Nouriel Roubini on the Instability of Bretton Woods 2

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The Bear Stearns/CDO drama has taken attention away from other worrisome conditions in the economy, and the biggest one is “global imbalances,” which is shorthand for the US running continuing, large current account deficits that are financed for the most part by foreign central banks, particularly those of China, Japan, and Saudi Arabia.

We’ve lived with this situation so long that a lot of commentators regard it with complacency. If these countries find it advantageous to finance our consumption, so much the better.

If these fund flows were operating on a more modest scale, that benign view wouldn’t be far off the mark. But a difference in degree is a difference in kind, and massive liquidity creation is feeding asset bubbles and other distortions. And it isn’t sustainable either. Countries that have been accumulating dollars are quietly shifting their currency mix.

NYU professor Nouriel Roubini’s analysis of the legacy of the 1997 Asian crisis and how it plays into the foreign exchange policies of Asian countries, particularly China, served as the meat of a recent Economist article and got high marks from Martin Wolf, the Financial Times’ lead economics editor. He gives us his latest thinking:

I just finished this week a new paper on The Instability of the Bretton Woods 2 Regime that I will present this week at a conference in Singapore.

A crucial feature of the global economy right now is the large US current account deficit and the surpluses of most – but not all – of the rest of the world. The US current account deficit rose from $640b in 2004 to $755b in 2005, to $811b in 2006 (or 6.1% GDP) and is likely to be even larger in 2007. The US, the world’s largest economy – and the world’s preeminent military and geo-strategic power – is also the world’s largest debtor. The current account surpluses of most other regions of the world are the mirror image of the US deficit. The US absorbs about 70% of the savings that the rest of the world does not invest at home. Several other economies (both advanced and emerging) are also running large (as a share of their GDP) current account deficits; but the US deficit is the largest in absolute terms. Also, barring an economic slump in the US or a major fall in the dollar, the US current account deficit looks set to remain high in 2007 and beyond.

As I showed in my previous work with Brad Setser the defining feature of the current international financial and monetary system is that it finances the United States’ enormous external deficit – and the associated fiscal deficit and private sector savings deficit — at low interest rates. Also the world’s central banks, not private investors, increasingly provide the bulk of the financing the United States needs to sustain its deficits. The increase in central banks’ holdings of U.S. Treasuries has been large enough to finance most of the structural deterioration in the US fiscal deficit since 2001 and the further worsening of US private savings since 2004.

How to explain such large and persistent global imbalances? In a series of influential papers Michael Dooley, David Folkerts-Landau and Peter Garber (DFG) have argued, that the Asian economies and, increasingly, most emerging market economies have constituted a new Bretton Woods system of pegs to the US dollar (BW2) and that this new BW2 system explains the global current account imbalances of the last decade. In the original Bretton Woods system, Europe and Japan tied their currencies to the dollar; today, in their view, most emerging market economies – starting with China and others in Asia – formally or informally tie their currencies to the dollar to maintain weak currencies, run current account surpluses and achieve export-led growth and industrialization.

More recently DFG have argued that this growth model based on weak currencies, reserve accumulation and current account surpluses is the only model and optimal model of growth for most emerging markets: accumulating reserves allows these countries to build international collateral and thus attract the FDI that they need to grow given that their inefficient domestic financial systems cannot allocate savings to the right investments. These economies need the superior financial intermediation services of the US and of advanced economies in order to grow. Thus, the US current account deficits are stable and sustainable and are the reflection of the only model of growth that works for emerging markets.

The BW2 hypothesis has received a lot of attention given that China and several other emerging market economies seem to superficially fit the DFG description of the data: semi-fixed undervalued exchange rates, aggressive forex reserve accumulation to prevent appreciation, gross inflows of capital and FDI, large current account surpluses and high economic growth.

Many others scholars – who disagree with DFG – have argued that while the current global financial system partly fits the BW2 model, that there are many flaws in this description of the system as a new dollar zone, and that this system is unstable and unsustainable even for its current members. (see this page at the RGE Monitor for our complete coverage of the BW2 debates)

In my new paper “The Instability of the Bretton Woods 2 Regime” I systematically assess the evidence about the existence of a BW2 regime, the correctness of its explanation of global imbalances, its optimality for emerging markets, and its stability and sustainability over time.

The main results and conclusions of the paper are as follows:

First, BW2 is not the best explanation of global imbalances; other explanations fit the data much better for the 2000-2004 period; even from 2005 on the data are consistent both with some of the aspects of BW2 as well as other alternative explanations.

Second, most emerging market economies are not member of BW2; even among the Asian nations the members of this regime is a small and shrinking set of countries.

Third, membership of BW2 leads to significant financial, monetary and real distortions for its members, most of which have to do with the loss of monetary and credit policy independence that a fixed exchange rate peg entails. These distortions are increasingly taking the form of economic overheating, rising inflation and dangerous asset bubbles.

Fourth, these financial and real imbalances have led many previous members of BW2 to exit this regime as the costs of membership are increasing.

Fifth, the argument that reserve accumulation is a collateral against the risk of default and expropriation is found to have no basis.

Sixth, BW2 is increasingly turning from a stable disequilibrium into an unstable one. The risks of its unraveling are increasing.

My critique of the BW2 hypothesis clearly relates to my recent work and paper on Asia learning the wrong lessons from its 1997-98 crisis. But it deals with a broader range of issues regarding the nature and functioning of the current global financial system. For a recent and possibly different perspective on BW2 from my collaborator Brad Setser see his recent blog Does Bretton Woods 2 end with a bang or with a wimper — a dialogue.

Let me now flesh out in more detail the above results and conclusions that are discussed in greater detail in my new BW2 paper…

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