Roubini’s on the Endgame for Bretton Woods 2

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Nouriel Roubini has an excellent, and typically sobering piece on what he sees as the denouement of what he calls Bretton Woods 2, the system we have of less than floating exchange rates (i.e., many East Asian countries + the Gulf States maintain hard pegs; China has a dirty float).

Conventional wisdom has been that at some point rising inflation would force these countries to break their pegs (the inflation is due to considerable degree to the inability to fully sterilize the purchases of dollars they must make to keep the value of their currencies in line with the greenback).

However, Roubini, who has been prescient on this topic, sees another outcome: with world growth and demand looking wobbly, these countries (which are not the most politically stable, an important fact to keep in mind) are reluctant to risk a big slowdown or huge damage to exporters by letting their currencies appreciate.

Roubini believes they will let inflation run, and even allow it to become embedded. In the long run, this will achieve similar results to a revaluation (as local goods prices rise in nominal terms, it winds up increasing the price of exports, much as currency appreciation would. However, it would happen more gradually and (implicit in Roubini’s argument) it would be hard to point fingers (while a change in the currency regime would clearly be tied to specific authorities).

While Roubini may well be correct, that many countries will follow the path of least resistance, the consequences of this development would be profound. Highly inflationary economies are terrible for financial investment (I recall that the 24 stocks traded on Mexico’s Bolsa in 1984 had P/Es of either 2 or 4), indeed, investment of any kind.

Similarly, in the stone ages of my youth, currencies that offered investments with high interest rates were shunned. The assumption was that they were fundamentally unsound and prone to devaluation. The bad image of high inflation economies carried over to moderate inflation ones, the reverse of the yield-chasing carry trade logic of today. Although one robin does not make a spring, India is now apparently having to defend its currency from a fall, the converse of what one would have expected a year ago.

Roubini’s post is very much worth your attention. Aside from a thoughtful discussion of our current situation, it makes illuminating comparisons to the breakdown of Bretton Woods 1.

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  1. Anonymous

    How long the dollar-peg policies of East Asia and the Gulf will continue is anybody’s guess. But they certainly help explain, during this decade, the ongoing official purchases of dollars which have ballooned the Fed’s off-balance-sheet custody account into a brobdingnagian $2.3 trillion slush fund.

    These purchases imply that the dollar — weak as it may be versus euros and yen — has been systematically overvalued, while U.S. interest rates correspondingly were held artificially low. This configuration in itself implies malinvestment. For instance, a systematically overvalued currency doesn’t lend itself to being a manufacturing platform. And indeed, U.S. manufacturing has been in freefall.

    Meanwhile, depressed real rates of interest tend to induce asset speculation. Check — we sure got plenty of that. Of course, these same tendencies will occur in local currencies which mirror the dollar. The out-of-control building boom in the Gulf states is a prime example.

    How does it all fail? The question is finding the weak link. Any gigantic pool of liquid funds is inherently risky, because its owners can seek to redeem it. The Fed’s custody account is nearly 2.5 times the size of its balance sheet, which is itself levered on a thin slice of equity. A sudden redemption call on the Fed’s custody account could send rates skying. That’s one possible mode of Bretton Woods II failure. Doubtless there are others.

    CONfidence is everything, Ben. Don’t let central bankers in bowler hats line up outside the Eccles Building — it could cause panic!

  2. Peripheral Visionary

    At the risk of sound apocalytpic (not that that ever happens on blogs), inflation is a serious concern because it so often is a harbinger of economic collapse. Of the countries that have gone down the road to collapse, for many the first sign of trouble was spiraling inflation. At a fundamental level, the fight against inflation is a fight to keep the government stable; confidence in the currency is a proxy for confidence in the government. That so many countries have tacitly decided to let inflation take its course does not bode well for political stability worldwide.

  3. Anonymous

    There are no degrees of freedom left. Either the value of the currency adjusts or the homies have inflation.

    The game has been to stimulate consumption in the US and return dollars as underpriced debt. The borrowing capacity of the US has been filled. All those new yuan and yen and Euros, printed to purchase dollars are inflationary.

    Only one way out. Buy American goods and services. A quaint idea in the new globalized free trade world.

  4. donna

    Not really “buy American”, but produce something the world wants. We need a new tech boom, things that can be produced with light industrial here, medical advances, etc. We need to reconfigure what Americans are good at. Stop just consuming and start being productive again…

    And create the infrastructure to support it. Massive investments needed in education, health care, transportation, wireless, etc, etc…

    Stop fighting wars to try and keep oil cheap (it’s not going to be any longer) and put the money back into supporting our own people.

  5. Anonymous

    Wouldn’t currency appreciation result in higher purchasing power? While inflation would lead to the opposite direction for their citizens. Other outcomes would be all sorts of speculating, hoardings, asset price inflation, other destabilizing economic activities… Tough choices for the authorities!

  6. Richard Kline

    To Anon of 8:27, I fully agree with all your comments. The $ has been systematically overvalued, at least since 85 but really even longer, for a generation. And the global economy has adapted to arbitrary levels. What we have now, in a world historical context, is the deleveraging of _that_ unsustainable fiction. So far, change is slow, but the slope of change changes . . . .

    I don’t have the info in front of me, but it is my recollection that over several centuries that typical result for the end of a currency-linked period of relative macrofinancial stability leads to sustained periods of high but erratic inflation. If we return to that now, the development of interventionary central banks notwithstanding which are quite new economic actors, we are only reiterating an historical norm. These high inflation periods . . . they weren’t all that good. Inflation is very hard to control. The typical result was that economies with little trade or value added saw their credit collapse internally, first financially, then politically. Yes, inflation erodes government; that is an historical constant. But it’s the easy way out in the short term, so governments often go willingly to their grave. Raising taxes, cutting expenditure, and nurturing productive enterprises take, well, EFFORT.

    “. . . China has a dirty float.” So Yves, I realize that this is the term often used. Personally, I prefer ‘rigged float’ as a better metaphor. But both are pejoratives and meant to be; I’m not sure that that language is in general either fair or wise, not that it is or your or our making. ‘Captive float’ says the same thing without namecalling. Maybe it’s just me, but I have trouble getting my head around the idea that China’s policies are, well, dastardly. Everyone in the global financial system cheats to enhance the hand they play. We don’t recognize our own cheating as, well, _cheating_: it’s just how we play the game and always have, so if no one calls us on it how can we be doing anything dastardly? But we do ourselves, very much so. Floating debt and credit we can’t back on the world markets is cheating if anything is: we do that. How many Chinese statements call us capitalist pigs for us? I mean how many these days? China’s policies are unquestionably problematic for the global economy, and should be discussed as so in unvarnished language. So are our own, which I know that you know. But pejorative language makes it look like some_one_’s a villain when really everyone at the table is a pirate. So let’s either villefy everyone or no one. And I’m for ‘no one,’ because we’ll need cool heads here. Except for, well the Bosses, I find it hard to speak temperately of them.

    And one other point of disagreement: I do _not_ see China and the Gulf States as politically unstable environments. Really. They are quite rigid and their political regimes have endured very well because of that. Now, adaptive political environments can absorb change, so that they look messy but endure, whereas rigid ones snap suddenly. But that’s a mid-term position. In the near term, China and the Gulphies have proved quite stable by suppressing political competition while throwing bread and circuses at the proles. I suspect that over the next thirty years, China will prove ‘more stable’ than will the US. Not over the next sixty, but the next thirty, yes.

  7. Richard Kline

    One further note on those long historical periods of inflation: Successful economies put their money into international commerce in high-value commodities and plowed their profits back into domestic land, because both asset classes had intrinsic value currency follies notwithstanding. This was all before the growth of industrial manufacturing, mind you. But as mentioned in a comment in this thread, high inflation deals a severe blow to manufacturing profitability. If we want a ‘post-industrial society,’ high inflation will get us there the quickest. . . . Is that what we want, central bankers? Really?? To invest in manufacturing enterprises, one needs bonds which hold their value. That takes a currency of stable value. That takes positive rates. That takes guts. . . . That takes new central bankers, except in the EU. Which suggests that their take on matters is the one most cogent.

  8. Anonymous

    The Economist also makes the point that inflation is bad for stocks, even though at first glance you might that stocks ought to be a hedge against inflation.

    The article point out that in the 1970s inflation, even though corporate revenues kept pace with high inflation, business profits fell as a percentage of GDP and P/E ratios fell to single digits. It’s not clear though if a reproducible cause-and-effect relationship is claimed, or if this is just an empirical observation of what occurred in the seventies.

    (Actually, what the article literally says is that business “profits” keep pace with inflation but business profits fall sharply as a percentage of GDP, which would imply that GDP rises considerably in real terms during inflationary times?? Perhaps they meant revenues instead of the first occurrence of “profits”?)

    However, I wonder if this sharp drop in P/E ratios would still necessarily occur in China in the let-inflation-rip scenario, for two reasons. First, because Chinese savers don’t have alternatives to stocks (reasonable bank account interest rates, inflation-indexed bonds, etc) that pay them a non-negative real rate of return. And second, because hot money keeps finding its way into China and has to end up somewhere.

    Indeed, in the scenario of the Chinese government choosing inflation (and a constant exchange rate) rather than revalution, the best strategy for hot money might be to buy into yuan-denominated revenue streams backed by consumer spending (a proxy for which might be, say, shares of a Chinese telecom company) rather than buying Chinese cash, since the former would keep pace with inflation while the latter would not.

    So in this case, hot money would prop up at least the shares of Chinese companies that derived their revenues from domestic consumption (telecoms? online multi-player gaming companies and Tencent? advertising networks like Focus Media?), although exporters would still take a big hit.

  9. Richard Kline

    To Anon of 11:41 PM, regarding China one must, I think, bring the whole population into the picture. There are rather a lot of them. Most of them are poor dirt farmers who do not own stocks, and who certainly don’t speculate in them. Yes, inflation in China poses investment quandries for the nascent middle class and tiny wealth class. For everyone else, they are going to eat their cash, almost literally, because inflation will act most on food and fuel which are essential to their daily bowl and quality of life. Which is why I do not see China voting for an inflation scenario, anytime, period. Inflation is a financial problem for most countries and their governments; it will be an existential problem for a significant share of China’s population and in consequence for China’s government. Remember, most of the Chinese grew up in a country where the government owned everything, so don’t think for a second they would hesitate to go back, in some ways to government control of X commodity if faced with potential severe inflation.

    I’m not saying that I have a clear view on what China’s government will do. I doubt that they know themselves. But opting for high domestic inflation will be a policy at the nether foot of the decision queue, to me.

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