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. Developing…..