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NS3040 Fall Term 2015 Issues With Bretton Woods II 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 2 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 3 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 fore frequent in the past three decades • Emerging countries often have floods of capital or sudden droughts – not best basis for long-term growth 4 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 5 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 7 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 8 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 9 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 10