Bretton Woods II – let’s remember the last time David Steven

January 11, 2009 | More on Climate and resource scarcity, East Asia and Pacific, Global system, Key Posts, London Summit, North America | No comments

In last month’s New Atlantic, James Fallows had a fascinating interview with Gao Xiqing, Chief Investment Officer at China’s sovereign investment fund, and the man responsible for a significant chunk of China’s huge holdings of American dollars.

Gao – who Fallows dubs one of the US’s new banking overlords – thinks Americans need to learn some humility and fast.

“The simple truth today is that your economy is built on the global economy,” he says, “and it’s built on the support, the gratuitous support, of a lot of countries. So why don’t you come over and … I won’t say kowtow [with a laugh], but at least, be nice to the countries that lend you money.”

The US should disentangle itself from expensive overseas conflicts, Gao believes, raise its diplomatic game, and – above all – tell its citizens to get saving as part of a “long-term, sustainable financial policy.”

It’s all well and good, but maybe Fallows should have pushed Gao a little harder on whether China’s own financial policy is sustainable. After all, despite recent appreciation, the yuan remains substantially under-valued against both the dollar and the euro – the main reason why the Chinese has ended up holding so much Western debt.

Gao’s comments on the dollar are somewhat contradictory (and reflect all the ambiguity of China’s own dollar position). On the one hand, it defends its status as a reserve currency. The US is still the most viable and predictable market, he says. But on the other, Chinese investment in the dollar is widely unpopular at home. According to Gao, China’s citizens ‘hate’ its support of rich Americans (“people eating shark fins”) at the expense of “poor [Chinese] people eating porridge.”

More significant than public pressure, perhaps, is Gao’s belief that the dollar is highly likely to lose value over the short to medium term (with a corresponding appreciation for the yuan). This will wipe billions of Chinese reserves (reserves that have only been built up through consumption foregone) – while challenging China’s export-led growth model:

We are not quite at the bottom yet. Because we don’t really know what’s going to happen next. Everyone is saying, “Oh, look, the dollar is getting stronger!” [As it was at the time of the interview.] I say, that’s really temporary. It’s simply because a lot of people need to cash in, they need U.S. dollars in order to pay back their creditors.

But after a short while, the dollar may be going down again. I’d like to bet on that! The overall financial situation in the U.S. is changing, and that’s what we don’t know about. It’s going to be changed fundamentally in many ways.

Unravelling these imbalances seems certain to be ugly. Reading George Cooper’s book, The Origin of Financial Crises, on a plane the other day, I was struck by strong parallels between today’s economic woes, and a crisis we have heard little about recently – the ‘Nixon Shock’ that led to the end of the Bretton Woods system.

Nixon blamed his decision to sever the link between the dollar and gold on ‘international speculators’. Sounding like an early-Naomi Klein, he accused them of engineering an economic shock for financial gain. But in fact the problems were structural. Europe’s economies had recovered from the war and were booming. The US economy had become relatively less competitive and was running a growing trade deficit. As Cooper explains:

This unbalanced trade and currency flow tended to depress the value of the US dollar. However, under the Bretton Woods agreement non-US countries were obliged to keep the value of their currencies fixed with respect to the US dollar. To maintain these fixed exchange rates foreign governments were obliged to recycle the trade surplus back into America. Put differently, if the European currencies were to remain fixed with respect to the US dollar, then for every dollar America spent on European goods Europe would have to spend that same dollar amount on something in the US – that something was US government debt.

You can see how close the fit is. The main difference, of course, is that in the 1970s the US controlled the devaluation lever not the Europeans. Today, the yuan’s peg (first to the dollar and now to a basket of currencies) is controlled (jealously) by the Chinese. The US can bluster a little if it likes, but the last thing it wants is China to start dumping dollars in an uncontrolled fashions.

Both then and now, of course, the US government badly needed credit. Then Vietnam – and ongoing aid to Europe – was swallowing up resources. Now its Iraq, Afghanistan and swelling social security commitments. In the 1970s, the result was a series of runs on the US’s gold reserve. In August 1972, the British ambassador is said to have made a particularly spectacular foray – turning up at the Treasury Department to request that $3bn be turned into gold.

Soon after, Nixon set out to Camp David with his advisers, where the decision to abandon the gold standard was taken, and price and wage controls instituted to damp down inflation. Although Nixon promised the world a new international monetary system (sound familiar?), the step was tactical not strategic. Apparently, the President spent more time worrying whether to interrupt a popular Sunday evening television show to announce the policy than he did in thinking through its consequences.

At first, Nixon’s new policy was very popular at home – but it had far-reaching (and unpredictable) economic and geopolitical impact. By 1973, the dollar had plunged 25% against a basket of European currencies. The resulting inflationary spiral was not cured until Reagan and Paul Volcker, tamed the beast in the 1980s. (Volcker, by the way, is a Democrat and will head Obama’s Economic Recovery Advisory Board).

Internationally, as David Hammes and Douglas Wills have argued, Nixon’s decision to abandon gold was, in part, responsible for the oil crisis that followed a few years’ later (though the proximate cause was US support for Israel in the Yom Kippur war).

Although the dollar price of oil increased by a factor of ten in the 1970s and rose 135% on the first day of 1974, this does not take into account depreciation of the dollar (and other Western currencies) or the rampaging inflation consumer countries experiencing. Oil’s price in gold shows a very different pattern:

• In 1970, 10 barrels of oil would buy an ounce of gold.
• This rose to 12 barrels in the aftermath of the end of Bretton Woods, and had reached 34 by mid-1973.
• After the big price shock of 1 January 1974, the price was back down to 12 barrels per ounce. It was 14 barrels by the end of the decade – making it 25% cheaper in gold terms than it had been ten years’ earlier.

The US response to the embargo, in turn, created a raft of what the State Department politely terms ‘foreign policy challenges’ – most of them in the Middle East, though there was a pronounced transatlantic rift as well. In addition, Nixon promised energy independence by 1980. The US also attempted to forge a consumers’ cartel to control prices – an idea that didn’t fly then, but appears to be back on the cards today.

Today, I’d bet good money (if there was any left) that the banking crisis is far from over – a point that I’ve argued on Global Dashboard before. Despite all the money being pumped into the banking system, most institutions seem to have a long way to go before they own up to all their toxic liabilities. (Henry Blodget has a brutal take on what needs to be done to avoid a lost decade with Japanese style ‘zombie banks’.)

Meanwhile, I expect the big story of this year (or perhaps it can be put off until 2010) will be how to unravel global imbalances. As the 1970s, that will undoubtedly be a messy (and one would presume inflationary) process – but the pain can presumably be controlled if we don’t blunder into it like Nixon did in 1971.

Success will require not just good US (and European and Japanese) leadership, but oodles of strategic thinking from the Chinese as well. As Gao Xiqing has made clear, the Chinese certainly hold plenty of the cards.

As in the 70s, scarcity drivers (not just oil this time – but food, water, land and the right to emit carbon) seem highly likely to play a complicating role. That’s why, as Alex and I argued in a paper for last years’ G20, a global deal for economics cannot be separated from one on climate (which, in turn, will tell us a lot about how scarce resources are to be allocated).

Next stop, of course, is April’s G20 summit in London – which needs to take a broad and long-term view of the challenges ahead. If the agenda is limited to tinkering with financial regulation, we could be in for a long and increasingly bumpy ride.

Let’s hope the ‘Obama moment’ forces leaders to think a little bigger than that… and as they work on BWII, they remember the demise of the last Bretton Woods…

Further reading: A Bretton Woods II Worthy of the Name

Update: The New York Times has a good piece from the end of last year on China’s role in the US meltdown

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