of global reserve accumulation global reserves would rise from 60% America’s GDP in 2010 to 200% in 2020 and 700% in 2035

Bretton Woods II Issues VIII Possible Alternative Systems SDR Favored by China Would still be heavily weighted by dollar Not much of a SDR bond market – why hold them? IMF would have to be a World Central Bank – not much chance countries would give up sovereignty to IMF China Yuan Country still has capital controls – limited bond market Currency not used much internationally System may evolve in this direction as dollar and British pound did before dollar dominance – perhaps by 2030 Greater role of IMF in providing reserves Countries would have a line of credit, so no need for large reserves

Bretton Woods II Issues IX Keynes idea of putting caps on balance of payments surpluses and deficits Would force Asian countries to rebalance U.S. would have to increase savings, reduce government deficits Might eliminate need to maintain week currencies if economies more diversified. What if countries ignore limits as in Europe? In sum – system will continue evolving with no formal agreement in place -- unless a complete collapse occurs