Brian Reading 73, Director Lombard Street Research. First class honours, PPE, Wadham college, Oxford 1958. George Webb Medley Senior Prize. Nuffield College 1958–60.
Lecturer, Christchurch, Oxford 1960–62. Adviser to the Governor, Bank of England 1962–64. Department of Economic Affairs 1964–66. Adviser to Edward Heath as Leader of the Opposition and then as Prime Minister, 1966-72. Economics Editor, The Economist 1972–77. Consultant to Dillon Reed, 1975–1981. Consultant with US Adivory Associates, 1981–91. Adviser to Nomura Assel Management 1985–, founder, LOmbard Street Research International Service 1991–, Founder, the Item Club. Sometime adviser to the Commons Treasury Commitee and visiting Professor Strathclyde University. Author of numerous articles in the Investors Chronicle, the Sunday Times, the Financial Times and other newspapers. Author ‘Japan the Coming Collapse’ 1991.
The New Dollar Area
They called it “Bretton Woods 2.” A better name would have been the “new dollar area” (NDA), especially when the November 2008 G20 summit to fix the global financial architecture was labeled by the media as Bretton Woods 2. It is an informal, fixed, or semi-fixed exchange rate regime centered on the dollar. Whatever it is called, it did much to cause the world financial crisis. While the two are intimately linked, they are rarely discussed together.
NDA members comprise countries that peg their currencies to the dollar, or dirty float against it. China, Hong Kong, and developing Asia are at the core. The periphery is fuzzy. Membership is best defined by the accumulation of excessive foreign currency reserves (mostly dollars, although the currency content of international reserves is not available by individual country holdings).1 Broadly speaking, members also include Asian newly industrialized countries (NICs), Japan (off and on, because it does not always intervene to manage the yen/dollar rate), and Russia. Most Gulf oil producers peg to the dollar, but as long-standing members rather than new. The NDA, including the United States, accounts for half the world’s GDP.
Fears for a Dollar Freefall Unfounded
Martin Wolf, writing in the Financial Times, has credited economists at Deutsche Bank with coining the name Bretton Woods 2.2 Prominent among many discussing the issue were Michael Dooley, David Folkerts-Landau, and Peter Gaber working together.3 Dooley et al set the ball rolling in 2003, by suggesting the new system could sustain large US current account deficits for years to come. Their thesis was that when import-substituting developing countries and ex-command economies opened up to the world, they discovered that their capital stock was obsolete. They needed to rebuild their economies, as did war-devastated Europe and Japan after 1945. The “revived” Bretton Woods model was similar to Europe and Japan’s postwar relationship with the United States until those nations were strong enough to stand on their own feet. China and Asia’s undervalued exchange rates against the dollar (the United States is the world’s largest manufactured goods market) and secured export/investment-led growth. In this way, they could build up large and high-quality physical capital stocks, at the expense of acquiring large and low-quality financial capital.
The United States was the other side of a symbiotic relationship. Fiscal policy could be eased aggressively in 2001–2002 to counter the recession caused by the burst dotcom bubble, without driving up interest rates.4 The consequent current-account deterioration was accommodated without the dollar crashing.5 On the contrary, the Federal Reserve was able progressively to cut its Fed funds target rate from 6.5% in December 2000 to 1.0% in June 2003, and hold it there until June 2004. The trade-weighted dollar appreciated strongly until early 2002 before sliding, and then only against the euro and other floaters.6 It took new dollar area currencies down with it.
This analysis spawned a debate in 2004–05 concerning the durability of the regime. A widely held view was that the ever-increasing US current account deficit was unsustainable. Like Bretton Woods, the system was expected to collapse because of a run on the dollar, causing it to go into freefall. US interest rates would soar and the economy crash. The argument was not whether this would happen, but when. Dooley’s suggestion of “several more years” was challenged. The US economists Nouriel Roubini and Brad Setser, and many others, feared the dollar’s collapse was imminent.7 There was much discussion of the extent to which it must fall to reduce the US current account deficit to a manageable 3% of GDP. A trade-weighted decline of 30% from its 2002 peak was widely regarded as necessary to shift demand and output from nontraded goods and services to traded goods (as a rule of thumb, a 10% fall equals a 1% shift). Martin Wolf, reporting work by Morris Obstfeld and Kenneth Rogoff, made clear that, in the absence of dollar depreciation, US GDP would need to fall by 7% in order to produce a 3% GDP points improvement in the current account deficit.8 He did not explain why, if the United States could finance its deficit without the dollar depreciating, it would need to reduce the deficit. The trade-weighted dollar did depreciate by more than 30%, but not withstanding China’s managed crawl and a suspension of yen intervention, this was almost exclusively against the euro. (At time of writing in March 2009, the United States was in recession, and, according to cycle-dating, has been in one since January 2008.9 It is likely the peak-to-trough fall will not be as much as 7%, but 3–4% is possible.)
How Some Forecasts Erred
This analysis erred in three major respects. It provided an ex-post rationalization of the system, not an explanation of its actual genesis. It foresaw a debt trap where there was none. It ignored the possibility that the United States would bring it down, meaning it was blind to the danger that the financial bubble it spawned would burst. Many commentators then made a fourth error—they assumed the developing world could decouple from the United States. Chris P. Dialynas and Marshall Auerback exposed the first error.10 China was responsible for the genesis of the system. It adopted a pegged and deeply undervalued yuan exchange rate in 1995, deliberately to promote export-led growth so as to absorb a massive surplus of cheap rural labor. China’s move was the logical consequence of the transition from a closed command economy to an open-market one. Command economies are extremely efficient at wasting savings in value-subtracting investment. Transition to a market economy exposed a Chinese savings glut. The pegged and undervalued yuan allowed China to waste its excess savings by lending to the United States, so that Americans could buy its excess products. It thereby avoided, if perhaps only for a time, an economic and political catastrophe.
The undervalued yuan undermined south-east Asian competitiveness, helping to precipitate the 1997–98 Asian crisis. The consequences were so traumatic (GDP collapsing and unemployment soaring, not least owing to a grossly austere IMF bailout conditions) that they swore “never again.” The upshot was they, too, pegged to the dollar, ran up massive foreign exchange reserves, keeping their currencies undervalued, and copied China’s mercantilism. Japan, on the other hand, hardly fitted Dooley’s model of a developing economy upgrading its physical capital stock. Yet it, too, was a country in transition, albeit glacial, from “communism with beauty spots rather than capitalism with warts,” as I put it years ago.11 It did not peg the yen to the dollar, but frequently intervened to prevent extreme movements. The bias, as witnessed by the accumulation of nearly $1 trillion of foreign exchange reserves (20% of Japan’s GDP), was to maintain yen competitiveness, and foster export-led growth.
The NDA has created a tripolar world. Asian and other member countries, the first pole, managed capital flows by official intervention. Their central banks financed the United States’ twin current account and budget deficits by purchasing US Treasury and agency paper, regardless of risk or return. The second pole, the United States, is the center of the area, operating no controls over international trade or capital flows. However, it enjoyed the freedom to live beyond its means. The third pole is the floaters. Their private capital flows underwrite current account balances on commercial terms, causing exchange and interest rates to adjust as and when necessary to clear markets. The other great divide is between the savings gluttons and the profligate. The gluttons run large current account surpluses; they are the world’s savers and lenders. The profligate run large current account deficits; they are the world’s borrowers and spenders. The gluttons include most NDA member countries, particularly China and Japan. But some NDA members, such as India,12 are not gluttons. Equally, some gluttons, such as Germany and its northern European neighbors, are not NDA members.13 Until the crisis and recession, the United States was by far the greatest profligate, absorbing 50% of global surplus savings. It was joined by the United Kingdom and the southern hemisphere trio of Australia, South Africa, and New Zealand (plus southern Europeans such as Spain, Greece, and Ireland, but see note 12).
Paradoxically the Savings Glut Spawned a World Boom
The savings gluttons should have stagnated unless and until they boosted domestic demand. The profligate should have been prevented from generating grotesque and unsustainable domestic sector financial imbalances. The global economy would have foregone an unprecedented boom—four years of 5% GDP growth—largely concentrated in vibrant Asia, but, equally, it would have escaped the present recession. My colleague, Charles Dumas, was first to draw attention to the consequences of the Eurasian savings glut, subsequently popularized by Ben Bernanke.14 Incredibly, the Eurasian savings glut spawned a global boom. Eurasian parsimony caused US profligacy, and not the other way round. If US spending had crowded out Asian spending, interest rates would have been historically high and global inflation rapid. Instead, Asian saving crowded out US savings by making credit abnormally plentiful and cheap. Without a glut, there could have been no spree; but without a spree, there could have been no glut. And, without NDA pegs and dirty floating, leading to Asian central banks financing the US twin deficits regardless of risk or return, there could have been neither. Private investors would never have lent on so massive a scale, faced with the risk of a dollar freefall. Yuan and yen appreciation would have stifled export-led growth.
US consumers went on a spending spree. Personal savings evaporated. The household sector’s financial balance (the difference between income and all spending, consumption plus capital investment, especially in real estate) moved into an unprecedented deficit. Debt levels consequently rose to unprecedented and unsustainable levels. The other factor of the utmost importance was the explosion in financial innovation. It would take a book to explain the mechanics of the US credit bubble. It was not simply caused by the Eurasian savings glut lowering interest rates. The witches’ brew included: Structured finance; the need and greed for high returns; obscene bonuses; regulatory and information black holes; interest-conflicted rating agencies given power without responsibility; flawed Basel rules; central banking bubble bingers; mark-to-model or make-believe; and so on. However, the point is that the crunch did not come from an inability to finance the US external deficit, but from unsustainable domestic imbalances and the inevitability of burst credit bubbles. The credit crash came because Ponzi finance required asset prices to rise for ever. As the gap between asset prices and output prices (i.e., incomes) widened, so the ability to service and repay debt diminished. New loans were increasingly required to refinance old.
The belief that the NDA collapse would come because member countries would no longer be willing to finance US profligacy was wholly mistaken.15 The dollar has not gone into freefall, nor have Treasury rates soared. The reverse has happened. The NDA remains alive and kicking. Indeed, it was obvious that this would be so. The Eurasian savings glut has not evaporated. The gluttons’ desire to save and lend has, in no way, been satiated. There is no limit to the extent to which creditors can accumulate assets, regardless of risk and return, when the alternative is a domestic economic slump, driven by falling exports and investment. China’s prime minister, Wen Jiabo, has made this “crystal clear.”16 The limit has been the US ability to borrow and spend, as it was certain to be. It was thought that the US current account deficit would have to be reduced because it could no longer be financed. It was expected that policy tightening would be needed to cause the economy to contract, because the dollar’s freefall and foreigners’ flight from Treasuries would threaten inflation. The public sector deficit would have to be reduced in order that its twin, the current account deficit, could be brought down. Monetary policy would have to be tightened to stop consumers living beyond their means. This view was widely held even as the crisis began to unfold.
It has not worked out that way at all. Instead, the economy’s contraction is causing the US current account deficit to diminish. The public sector deficit is increasing as the current account deficit falls. This simply means that both the public sector’s and foreigners’ financial balances are deteriorating, as consumers have stopped borrowing, started saving, and are reducing their debts. The improvement in the household sector’s financial balance is the driver, not the driven. Hence the strength of the dollar and continued cheap, but unobtainable, credit (except by the government). Indeed, the banking crisis has led to government bailouts and risk aversion, and has reduced the availability of credit, while the collapse in asset values has simultaneously reduced consumers’ ability and desire to borrow. It follows that if household debts are reduced, so must be lending to households.
The Asian decoupling notion was ever absurd. What would make frugal Eurasian savers and lenders become profligate borrowers and spenders, as long as they enjoyed a free ride on export-led growth? The November 2008 summit advocated fiscal synchro-stimuli. The April 2009 summit faced this issue with a proposal, favored by the United States, Japan, and (half-heartedly) the United Kingdom, that all G20 countries should increase public spending and cut taxes to the tune of 2% of GDP. The French and Germans were against this proposal. The aim of synchronized fiscal stimulation was to prevent free-riding on exports to those that did expand domestic demand. It was the right policy for big savers, but only a temporary expedient for the former profligates. When households no longer borrow and spend, for their governments to do so instead merely slows down the correction in financial imbalances by trashing public sector balance sheets. The savings gluttons cannot indefinitely be rescued from the Keynesian consequences of their own thrift by deficit countries’ spending—now public instead of private. Consequently, they are suffering a more severe recession than the United States. After all, as American consumers are stopping living beyond their means, they have stopped buying Asia’s surplus products. Asian exports crashed in early 2009 by up to 50%. The opposite of export-led growth is import-fed sloth. As Asia is denied the former, the United States can escape the latter. The Asian investment-accelerator-driven recession is sharper, but at least for China it will probably be shorter than the US consumer-retrenchment-driven one. Technically, the United States should escape from recession in late 2009, but growth is expected to remain feeble.
One final word. Deficit countries have few sanctions with which to persuade surplus ones to revalue and/or reflate. One is to threaten trade protection. If synchro-stimuli trash deficit countries’ public sector balance sheets before big savers start to spend, protection will become a serious prospect.
1 See the IMF’s COFER quarterly database. IMF members’ foreign currency reserves totalled $7 trillion at end-June 2008. Only some $4.3 trillion was allocated among currencies, and identified US dollar holdings were $2.7 trillion, or 62%.
2 May 9, 2006.
3 “An Essay on the Revived Bretton Woods System,” NBER Working Paper 9971, September 2003.
4 Between 2000 and 2003, the US general government balance went from 1.6% of GDP surplus to a 4.8% deficit, an adverse swing of 6.4% points. The cyclical deterioration was a mere one percentage point. OECD, Economic Outlook, 83, Appendix tables 27 and 28.
5 The current account deficit climbed from 3.3% of GDP in 1999 to 4.8% in 2003, on its way to a 6.2% peak in 2006, or a record $800 billion. OECD, op. cit., Table 50.
6 The Fed’s trade-weighted dollar exchange rate against major currencies climbed 16% between December 1999 and February 2002, and did not drop back below its 1999 level until May 2003. St Louis Federal Reserve database, FRED II.
7 “Will the Bretton Woods 2 regime unravel soon? The risk of a hard landing in 2005-06”, paper written for the Federal Reserve Bank of San Francisco and UC Berkley conference on The Revived Bretton Woods System, February 2005.
8 “Let the dollar fall or risk global disorder,” Financial Times, May 10, 2006; Obstfeld and Rogoff, “The Unsustainable US Current Account Position Revisited,” NBER working paper 10869, 30 November 30, 2005.
9 NBER recession data is available on www.nber.org/cycles.
10 “Renegade economics: The Bretton Woods II fiction”, PIMCO. September 2007.
11 Reading, Brian. Japan: The Coming Collapse. London:George Weidenfeld and Nicholson Ltd, 1992.
12 According to the IMF’s WEO database, India ran a current account deficit of around 1% of GDP during the three-year period 2005–07. A current account balance equals the surplus or deficit in national savings over domestic investment.
13 However, they are members of a different “fixed exchange rate regime,” the European common currency, the euro. The Eurozone, like the NDA, has its savers and lenders (northern Europe), and borrowers and spenders (southern Europe). This is for the same reason. Exchange rate changes are not allowed to clear markets, so payments imbalances can persist.
14 Charles Dumas, and Diana Choyleva. The Bill from the China Shop–How Asia’s Savings Glut Threatens the World Economy, Lombard Street Research January 2006. Martin Wolf wrote: “In 2005, incoming Fed Chairman Ben Bernanke argued that a global savings glut is causing the huge US current account deficits. Charles Dumas recognized this truth long before him.” Financial Times 28 March 2006.
15 Brad Setser has admitted as much in his blog, Follow the Money. See “The end of Bretton Woods 2,” blog entry, October 21, 2008.
16 “We must be crystal clear that without a certain pace of economic growth, there will be difficulties with employment, fiscal revenues, and social developments … and factors damaging social stability will grow.” Speech by Wen Jiabo, reported by the Financial Times, November 2, 2008.