Bretton Woods 2, R.I.P.

A wide range of commentators, including your humble blogger, have worried about the clearly untenable system known as global imbalances, or more formally, Bretton Woods 2. That was the tacit arrangement under which the US ran significant current account deficits which were financed by large purchases of Treasuries and more recently, Agency securities by foreign central banks in countries running big trade surpluses, namely China, Japan, Taiwan, and the Gulf States.

Even though economist Herbert Stein famously declared, “That which is unsustainable will not be sustained,” there were plenty who argued this arrangement would continue, just as dot com valuations had their defenders in 1999.

Brad Setser, who with Nouriel Roubini has given this topic considerable thought, had identified one factor that doomed this arrangement. America’s foreign creditors aren’t simply funding its current overconsumption; they are also funding the interest payments on past overconsumption. Once the interest component became too large relative to the trade deficit, our friendly funding sources would start to question the merits of this arrangement. Indeed, there is already infighting in China between the central bank and the finance ministry over what the policy on the dollar should be (letting the dollar fall relative to the RMB would eliminate the need to buy Treasuries to keep the currency low, but would also considerably reduce the trade surplus with the US).

Setser writes today in a very important post that the system is on its last legs, but not for the reasons he anticipated. Even though the arrangement has been colloquially described as “China funding our trade deficit” that is not the mechanism at work. China’s central bank is not lending to credit card issuers and banks that provide home equity loans. China buys Treasuries. A series of intermediate processes allows this foreign largess to result in support for consumer borrowing. Everyone expected our once-indulgent creditors to wake up and start demanding higher interest rates, which would wreak havoc on the US. Instead, the US financial system broke of its own accord under the weight of too much debt.

You must read the whole post, but here are some key sections:

In some sense Bretton Woods 2 has been on life support for a while now. China’s recent export growth has depended far more on Europe than on the US. US demand for non-oil imports peaked in 2006. One irony of the past year is that the US was borrowing far more from China that it was buying from China. Campaign rhetoric that the US was paying for Saudi oil with funds borrowed from China isn’t far off – though it leaves out the fact that the US also borrows from Saudi Arabia to pay for Venezuelan, Mexican and Nigerian oil….

The US and European banking system collapsed before the balance of financial terror collapsed. Dr. DeLong writes:

All of us from Lawrence Summers to John Taylor were expecting a very different financial crisis. We were expecting the ‘Balance of Financial Terror’ between Asia and America to collapse and produce chaos. We are not having that financial crisis. Instead we are having a very different financial crisis. Catastrophic failures of risk management throughout the entire banking sector caused a relatively minor collapse in housing prices to freeze up global finance to a degree that has not been seen since the Great Depression.

Yves here. I wouldn’t call the reversal of a housing bubble that pushed prices nationally to 30% to 35% over their long-standing relationship to incomes and rentals a “relatively minor collapse.” The fall in US net worth August 2007 to August 2008 was greater in percentage terms than during any 12 month period in the Depression, and is due mainly to the fall in home prices. The 12 months September to September, which would pick up the worst of the stock market swoon, are certain to be more dramatic. But each to his own characterization. Back to Setser:

The end result of this crisis though could be rather similar: a sharp contraction in credit, a fall in US economic activity, a fall in US imports and a fall in the amount of foreign financing the US needs.* The US government is (possibly) trying to offset the fall in private demand by borrowing more and spending more — but as of now there is realistic risk that the fall in private activity will trump the fiscal stimulus.

Consequently, this still strikes me a crisis of the Bretton Woods 2 system. In retrospect, Bretton Woods 2 depended on two things: ongoing flows from the emerging world’s governments to the US Treasury and Agency market, and the ongoing ability of the US financial system (broadly defined to include the dollar-based “shadow” financial system operating in London and other offshore centers) to transform these flows into loans to ever-more indebted US households. US investors** effectively sold their holdings of Treasuries and Agencies to the world’s central banks, and then redeployed their funds into private-label mortgage-backed securities. Between the end of 2003 and q2 2007 (three and a half years), the stock of mortgages held by private issuers of asset-backed securities rose from about $1 trillion to around $3 trillion. That demand meant that credit was available to any household that wanted it – even those without much ability to pay if the housing market ever turned.

Or, to put it more succinctly, Bretton Woods 2, as it evolved, hinged both on the willingness of foreign central banks to take the currency risk associated with lending to the US at low rates in dollars despite the United States large current account deficit AND the willingness of private financial intermediaries to take the credit risk associated with lending at low rates to highly-indebted US households.

The second leg of the chain collapsed before the first. And it collapse looks set to deliver a nasty shock to everyone – including the countries that supply the US with vendor financing.

In some sense, the vendor finance analogy never really worked. The “vendor” financers didn’t actually lend directly to the US households that were buying their goods. The big emerging market central banks were willing to take on currency risk associated with lending to the US but not the credit risk associated with lending to US households.

That didn’t matter so long as US financial institutions were willing to take the credit risk.

But now US financial institutions are neither willing nor able to take on the risk of lending even more to US households….

In retrospect, the fact that (reported) bank profits didn’t fall as the Fed raised rates should have been a clue that risks were building. An inverted yield curve isn’t good for institutions that borrow short and lend long – but it initially didn’t seem to have an impact on financial sector profitability. It is now clear how the financial sector kept profits up: it took on more risk…

Many have highlighted the role that loose US monetary policy played in supporting the housing boom. And there is no doubt much truth in this story: pushing rates down to help “clean” up the bursting of the .com bubble and holding them down for several years certainly helped induce the rise in home prices and the housing boom. At the same time, this story leaves out what to me is a crucial part of the story: the housing boom didn’t end when the Fed reversed course and raised long-term rates. The really risky loans were made in late 2005, 2006 and early 2007 – after policy rates had increased…..

I hope that the process of adjustment now underway isn’t as sharp as I fear. The US economy gradually can shift from producing MBS for sale to US investors flush with cash from the sale of safe securities to China and Saudi Arabia to producing goods and services for export – but it cannot shift from churning out complex debt securities to producing goods and services overnight. Indeed, in a slowing US and global economy, improvements in the US deficit will likely come from faster falls in US imports than in US exports – not from ongoing growth in US exports….

US taxpayers are going to be hit with a large tab for the credit risk taken on by undercapitalized financial intermediaries. Chinese taxpayers may get hit with a similar tab for the losses their central bank incurred by overpaying for US and European assets as part of its policy of holding its exchange rate down. The TARP is around 5% of US GDP. There are plausible estimates that China’s currency losses will prove to be of comparable magnitude. Charles Dumas puts the cost at above 5% of GDP:

Charles Dumas of Lombard Street Research estimates that China makes 1-2 per cent on its (largely) dollar reserves. It then loses up to 10 per cent on the exchange rate and suffers a Chinese inflation rate of 6 per cent for a total real return in renminbi of about minus 15 per cent. That is a loss of $270bn a year, or a stunning 7-8 per cent of gross domestic product.

I have estimated that the annual cost of adding $600b (15% of China’s GDP) of unneeded reserves to China’s stockpile is roughly 5% of China’s GDP — though the exact loss depends on the size of the RMB’s eventual appreciation. Others have calculated large losses to Chinese households on the basis of the very low rates China has maintained on domestic deposits to support the RMB.

Yves here. Note that Chinese households have taken huge losses indirectly as a result of the very low rates on Chinese bank accounts. With inflation at over 7% and bank deposits paying only 0.5%, it was rational to pile into the stock market. Many households put funds which were really savings rather than investment (as in, it included the reserves they needed for bad times) into shares and many have taken sizable losses.

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  1. Anonymous

    So what does this mean for the USD in the short term? Will it tank or hold ground until BWIII???

  2. Anonymous

    Anon 5.18,

    USD is holding pretty solid given unstable foundations of twin deficits.

    Will the foundation fall and/or a new world of balanced super powers to emerge and the USD along with it’s superior know how and nuclear power to emerge yet again would be anybody’s intelligent guess at this point, imho.


  3. Yves Smith

    Currencies, more than any other traded instrument, are noted for how long they can hold price levels not warranted by their fundamentals.

  4. Anonymous

    Currencies, more than any other traded instrument, are noted for how long they can hold price levels not warranted by their fundamentals.

    What are “fundamentals” in your view?

  5. Yves Smith

    Countries with large current account deficits should show depreciation, but often can take a while for that to play out, and conversely, when their trade balance improves due to a fall in value, the currency level can also be slow to improve. That has been the big reason for the dollar’s slide until the financial panic became acute and demand for dollars soared (not just flight to quality, but also unwinding of dollar financings). The dollar fell less than it “should” have due to hard pegs and dirty floats by many countries in Asia, most notably China. The $/RMB is still a managed rather than a market price.

  6. Stuart

    When this short squeeze is over or subsides, the dollar should be in for a nasty fall. The US has probably burned it overseas credit quite nicely. Few will likely want dollars again if they can avoid it and just at a time where the Treasury’s funding requirements are surrealistically higher. Anybody with a longer time frame than a few weeks better make sure they start accumulating dollar/inflationary hedges as I hear choppers coming.

  7. Richmond Rambler


    While I’ve recently accumulated a few hedges against inflation, I remain troubled by the arguments (confusion) surrounding the inflation/deflation debate. Mish, for instance, has been unswerving about a deflationary outcome, yet how to explain the way the Fed is going to sop up all the excess liquidity when the time comes? And why is Faber in cash if he fears inflation? Any Windex to this cloudy glass is welcome!

  8. Talo

    I know this sounds bizarre, and I need to look into it a bit more because this latest plunge is likely capital flows and not based on anything fundamental, but I think the dollar is going to be strong (maybe not this strong) until its not. In other words, I don’t think we will ever see a true collapse of the dollar to say 2 or 3$ to the Euro or 25 yen to the dollar -as importer of 70% of our oil, it would decimate the country. Rather than WW3, which would be a distinct possibility, I think they would attempt Bretton Woods III — they are not smart enough (I fear) to take the short term pain and link currencies to real capital, so there would be some new grand, fiat scheme and it just might be the “Global$” – one currency for the OECD nations. I know there are dozens of reasons why it wouldn’t work – but the central banks are already guaranteeing everything, and working together to keep the exisiting financial system intact.

    The dollar will be the worlds reserve currency until it isn’t. This is based more on politics and human history on going to war for real resources than on ‘economics’ (which is why it could be right). Although an alternative to the $ might be ‘better’, it would precipitate violence. The current global economic system will sink or swim with the dollar – even though other economies are ‘stronger’ than the US, we have the military, and consume 25% of worlds goods etc. (both bad things).

  9. Anonymous

    I disagree with Setser’s assertion that this was not vendor financing. Yes, it was not direct vendor financing. But indirectly, US consumers used their homes as ATM machines (not to mention credit cards, auto, etc) and took the money to consume goods — much of which came from those countries purchasing the Treasuries and Agencies.

    And, yes, some of the proceeds of this leveraged creation of credit/debt did effectively borrow from China and ship to Saudi Arabia.

    But, it was leveraged. It was not dollar for dollar. So, while some when to Saudi Arabia, other amounts went to purchase, e.g., large inflatable holiday creatures ‘made in China’. And more.

  10. Anonymous

    one reason the current environment may not be inflationary is that a lot of the cash injections are falling into a black hole. Wealth is being destroyed, not created or saved. If consumers continue to default on home loans and credit card debt and companies with large CDS written on them or by them go bankrupt, more wealth will be destroyed. This is not wealth that can have a second life(especially in CDS or credit card debt) as there are no assets to back it up. (At least with a mortgage, there is a house to hedge some of the losses – although it is hedging less and less of the losses as prices continue to fall). Money just disappears. By injecting money into the banks and other troubled companies, you may be sustaining them by stabilizing them but the money injected is lost forever.

    Maybe someone can answer this – Has there ever been a time in history were money was truely sucked into a black hole to be gone forever and what was the effect?

  11. SlimCarlos

    BW-II will fail for the same reason BW-I failed — creditor fatigue.

    A more interesting question is this: what will BW-III look like. Thoughts, anyone?

  12. Anonymous

    What about the demand in emerging markets for dollars in the post Asian financial crisis world? Isn’t the appetite for dollars and dollar-denominated assets by central banks building up defensive reserves and by persons seeking to accumulate generally-accepted “wealth” a significant factor in the willingness of the world to accept the supply of US Treasuries and securities backed by dollar-backed assets?

    If yes, then won’t shutting off the valve and, moreover, destroying many of these assets leave the world short of dollars? The immediate consequence of this would be an appreciation of the dollar (which happens to be what we are seeing now–and I’m not convinced it is the result of a pure-hearted “flight to safety”) and an obviously major risk of deflation, at least in the short term. It seems to me that the western central banks created this problem not only by creating conditions that made it easy for banks, investors, and homeowners to have a big bubble-party, but also because they failed to provide a direct increase in the money supply so as to directly meet the demand from emerging markets joining the global markets.

  13. Anonymous

    ‘Has there ever been a time in history where money was truely sucked into a black hole to be gone forever and what was the effect?’

    Although the 1929 stock crash and subsequent Great Depression was not exactly the same as the current ‘disappearance of money’, it was similar. Once stock prices that had been purchased with as little as 10% margin crashed, the ‘money’ that speculators thought that they had quickly disappeared, never to be seen again. Well, had the investors held their stocks untill 1954 they would have broken even or perhaps made a profit, depending on the dollars being adjusted for inflation.

    One could say that the Great Depression was partially caused by the crash of 1929, although many other factors came into play.

    Loss of confidence of investors/consumers after the crash of 29, and a drying up of credit, was similar to what we are seeing today, imo.

  14. Matt Osborne

    You note the bubble in home lending took place after the Fed raised interest rates. Here is a dramatic reconstruction of what happened:


    “Hi! Is this Ms. Smith? Bank of Palooka just wants to let you know that as a carbon-based, oxygen breathing organism, you qualify for an unsecured Visa with a $10,000 line of credit and a home equity loan up to $150,000! Rates are still at historic lows. Perhaps you have seen our commercial with its touching music and minority family? THAT COULD BE YOU!”

  15. Matt Dubuque

    Matt Dubuque

    As previously stated, the most likely scenario for the inevitable replacement of the Bretton Woods framework is the introduction of an ACU (Asian currency unit) as has been discussed at length in both APEC and ASEAN +3, followed by an introduction of other currencies into that framework.

    Although capital surpluses are huge in China, when they are taken together with the rest of north Asia and other Asian states, they become decisive.

    This is clearly the most likely path for the new economic world order over the next 3-5 years.

    Why Setser repeatedly omits the ACU in his discussions is beyond me. Normally his Asian analysis is above average, but this omission represents a real shortcoming in his otherwise commendable work product on Asia, in the view of this writer.

    Matt Dubuque

  16. SlimCarlos

    >> As previously stated, the most likely scenario for the inevitable replacement of the Bretton Woods framework is the introduction of an ACU (Asian currency unit) as has been discussed at length in both APEC and ASEAN +3, followed by an introduction of other currencies into that framework.

    You think London and New York, to say nothing of Washington, will stand to see global monetary policy set in Asia?

    I believe the only way to get all players to sign on is to de-politicize the system. BW-I and BW-II are a reflection of the US' standing in the world atfer WW2. This is no more. But no other country has stepped up. There is no country that dominates now the way the US dominated in '44. So I don't see how you get a buy-in by all the players unless the system is somehow "neutral", whatever that means.

  17. Anonymous

    While I can imagine an ACU somewhere far into the future, I can’t imagine how one would succeed as soon as the next 3-5 years.

    The capital surplus China and others hold don’t seem terribly relevant to me, as they are simply fiat currency or financial assets denominated in and supported by fiat currency. Presumably they have amassed a sufficient hoard to defend their own currencies to a point, but they would eventually be swamped by incompatible policies by the US and EU.

    Regardless of how much value one places on the capital surplus, the other hurdle–trust–looms even larger. Why would the world participate in such a scheme? Faith would be required that those in charge of the ACU would act responsibly and (less importantly, perhaps) for the greater good. Neither seems easy to accept in the near term. Consider too the example of the EU. The fractured interests among the euro’s membership is enough to send holders scurrying, and ASEAN has a long way to go to even reach that low degree of demonstrated coherence and cooperation.

  18. FairEconomist

    Great writeup, Yves. But the Chinese/foreign central bank support of the consumer binge was even more indirect than you say (apart from Agency purchases, of course). T-bill purchases didn’t go into the shadow banking system; they went into the federal coffers. They *freed* domestic money, coming from corporations and the wealthy who own them, to go into the shadow banking system. *That* money got converted into loans supporting consumer purchases.

    So the loop we mock of the Chinese loaning us money to buy our junk was actually *us* loaning ourselves money to buy Chinese junk. The Chinese really were propping up our government during this fiasco, allowing us to really hang ourselves.

    The Agency purchases, to be fair, were an important exception because they went directly to the heart of the bubble, helping to push up housing prices, which in turn provided the equity which supported most of the borrowing. I don’t think the foreign banks were intending to destroy us; but the way the intervention worked out (pushing up housing prices to sustain empty loans within our economy) was almost tailor-made to wipe our financial system out.

  19. Anonymous

    It is possible that Bretton Woods will die only to be replaced by nationalisim…A return to trade barriers, tarrifs, etc.

    Of course, the threat of war usually follows nationalistic fervor and practices…Stirred by bankers and businessmen that desire ‘what is over there’.

    Globalization might be a thing of the past, unless one considers colonialisim to be globalization.

  20. corbett wall

    Hi Yves, informative post, but I’d like to point out something important. You said that it was only rational for Chinese households to put their savings into the stock market since inflation at over 7% and bank deposits paying only 0.5%.

    In actuality Chinese put their bread and butter money into real estate, not stocks The SSE is only a small portion of GDP compared to the real estate market.

    If China’s real estate continues to drop – and it is very quickly – and if the continued measures to boost it back up don’t work – and they aren’t – Chinese people will start figuring out where they stand in this global equation and the real bickering will begin, and Beijing will come up with some serious policy changes in their upcoming Nov. meetings, which will probably add another interesting spin on all this chaos.

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