Thursday, February 24, 2005

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How stable is Bretton Woods 2?

The Bretton Woods regime for managing the international monetary system was inherently unstable because of the Triffin dilemma. Nevertheless, the true Bretton Woods system did last for 14 years (1958-1971). It lasted for eleven years after Triffin explained the system couldn't last forever.

Economists are labelling the current monetary arrangements as Bretton Woods 2. Under this system, the U.S. is running massive current account deficits to be the source of export-led growth for other countries. To fund this deficit, central banks, particularly those on the Pacific Rim, are buying up dollars and dollar-denominated assets.

The dollar’s fall in value relative to the euro is costly for the central banks holding large amounts of dollar-denominated assets. In purchasing so many dollars, these banks have a powerful incentive to ensure that their investment retains its value -- but they an equally powerful incentive to sell off their dollars if it appears that they will rapidly depreciate. This cost creates a dilemma for these central banks. Collectively, these central banks have an incentive to hold on to their dollars, so as to maintain its value on world currency markets. Individually, each central bank has an incentive to sell dollars and diversify its holdings into other hard currencies. This fear of defection leads to a classic prisoner’s dilemma—and the risk that these central banks will simultaneously try to diversify their currency portfolios poses the greatest threat toward a run on the dollar.

So, the stability of this arrangement depends heavily on how much cooperation there is among the official purchasers of the dollar, and the extent to which these institutions are willing to absorb the costs of holding a depreciating asset compared to the benefit of subsidizing export-led growth as a means of absorbing underutilized labor.

What are the answers to these questions? Pick your door. Behind door # 1 is Nouriel Roubini and Brad Setser. Billmon ably summarizes the latest version of Roubini and Setser's paper:

The major Asian central banks hold $2.4 trillion in reserves, and probably around $1.8 trillion in dollars (roughly half the US [net international investment position). Asian central banks . . . cannot avoid taking capital losses on their existing holdings of dollar reserves. The only question is when they will incur the unavoidable losses, and to a lesser degree, how large those losses will be.

For another voice behind this door, see this FT article (both links courtesy of Brad Setser).

Earlier this week it looked like South Korea was about to trigger the fall in dominoes. As Brad recounts:

It looks the remarks of Korea's Central Bank President last week were a leading indicator of today's big news: Korea plans to diversify its reserves away from the dollar!

....the real question is who [formerly, how -- oops] else follows suit -- Thailand already has shifted out of the dollar (look at how its reserves moved in January, when the dollar rose v. the Euro), Russia too. But most central banks are still massively overweight dollars....

The other big question, of course, is how much additional pressure this all places on China: the Bretton Woods 2 system of central bank financing of the US current account deficit increasingly hinges on the People's Bank of China's willingness to keep adding to its dollar reserves at an accelerating rate.

However, it turns out that the predictions of Korean behavior were greatly exaggerated, as Hae Won Choi, Seah Park, and Mary Kissel explain in the Wall Street Journal:

Maybe it was all just a big misunderstanding.

Central bankers in South Korea and around Asia fought yesterday to reassure traders that they aren't about to dump their dollar holdings. Fears a day earlier that such a move might be imminent caused the U.S. currency to fall 1.4% against both the yen and the euro, roiling securities and commodities markets around the globe. Official denials helped stabilize the U.S. currency yesterday....

The dollar selling was ignited by market reports that the Bank of Korea sought to "diversify" its foreign-exchange reserves -- the world's fourth-largest -- something traders interpreted as a decision by the bank to cut its dollar holdings.

Central-bank officials insisted their statements had been misconstrued.

Kang Myun Mo, director general of reserve management at the bank, said that there is no plan to sell dollars and that the "proportion of U.S. dollars in the bank's foreign-exchange reserves will not change." The bank, he says, simply intends to invest more in higher-yielding nongovernment bonds in the future. "At the moment, there is no reason to sell U.S. dollars," Mr. Kang said.

In response to comments from Mr. Kang and other officials -- as well as statements by central bankers in Japan and Taiwan that they don't plan to sell dollars, either -- the currency rebounded during the Asian trading day against both the won and the yen.

[So Roubini and Setser weren't right today -- what about next week, next month, or next year?--ed.] Ah, this leads to door #2: David H. Levey and Stuart S. Brown's "The Overstretch Myth" in the March/April 2005 issue of Foreign Affairs. The key section:

U.S. financial markets have stayed strong even as the financing of the U.S. deficit shifts from private investors to foreign central banks (from 2000 to 2003, the official institutional share of investment inflows rose from 4 percent to 30 percent). A large percentage of the $1.3 trillion in Asian governments' foreign exchange reserves is in U.S. assets; central banks now claim about 12 percent of total foreign-owned assets in the United States, including more than $1 trillion in Treasury and agency securities. Official inflows from Asia will likely continue for the foreseeable future, keeping U.S. interest rates from rising too fast and choking off investment.

In a series of recent papers, economists Michael Dooley, David Folkerts-Landau, and Peter Garber maintain that Asian governments--pursuing a "mercantilist" development strategy of undervalued exchange rates to support export-led growth--must continue to finance U.S. imports of their manufactured goods, since the United States is their largest market and a major source of inward direct investment. Only a fundamental transformation in Asia's growth strategy could undermine this mutually advantageous interdependence--an unlikely prospect at least until China absorbs the 300 million peasants expected to move into its industrial and service sectors over the next generation. Even the widely anticipated loosening of China's exchange-rate peg would not alter the imperatives of this overriding structural transformation. Ronald McKinnon of Stanford argues that Asian governments will continue to prevent their currencies from depreciating too much in order to maintain competitiveness, avoid imposing capital losses on domestic holders of dollar assets, and reduce the risk of an economic slowdown that could lead to a deflationary spiral. According to both theories, there should be no breakdown of the current dollar-based regime.

Official Asian capital inflows, moreover, should soon be supplemented by a renewal of private inflows responding to the next stage of the information technology (IT) revolution. Technological revolutions unfold in stages over many decades. The it revolution had its roots in World War II and has proceeded via the development of the mainframe computer, the integrated circuit, the microprocessor, and the personal computer to culminate in the union of computers and telecommunications that has brought the Internet. The United States--thanks to its openness, its low regulatory burden, its flexible labor and capital markets, a positive environment for new business formation, and a financial market that supports new technology--has dominated every phase of this technological wave. The spread of the IT revolution to additional sectors and new industries thus makes a revival of U.S.-bound private capital flows likely.

An abstract of one of the Dooley, Folkerts-Landau, and Garber papers concurs with this evaluation of the "peripheral" economies:

Financial policies in these countries are seen as a component of a more general portfolio management policy in which the formation of an efficient domestic capital stock is a key objective. Because intervention in financial markets is an important part of their development strategy, intervention in exchange and financial markets has, and we argue will continue to be, large and persistent enough to generate predictable deviations of exchange rates and relative yields in industrial country financial markets from normal cyclical patterns. We argue that management of the currency composition of international reserves by emerging market governments and central banks is unlikely to alter these conclusions.

[So who's right? WHO'S RIGHT-???!!!ed.] I'm not so stupid as to claim the ability to render a judgment on this question. What I can say is that among the economists I talk to, more of them to open door #2. However, the market hiccup that took place earlier this week highlights the fragility of this equilibrium. In the end, this is more a question of political economy than straight economics, and the likelihood of successful cooperation among this group of economies makes me wonder about the robustness of Bretton Woods 2. So even though I understand the logic of their arguments, I remain a little less sanguine than my economic advisors.


posted by Dan on 02.24.05 at 12:57 AM


I think I remember reading on Brad DeLong that the word "bull****" was used by one of the principals in this debate with reference the Bretton-Woods 2 optimists. And if you read the descriptions of the dynamics, is it prisoners' dilemma or just a plain old bubble -- it works as long enough people expect to continue working. The FA piece is really just two assumptions -- that the bubble won't pop anytime soon, and a Hail Mary pass of a new tech boom that generates new capital inflows. But of course ultimately the market will speak.

posted by: P O'Neill on 02.24.05 at 12:57 AM [permalink]

There was something interesting yesterday about this over at Little Green Footballs.

This Financial Times story had a paragraph reflecting comments made by George Soros at an economic conference in Jeddah. But a few hours later the FT removed the paragraph.

In this Reuters story published in USA Today, the comments are still evident. Soros said two things that strike me.

"The higher the price of oil, the more the dollars there are to be switched to euro (so) the strength of oil will reinforce the weakness of the dollar," he said. "That is only one factor, but I think there is such a relationship."


In later comments to Reuters, Soros said the U.S. current account deficit could be financed at the current level of the dollar. "There are willing holders of the dollar. There are the Asian countries that are happy to accumulate dollar balances in order to have an export surplus and a market for their dollars," he said.

In his comments, Soros lays out the groundwork to break the dollar. Perhaps that is no secret, trading petroleum in any other currency besides dollars gives the United States a huge advantage.

Recall that Iraq lobbied the United Nations to accept their demand to denominate oil exports in Euros. It wasn't easy, but two countries supported the change - France and Germany. The French Ambassador to the UN actually came to the defense of Iraq on the change by pointing out the GAINS Iraq would make from the conversion.

posted by: Brennan Stout on 02.24.05 at 12:57 AM [permalink]

The Levey/Brown Foreign Affairs piece stumbles as many people do on this subject when it refers to McKinnon's argument that Asian countries will continue to prevent their currencies from depreciating. The issue, of course, is the rate and timing of dollar depreciation and appreciation of Asian currencies.

This is not just a proofreading error, because the assumption underlying the optimists' case is that managed Asian economies, led by China, will continue to keep their currencies weak against the dollar to feed an employment strategy dependent on exports to the United States. I agree that this is possible. However, a stronger currency also has advantages, principally to people who have already secured an measure of prosperity and who in Asia as here are likely to have greater political influence over time than people who have not. In addition, Asia's own bill for energy imports is rising rapidly, and strengthening Asian currencies would be one obvious way to reduce its rate of growth.

I am wary of predicting something will happen because it must happen -- because the alternatives for us if it does not happen are too unattractive to contemplate. At this point a large amount of control over America's economic future has been ceded to foreign governments. It is possible to imagine a best case (say, another US-led IT boom and the indefinite continuation of export-driven industrial policies in Asia) in which the enormous American trade and budget deficits have few major negative consequences. Government policy, though, should not assume the best case when it comes to the surrender of sovereignty.

posted by: Zathras on 02.24.05 at 12:57 AM [permalink]

I wonder if Daniel has read Heinlein's political/economic-theory-as-thinly-vieled-fiction book For Us, The Living and has any comments on the monetary approach detailed therein.

posted by: flaime on 02.24.05 at 12:57 AM [permalink]

I think I must be missing something. If China et. al. keep buying dollars, won't they eventually trigger inflation at home? After all, they can't sterilize forever. Eventually the real exchange rate of the yuan rises ... but in a different fashion.

posted by: Noel Maurer on 02.24.05 at 12:57 AM [permalink]

Question: what's the opportunity cost of holding US assets?

In other words, if foreigners sell US assets, they have to buy something else...but where else can they get a better combination of low-risk high-return investment than in the United States?

Until there's a real competitive choice of investment destination out there, then I think that door #2 is a safer bet than door #1. Hence as long as the US remains a secure leader of global innovation-driven growth, we should not panic.

posted by: jprime314 on 02.24.05 at 12:57 AM [permalink]

I haven't yet seen anyone point out the irony inherent in the fact that the dollar optimists -- Garber, Dooley, the National Review crowd, etc -- who tend to be some of the most militant true believers in the rational expectatations/free markets-can-do-no-wong creed, are pinning their hopes for a continuation of the Free Lunch II, er, I mean, the Bretton Woods II system -- on the willingness of Asian central banks to go on rigging the currency and Treasury markets for the indefinite future.

And the ring leader of their favorite cartel? None other than the China formerly known as Red -- the Asian "development state" par excellence.

Truly, Marget Thatcher was right: It IS a funny old world.

posted by: Billmon on 02.24.05 at 12:57 AM [permalink]

Noel: You are correct. Other things being equal a strong currency will put downward pressure on inflation. This is one of the benefits I alluded to upthread.

jprime: Investments in US Treasuries are actually low risk/low return investments, and will stay that way as long as interest rates here remain low. That may not be long, as the stories Dan quotes suggest. I personally do not equate not panicking with doing nothing, but since this seems to be a minority view I'd say that yes, this is a perfect time to panic.

posted by: Zathras on 02.24.05 at 12:57 AM [permalink]

Isn't much of this problem based on the U.S. budget deficit, and to a larger extent easy money from the Fed? As long as these are short term problems- the Fed is raising interest rates...
What about the fact that these Asian economies need to prop up the dollar to remain competitive? If the dollar falls, their economies take a licking. The U.S. would take a licking too, but who is more likely to keep on ticking? This whole mess is caused by intervention by economies that are not as efficient as the U.S. Another thing (assuming we're not goign to have a free market anytime soon): which is more likely, the world artificially props up the dollar or artificially pushes the dollar down? The first is easier, because the U.S. doesn't want to print too much money and cause inflation. The second is nearly impossible because once you run out of dollars to sell, the game is over. (Unless nobody want to buy anything from the U.S., but that's a much bigger problem.) It seems to me, if there is a plunge, buy up America on the cheap and wait for equilibrium to reassert itself. The world's Central banks will have managed to wreck their economies and engineer the biggest wealth transfer from Central Banks to speculators since the Asian Crisis.

posted by: Ragnar on 02.24.05 at 12:57 AM [permalink]

then again, economists have about as good a past track record on predicting the future as dial-a-psychic lines...

posted by: passing thru on 02.24.05 at 12:57 AM [permalink]

Zathras: 1) US interest rates are moving up and have been for some time now; 2) relatively speaking our return is pretty good. I mean, would you rather buy a French long-term bond which only gets you 50 basis points more than a US short term bond, and where they have just announced double-digit unemployment? Or would you prefer to invest in Germany where they are sliding back into recession? On the whole, the US is the best investment game in town.

posted by: jprime314 on 02.24.05 at 12:57 AM [permalink]

Some perspective on this issue is added by the Washington Post today (

The key points: first, 76% of America's GDP over the last two years has been spending on consumer goods and housing, compared to an average of 69% over the last half-century. Second, in 1999 and 2000 spending on buildings, structures and equipment -- business investment -- was 13.5% of GDP; in 2002-04, this fell to about 10.25%. And third, echoing a point made in many other places, it isn't foreign businesses buying up productive assets in the United States but foreign governments seeking a place to park foreign exchange earning that is funding the American trade deficit.

None of these things support lazy complacency about the United States remaining self-evidently the world's most dynamic, innovative economy. Politicians whose horizon does not extend beyond the next campaign season have a vested interest in pretending nothing needs to be done to reduce the American trade and budget deficits. They are the only people who do.

posted by: Zathras on 02.24.05 at 12:57 AM [permalink]


if you are a foreign investors, particularly one in emerging Asia (i.e. Asia outside Japan), I am not sure why you should consider the dollar to be anything other than a low return/ high risk investment. The risk, of course, is that the dollar falls substantially in value against a range of emerging Asian currencies at some point in the future. In my book, lending to a country with a 6.5% of GDP current account deficit in that country's currency for a nominal yield of no more than 4.25% is rather risky! The scale of the exchange rate adjustment required to close a current account gap of that magnitude, or even to reduce it signficantly, is quite large -- particular given how little (relative to its GDP) the US exports.

Europe offers lower nominal yields now, but the Eurozone also has a current account surplus -- it strikes me as a more plausible safe haven. And some are considering a basket of commodity currencies (Australia, Canada, etc) ... that strikes me as a bit more risky given Australia's own current account deficit, but it offers a plausible alternative as well.

Billmon -- you truly write exceptionally well. I stand in awe. Free lunch 2 is brilliant.

posted by: brad setser on 02.24.05 at 12:57 AM [permalink]

Dan. You left out the most important part of the Choi, Park and Kissel story: What Bank of Korea actually said in its annual report, before it was forced to issue a retraction.

The Bank of Korea said it would "expand investment into nongovernmental bonds, which have relatively higher yields, and diversify the currencies in which it invests."

The "And" is crucial.

Now maybe by diversification the BOK really meant that it wants to hold on to all its dollar reserves, but protect itself by yen risk by taking the portion of its reserves now invested in yen and invest that portion of its reserves in broader set of currencies, a set that might include the Australian dollar and the Canadian dollar and the Norwegian krone ... Maybe. But I sort of doubt it.

We will see.

(p.s. -- would be interested in the reasoning people you talk to give for "door number 2.")

posted by: brad on 02.24.05 at 12:57 AM [permalink]

Dan -- I think it is a mistake to characterize the incentives of central banks -- especially ones from large developed countries -- in terms of profit-motivation (as I think your prisoner's dilemma example does). Central bankers are willing to absorb rather significant losses on their portfolios in pursuit of their fundamental mission, which is to not do things to destabilize financial markets. Furthermore, the prisoners in this game are very definitely communicating. cheers.

posted by: Dave Altig on 02.24.05 at 12:57 AM [permalink]

“Zathras: 1) US interest rates are moving up and have been for some time now; 2) relatively speaking our return is pretty good. I mean, would you rather buy a French long-term bond which only gets you 50 basis points more than a US short term bond, and where they have just announced double-digit unemployment? Or would you prefer to invest in Germany where they are sliding back into recession? On the whole, the US is the best investment game in town.”

Amen. You speak words of wisdom. Does anybody with half a brain think that the Old Europeans can compete with the United States? Please note that the stock market went up significantly in the last two days. There is only thing we need to do to keep the good times rolling: defeat Democratic candidates. The Democratic Party is our greatest economic threat.

I am utterly convinced that Americans would be at least 20% wealthier if the Democrats were not able to cause so much harm in the last 40 years. Thank God, the new media will prevent them from causing further damage. The new media act like sunlight falling upon a vampire. Thse clowns can no longer get away with their nonsense.

posted by: David Thomson on 02.24.05 at 12:57 AM [permalink]


I obviously lack 1/2 a brain, but I would note the following.

Old Europe (the Franco-German Airbus consortium) is doing rather well in civil aircraft, and also in helicopters (the new Marine one looks to me to be based on a European design ... )

And those socialists at the Economist noted recently that uncompetitive Germany's share of world exports has gone up over the fast few years, while the United States' share has gone down. Wage restraint and improved productivity have helped Germany's export performance, even if their domestic economy remains in the doldrums.

No doubt Europe has its problems, particularly weak domestic demand and the US has important strengths. But over say the past 6-8 years, a dyanmic export sector has not been one of the United States' strengths, for whatever reason. Since 2000, exports have fallen as a share of US GDP, even as imports have risen.

posted by: brad on 02.24.05 at 12:57 AM [permalink]

Dave Altig, a couple questions about the communication you mention:

This commenter's impression of the Bellagio Group is an Asian initiative, presumably coordinated with the Fed. Anything you can tell us about the organization and procedures for Fed input?

The ROK's pattern of announcements (big tactless 'diversification' fart, then 'never mind') sounds like one of two things: extraordinarily inept communication or pretty good signaling. Little ROK has one advantage in the bargaining over reserve policy: they have a chance to bolt for the exit, unlike China and Japan. With that in mind the noises from that quarter sound more like tensions than like stable comity. Nicht wahr?

posted by: psh on 02.24.05 at 12:57 AM [permalink]

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