[Pen-l] an okay summary

["Jim Devine" <jdevine03@xxxxxxxxx>]

The original Bretton Woods system dates from a conference at a New
Hampshire resort hotel in July 1944. Leading British and American
economists blamed the Great Depression and, to some extent, World War
II on the breakup of the international monetary system in the early
1930s and were determined to create a more stable arrangement in which
the dollar would replace the British pound as the accepted global
currency. The new system, devised by economists Harry Dexter White and
John Maynard Keynes, fixed the dollar's value at $35 for an ounce of
gold. National governments, rather than speculators, were to set the
value of their currencies in relation to the dollar and would have to
disclose any changes in advance to the new International Monetary Fund
(IMF).

[ the British pound wasn't the accepted global currency. Rather, it
was gold. The pound was linked to gold. It might be seen as the most
important, but dollars and the franc were also pretty strong. --JD]

The dollar became the accepted medium of international exchange and a
universal reserve currency. If countries accumulated more dollars than
they could possibly use, they could always exchange them with the
United States for gold. But, with the United States consistently
running a large trade surplus – meaning that countries always needed
to have dollars on hand to buy American goods – there was initially
little danger of a run on the U.S. gold depository.

Bretton Woods began to totter during the Vietnam war, when the United
States was sending billions of dollars abroad to finance the war and
running a trade deficit while deficit spending at home sparked
inflation in an overheated economy. Countries began trying to swap
overvalued dollars for deutschmarks, and France and Britain prepared
to cash in their excess dollars at Fort Knox. In response, President
Richard Nixon first closed the gold window and then demanded that
Western Europe and Japan agree to new exchange rates, whereby the
dollar would be worth less gold, and the yen and the deutschmark would
be worth more relative to the dollar. That would make U.S. exports
cheaper and Japanese and West German imports more expensive, easing
the trade imbalance and stabilizing the dollar.

By imposing a temporary tariff, Nixon succeeded in forcing these
countries to revalue, but not in creating a new system of stable
exchange rates. Instead, the values of the currencies began to
fluctuate. And, as inflation soared in the late 1970s, the system,
which still relied on the dollar as the universal currency, seemed
ready to explode into feuding currencies.

That's when a new monetary arrangement began to emerge. Economists
often refer to it as " Bretton Woods II" – not to be confused with the
name given this weekend's gathering – but it was not the result of a
conference or concerted agreement among the world's major economic
powers. Instead, it evolved out of a set of individual decisions –
first by the United States, Japan, and Saudi Arabia, and later by the
United States and other Asian countries, notably China.

Bretton Woods II took shape during Ronald Reagan's first term.

[ Judis skipped the period from the early 1970s and Reagan! this was a
period of floating exchange rates and severe inflation problems for
many countries. ]

To combat inflation, Paul Volcker, the chairman of the Federal Reserve
[appointed by Jimmy Carter], jacked interest rates above 20 percent.
That precipitated a steep recession – unemployment exceeded 10 percent
in the fall of 1982 – and large budget deficits as government
expenditures grew faster than tax revenues. The value of the dollar
also rose as other countries took advantage of high U.S. interest
rates. That jeopardized U.S. exports, and the U.S. trade deficit grew
even larger, as Americans began importing underpriced goods from
abroad while foreigners shied away from newly expensive U.S. products.
The Reagan administration faced a no-win situation: Try reducing the
trade deficit by reducing the budget deficit, and you'd stifle growth;
but try stimulating the economy by increasing the deficit, and you'd
have to keep interest rates high in order to sell an adequate amount
of Treasury debt, which would also stifle growth. At that point,
Japan, along with Saudi Arabia and other opec nations, came to the
rescue.

At the end of World War II, Japan had adopted a strategy of economic
growth that sacrificed domestic consumption in order to accumulate
surpluses that it could invest in export industries – initially
labor-intensive industries like textiles, but later capital-intensive
industries like automobiles and steel. This export-led approach was
helped in the 1960s by an undervalued yen, but, after the collapse of
Bretton Woods, Japan was threatened by a cheaper dollar. To keep
exports high, Japan intentionally held down the yen's value by
carefully controlling the disposition of the dollars it reaped from
its trade surplus with the United States. Instead of using these to
purchase goods or to invest in the Japanese economy or to exchange for
yen, it began to recycle them back to the United States by purchasing
companies, real estate, and, above all, Treasury debt.

That investment in Treasury bills, bonds, and notes – coupled with
similar purchases by the Saudis and other oil producers, who needed to
park their petrodollars somewhere – freed the United States from its
economic quandary. With Japan's purchases, the United States would not
have to keep interest rates high in order to attract buyers to
Treasury securities, and it wouldn't have to raise taxes in order to
reduce the deficit. As far as historians know, Japanese and American
leaders never explicitly agreed that Tokyo would finance the U.S.
deficit or that Washington would allow Japan to maintain an
undervalued yen and a large trade surplus. But the informal bargain –
described brilliantly in R. Taggart Murphy's The Weight of the Yen –
became the cornerstone of a new international economic arrangement.

Over the last 20 years, the basic structure of Bretton Woods II has
endured, but new players have entered the game. As Financial Times
columnist Martin Wolf recounts in his new book, Fixing Global Finance,
Asian countries, led by China, adopted a version of Japan's strategy
for export-led growth in the mid-'90s after the financial crises that
wracked the continent. They maintained trade surpluses with the United
States; and, instead of exchanging their dollars for their own
currencies or investing them internally, they, like the Japanese,
recycled them into T-bills and other dollar-denominated assets. This
kept the value of their currencies low in relation to the dollar and
perpetuated the trade surplus by which they acquired the dollars in
the first place. By June 2008, China held more than $500 billion in
U.S. Treasury debt, second only to Japan. East Asia's central banks
had become the post-Bretton Woods equivalent of Fort Knox.

Until recently, there have been clear upsides to this bargain for the
United States: the avoidance of tax increases, growing wealth at the
top of the income ladder, and preservation of the dollar as the
international currency. Without Bretton Woods II, it is difficult to
imagine the United States being able to wage wars in Iraq and
Afghanistan while simultaneously cutting taxes. For their part, China
and other Asian countries enjoyed almost a decade free of financial
crises; and the world economy benefited from low transaction costs and
relative price stability from having a single currency that countries
could use to buy and sell goods.

But there have been downsides to Bretton Woods II. Often noted was how
the accumulation of dollars in foreign hands – particularly those of a
potential adversary like China – threatens America's freedom of
action. A hostile nation could blackmail the United States by
threatening to cash in its dollars. Of course, if a nation like China
actually began to unload its dollars, it would jeopardize its own
financial standing as much as it would jeopardize America's. But
economists Brad Setser and Nouriel Roubini argue that even the
implicit threat of dumping dollars – or of ceasing to purchase them –
could limit U.S. maneuverability abroad. " The ability to send a
'sell' order that roils markets may not give China a veto over U.S.
foreign policy, but it surely does increase the cost of any U.S.
policy that China opposes," they write.

To date, however, that strategic impact has been chiefly theoretical.
The more tangible drawbacks of Bretton Woods II have been social and
economic. Bretton Woods II has perpetuated [and expanded] the U.S.
trade deficit, particularly in manufactured goods. Forced to compete
against foreign products kept cheap not only by low wages abroad but
by the dollar's high value, U.S. manufacturers have had little
incentive to expand or even retain their operations in the United
States. Since the early '80s, the United States has lost about five
million manufacturing jobs. True, the United States has gained some
highly skilled manufacturing jobs, but most of the lost jobs have been
replaced by low-wage service sector employment. This has been a factor
in creating a U.S. workforce with an overpaid financial sector at one
extreme and a sprawling low-wage service sector at the other.

In Japan, China, and other Asian countries, there has been a similar
downside to the grand bargain. The surplus dollars gained from trade
with the United States have not been used to raise the standard of
living, but rather have been squirreled away in Treasury securities –
" sterilized" is the technical term. Writes Wolf, " China has about
800 million poor people, yet the country now consumes less than half
of GDP and exports capital to the rest of the world. " In an odd way,
the contrast between the concentration of new wealth in China's
coastal cities and the grating poverty of its countryside has mirrored
the contrast between the lavish lifestyle of the Wall Street wizard
and the plight of immigrant and illegal-immigrant workers in America's
barrios.

Of more immediate concern, Bretton Woods II contributed to the current
financial crisis by facilitating the low interest rates that fueled
the housing bubble. Here's how it happened: In 2001, the United States
suffered a mild recession largely as a result of overcapacity in the
telecom and computer industries. The recession would have been much
more severe, but, because foreigners were willing to buy Treasury
debt, the Bush administration was able to cut taxes and increase
spending even as the Federal Reserve lowered interest rates to 1
percent. The economy barely recovered over the next four years.
Businesses, still worried about overcapacity, remained reluctant to
invest [in real assets such as factories]. Instead, they paid down
debt, purchased their own stock, and held cash. Banks and other
financial institutions, wary of the stock market since the dot-com
bubble burst, invested in mortgage-backed securities and other
derivatives.

The anemic economic recovery was driven by growth in consumer
spending. Real wages actually fell, but consumers increasingly went
into debt, spending more than they earned. Encouraged by low interest
rates – along with the new subprime deals – consumers bought houses,
driving up their prices. The " wealth effect" created by these housing
purchases further sustained consumer demand and led to a housing
bubble. When housing prices began to fall, the bubble burst, and
consumer demand and corporate investment ground to a halt. The
financial panic quickly spread not only from mortgage-backed
securities to other kinds of derivatives but also from the United
States to other countries, chiefly in Europe, that had purchased these
American financial products.

And that's not all. As American demand for Chinese exports has stopped
growing, China's economy has begun to suffer. Roubini has argued that,
if China's export-dependent growth drops from 12 percent to 5 or 6
percent per year, China will be unable to provide jobs to the 24
million new workers that join the labor force each year. China would
experience the equivalent of a recession, with repercussions
throughout Asia. More importantly for the United States, China would
no longer have the surplus dollars to prop up the market for U.S.
Treasury bills. The Obama administration could, of course, reduce its
dependence on China by reducing the budget deficit, but doing that now
would deepen the recession, as well as preventing the new president
from pursuing many of his domestic initiatives.

The consequences could be even more dire. In the past, countries in
recession could count on countries with growing economies to provide
outlets for their exports and investments. The hope this time is that
economic growth in Asia and particularly China can backstop a U.S. and
European recession. But, as a result of Bretton Woods II, prosperity
in the United States is intertwined with prosperity in Asia. China
depends on exports to the United States, and the United States depends
on capital from China. If that special economic relationship breaks
down, as it seems to be doing, it could lead to a global recession
that could morph into the first depression since the 1930s.

Economists and Treasury officials might dispute specific parts of this
analysis, but the bulk of it is neither original nor controversial.
For the last three years, if not longer, Bernanke, former Treasury
secretary Larry Summers, Roubini, Setser, Wolf, and other economists
have been making similar points. Their concerns did not penetrate the
presidential campaign, but the Obama administration will have to
address the breakdown of Bretton Woods II in January, if not earlier.
Wrote Summers this August, " The next administration faces the
prospect of having to make the most consequential international
economic policy choices in a generation at a time when the confidence
of governments in free markets is being increasingly questioned."

In making these choices, policymakers have to recognize that, while
Bretton Woods II is not the product of an international agreement, it
is not a " free market" system that relies on floating currencies,
either. Rather, it is sustained by specific national policies. The
United States has acquiesced in large trade deficits – and their
effect on the U.S. workforce – in exchange for foreign funding of our
budget deficits. And Asia has accepted a lower standard of living in
exchange for export-led growth and a lower risk of currency crises.

Some of the policies that Obama championed during the presidential
campaign can help move us to a new system – as long as they are not
seen merely as temporary palliatives to get the United States out of a
recession. These steps include public investments that would make U.S.
industries more competitive; subsidies under strict conditions to U.S.
automobile manufacturers; and the encouragement of new "green"
industries. (By contrast, Obama's principal proposal – a tax cut for
the middle class – would not necessarily improve America's economic
standing.)

But China, Japan, and other Asian countries – either on their own or
with prodding from the new administration – will also have to play a
part. Indeed, China may have already begun to do so by announcing a
$586 billion stimulus plan of public investment in housing,
transportation, and infrastructure. If China plows its trade surplus
back into its domestic economy, it will increase demand for imports
and put upward pressure on the yuan, reducing China's trade surplus
with the West.

This kind of adjustment – in which the United States commits itself to
reducing its trade deficit and China, Japan, and other Asian countries
abandon their strategy of export-led growth – is what many American
policymakers favor. But there is also growing sentiment, particularly
in Europe, that beyond these measures, the world's leading economies
have to agree on a new international monetary system – or at least
dramatically reform the existing one. British Prime Minister Gordon
Brown has explicitly called for a " new Bretton Woods – building a new
international financial architecture for the years ahead." Brown would
strengthen the IMF so it functions as " an early warning system and a
crisis prevention mechanism for the whole world." He would also have
it or a new organization monitor cross-border financial transactions.
French President Nicolas Sarkozy would go further, replacing the
dollar as the single international currency. " The time when we had a
single currency, one line to be followed, that era is over," he
declares.

Brown's proposals for regulatory reform make sense and are likely to
be considered in the new Obama administration, but Sarkozy's are
premature. The dollar isn't going anywhere in the short term. The euro
has little presence in Asia; and the Chinese don't want the yen to
dominate Asia, let alone the world. The current crisis has, if
anything, strengthened the dollar as the least untrustworthy of global
currencies.

But adjustments to the dollar's role are certainly needed. The era of
the dollar may not be over, but the special conditions under which it
reigned during the last decades are being dashed on the rocks of the
current recession and financial crisis. In the worst case, the system
could descend into chaos, as it did in the 1930s. More likely a new
Bretton Woods (call it " III" ) will emerge, but the question will be
whether it does so willy-nilly, as its predecessor did, and invite
repeated crises, or whether, like the original Bretton Woods, it will
be the product of deliberate agreement and lay the basis for stable
growth. Which it is will depend a good deal on the choices the new
Obama administration makes.

John B. Judis is a senior editor at The New Republic.

-- 
Jim Devine /  "Nobody told me there'd be days like these / Strange
days indeed -- most peculiar, mama." -- JL.
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