NBER WORKING PAPER SERIES AN ESSAY ON THE REVIVED BRETTON WOODS SYSTEM Michael P dooley David Folkerts-Landau Peter Garbe Working Paper 9 http://www.nber.org/papers/w9971 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge MA 02138 September 2003 The views expressed herein are those of the authors and are not necessarily those of the National Bureau of C2003 by Michael P. Dooley, David Folkerts-Landau, and Peter Garber. All rights reserved. Short secti of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full cre ◎no given to the so
NBER WORKING PAPER SERIES AN ESSAY ON THE REVIVED BRETTON WOODS SYSTEM Michael P. Dooley David Folkerts-Landau Peter Garber Working Paper 9971 http://www.nber.org/papers/w9971 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 September 2003 The views expressed herein are those of the authors and are not necessarily those of the National Bureau of Economic Research. ©2003 by Michael P. Dooley, David Folkerts-Landau, and Peter Garber. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source
An Essay on the Revived Bretton Woods System Michael P. Dooley, David Folkerts-Landau, and Peter Garber NBER Working Paper No 9971 mber 2003 No.F02,F32,F33 ABSTRACT The economic emergence of a fixed exchange rate periphery in Asia has reestablished the United States as the center country in the bretton Woods international monetary system We argue that the normal evolution of the international monetary system involves the emergence of a periphery for which the development strategy is export-led growth supported by undervalued exchange rates capital controls and official capital outflows in the form of accumulation of reserve asset claims on the center country. The success of this strategy in fostering economic growth allows the periphery to graduate to the center. Financial liberalization, in turn, requires floating exchange rates among the center countries. But there is a line of countries waiting to follow the Europe of the 1950s/60s and Asia today sufficient to keep the system intact for the foreseeable future Michael P. Dooley Department of Economics Social Sciences i University of California Santa Cruz, CA 95064 and NBer mpd@ucsc.edu David folkerts-Landau 1331 21st Street Nw Washington DC 20036 davidfolkerts-landau@db.com Peter Garber 7 Seaview Drive Harington, RI petergarber(@db.com
An Essay on the Revived Bretton Woods System Michael P. Dooley, David Folkerts-Landau, and Peter Garber NBER Working Paper No. 9971 September 2003 JEL No. F02, F32, F33 ABSTRACT The economic emergence of a fixed exchange rate periphery in Asia has reestablished the United States as the center country in the Bretton Woods international monetary system. We argue that the normal evolution of the international monetary system involves the emergence of a periphery for which the development strategy is export-led growth supported by undervalued exchange rates, capital controls and official capital outflows in the form of accumulation of reserve asset claims on the center country. The success of this strategy in fostering economic growth allows the periphery to graduate to the center. Financial liberalization, in turn, requires floating exchange rates among the center countries. But there is a line of countries waiting to follow the Europe of the 1950s/60s and Asia today sufficient to keep the system intact for the foreseeable future. Michael P. Dooley Department of Economics Social Sciences I University of California Santa Cruz, CA 95064 and NBER mpd@ucsc.edu David Folkerts-Landau 1331 21st Street, NW Washington, DC 20036 david.folkerts-landau@db.com Peter Garber 7 Seaview Drive Barington, RI peter.garber@db.com
Let me be more positive: if I had an agreement with my tailor that whatever money I pay him returns to me the very same day as a loan, I would have no objection at all to ordering more suits from him Jacques Rueff(1965) In this paper we explore the idea that the global system that has evolved and grown since the advent of Bretton Woods has maintained a single dynamic structure. In the Bretton Woods system of the 1950s, the s was the center region with essentially uncontrolled capital and goods markets. Europe and Japan, whose capital had been destroyed by the war, constituted the emerging periphery. The periphery countries chose a development strategy of undervalued currencies, controls on capital flows and trade, reserve cumulation, and the use of the center region as a financial intermediary that lent credibility to their own financial systems. In turn, the US lent long term to the periphery, generally through FDI Once the capital of these zones had been rebuilt and their institutions restored, the periphery graduated to the center. It had no further need for the fixed rate, controlled development strategy, especially when it perceived that the US, in performing its financial intermediation service, was reaping a large transfer payment. For an insightful and entertaining example of the French and US views see Rueff and Hirsch (1965) Then and now the debate focused on the willingness of the periphery to accumulate claims on the center country. Triffin, for example, argued that the US could provide reserves for a growing world economy but only if European governments and central banks were willing to abandon to the political, monetary and banking authorities of the United States their sovereignty over the management and use of reserves It is hard to see how they could be willing to underwrite blindly in this fashion future deficits of the United States irrespective of their amounts and of the multiple and variegated causes of their emergence and continuance. p 14 More recent analysis of fixed rate systems, notably Helpman(1981)and Giovannini(1989), sets out the intertemporal restrictions on the center country and provides a good understanding of the welfare mplications of rules of the game for adjustment and eventual repayment of debt. We are interested in a very asymmetric version of a fixed rate system in which, for some time period, periphery countries are willing to underwrite future deficits of the United States. Moreover, we do not think they do so blindly McKinnon and Schnoble(2003) provide several arguments that would support a fixed rate regime for Asian countries. We emphasize the idea that it has been a successful development strategy to subordinate the objective of maximizing the value of reserve assets in order to subsidize and build a domestic capital
Let me be more positive: if I had an agreement with my tailor that whatever money I pay him returns to me the very same day as a loan, I would have no objection at all to ordering more suits from him. Jacques Rueff (1965) In this paper we explore the idea that the global system that has evolved and grown since the advent of Bretton Woods has maintained a single dynamic structure. In the Bretton Woods system of the 1950s, the US was the center region with essentially uncontrolled capital and goods markets. Europe and Japan, whose capital had been destroyed by the war, constituted the emerging periphery. The periphery countries chose a development strategy of undervalued currencies, controls on capital flows and trade, reserve accumulation, and the use of the center region as a financial intermediary that lent credibility to their own financial systems. In turn, the US lent long term to the periphery, generally through FDI. Once the capital of these zones had been rebuilt and their institutions restored, the periphery graduated to the center. It had no further need for the fixed rate, controlled development strategy, especially when it perceived that the US, in performing its financial intermediation service, was reaping a large transfer payment. For an insightful and entertaining example of the French and US views see Rueff and Hirsch (1965). Then and now the debate focused on the willingness of the periphery to accumulate claims on the center country. Triffin, for example, argued that the US could provide reserves for a growing world economy “but only if European governments and central banks were willing to abandon to the political, monetary, and banking authorities of the United States their sovereignty over the management and use of reserves ……. It is hard to see how they could be willing to underwrite blindly in this fashion future deficits of the United States irrespective of their amounts and of the multiple and variegated causes of their emergence and continuance.” p.14. More recent analysis of fixed rate systems, notably Helpman (1981) and Giovannini (1989), sets out the intertemporal restrictions on the center country and provides a good understanding of the welfare implications of rules of the game for adjustment and eventual repayment of debt. We are interested in a very asymmetric version of a fixed rate system in which, for some time period, periphery countries are willing to underwrite future deficits of the United States. Moreover, we do not think they do so blindly. McKinnon and Schnoble (2003) provide several arguments that would support a fixed rate regime for Asian countries. We emphasize the idea that it has been a successful development strategy to subordinate the objective of maximizing the value of reserve assets in order to subsidize and build a domestic capital
stock capable of competing in international markets. This is not a first best strategy. It would be better to have both an internationally competitive capital stock and reserves that were superior investments. But, if a country had to choose one or the other, a competitive capital stock may well be the better choice. It is clear that capital controls are necessary to keep residents of the periphery country from offsetting the governments second best international investment decisions. Nevertheless, with rising real wages in export industries this can be for a considerable interval a successful and politically sustainable development strategy When Europe's development strategy shifted toward free markets, financial controls were lifted and the fixed rate system soon collapsed into the floating regime of the 1970s. But in our view the system of freely floating exchange rates and open capital markets was itself only a transition during which there was no important periphery. To be more precise, there was no periphery for which a development strategy based on export-led growth was the dominant objective for economic policy During this generalized floating" transition the communist countries were irrelevant to the international monetary system. Most other developing countries, particularly the newly decolonized states, flirted with socialism or systems of import substitution that closed them off from the center. This development strategy was inhospitable to trade and the importation of long-term foreign capital. It fostered a local production of goods that could not compete globally and therefore built an inefficient capital stock that would in the end have little global value. Just as in the communist countries, when these opened to world trade and capital flows, they discovered that their cumulated capital was fit only to be junked. That is, they were in the same real capital-poor position as the post-war European countries With the discrediting of the socialist model in the 1980s and then the collapse of communism in 1989-91,a new periphery was melded to the US-Europe-Japan center. These countries were newly willing to open their economies to trade and their capital markets to foreign capital These countries all were emerging from decades of being closed systems with decrepit capital stocks repressed financial systems, and a quality of goods production that was not marketable in the center. The Washington Consensus encouraged them in a development strategy of joining the center directly by throwing open their capital markets immediately Others, mainly in Asia, chose the same periphery strategy as immediate post-war Europe and Japan undervaluing the exchange rate, managing sizable foreign exchange interventions, imposing controls, accumulating reserves, and encouraging export-led growth by sending goods to the competitive center countries It is the striking success of this latter group that has today brought the structure of the international monetary system full circle to its essential Bretton Woods era form. The Europe-Japan of the 1950s was already large enough so that in our analyses we did not have a"small country"view of the periphery but rather recognized it as the driving force of the international monetary system. Now the Asian periphery as reached a similar weight: the dynamics of the international monetary system, reserve accumulation, net capital flows, and exchange rate movements, are driven by the development of these periphery countries The emerging markets can no longer be treated as small countries, weightless with respect to the center At some point, the current Asian periphery will reach a developmental stage when they also will join the center and float. But that point will not be reached for perhaps 10 more years and, most likely, there will be at that time another wave of countries, as India is now doing, ready to graduate to the periphery
stock capable of competing in international markets. This is not a first best strategy. It would be better to have both an internationally competitive capital stock and reserves that were superior investments. But, if a country had to choose one or the other, a competitive capital stock may well be the better choice. It is clear that capital controls are necessary to keep residents of the periphery country from offsetting the government’s second best international investment decisions. Nevertheless, with rising real wages in export industries this can be for a considerable interval a successful and politically sustainable development strategy. When Europe’s development strategy shifted toward free markets, financial controls were lifted and the fixed rate system soon collapsed into the floating regime of the 1970s. But in our view the system of freely floating exchange rates and open capital markets was itself only a transition during which there was no important periphery. To be more precise, there was no periphery for which a development strategy based on export-led growth was the dominant objective for economic policy. During this “generalized floating” transition the communist countries were irrelevant to the international monetary system. Most other developing countries, particularly the newly decolonized states, flirted with socialism or systems of import substitution that closed them off from the center. This development strategy was inhospitable to trade and the importation of long-term foreign capital. It fostered a local production of goods that could not compete globally and therefore built an inefficient capital stock that would in the end have little global value. Just as in the communist countries, when these opened to world trade and capital flows, they discovered that their cumulated capital was fit only to be junked. That is, they were in the same real capital-poor position as the post-war European countries. With the discrediting of the socialist model in the 1980s and then the collapse of communism in 1989-91, a new periphery was melded to the US-Europe-Japan center. These countries were newly willing to open their economies to trade and their capital markets to foreign capital. These countries all were emerging from decades of being closed systems with decrepit capital stocks, repressed financial systems, and a quality of goods production that was not marketable in the center. The Washington Consensus encouraged them in a development strategy of joining the center directly by throwing open their capital markets immediately. Others, mainly in Asia, chose the same periphery strategy as immediate post-war Europe and Japan, undervaluing the exchange rate, managing sizable foreign exchange interventions, imposing controls, accumulating reserves, and encouraging export-led growth by sending goods to the competitive center countries. It is the striking success of this latter group that has today brought the structure of the international monetary system full circle to its essential Bretton Woods era form. The Europe-Japan of the 1950s was already large enough so that in our analyses we did not have a "small country" view of the periphery but rather recognized it as the driving force of the international monetary system. Now the Asian periphery has reached a similar weight: the dynamics of the international monetary system, reserve accumulation, net capital flows, and exchange rate movements, are driven by the development of these periphery countries. The emerging markets can no longer be treated as small countries, weightless with respect to the center. At some point, the current Asian periphery will reach a developmental stage when they also will join the center and float. But that point will not be reached for perhaps 10 more years and, most likely, there will be at that time another wave of countries, as India is now doing, ready to graduate to the periphery
Eichengreen(1995) points out that"one of the more remarkable features of the last hundred years of international monetary experience is the regularity with which one regime(fixed and floating rates)has superseded the other. He sets out six explanations for this rotating dominance of exchange rate regime All are interesting and plausible and contribute to our understanding of the system. Our answer to this puzzle is that the system has not changed but the objectives for important blocs of countries within the system have changed over time. Fixed exchange rates and controlled financial markets work for twenty years and countries that follow this development strategy become an important periphery. These development policies are then overtaken by open financial markets and this, in turn, requires floating exchange rates. The Bretton Woods system does not evolve, it just occasionally reloads a periphery Bordo and Flandreau(2003) provide an excellent analysis of the link between financial development and the choice of exchange rate regime in the periphery. They also relate this choice to the debate on original sin, fear of floating and other recent topics related to economic policies in emerging markets. We are more concerned here about the effects of the periphery on the center For the most part, the reigning economic analysis of the system proceeds as if the periphery does not exist or is not important enough to affect the economies of the center countries. This is, we believe, a serious omission. To illustrate this point we focus below on the emerging current account deficit in the United States. In our framework, the US is once again the center country and, as such, plays by a different set of Where is the International Monetary System Driving Us? The recent weakness of the dollar against the euro seems consistent with the idea that the large and rising expected US current account deficits will become more difficult to finance as the net international investment position of the United States deteriorates. But if investors were becoming reluctant to invest in the US they would have to be rewarded with rising returns. Yet yields and spreads have generally been falling in the US not rising To explain this anomaly it is helpful to step back for a broad look at how the international monetary system has evolved. In general we know that the Us current account would have to adjust if the international monetary system consisted of floating currencies and open capital markets. But we do not live in such a world. We have re-entered a Bretton Woods reality and have to relearn and understand the very different djustment requirements for the center country in such a system emerging markets and Europe, which will face the most difficult macroeconomic challenges oing on ma o a The view of the world monetary order that we assemble here allows for strong conclusions about whe current global supply surpluses will be focused and how various participants will adjust to a very current account deficit in the center country. It especially allows us to understand what is goi
Eichengreen (1995) points out that “one of the more remarkable features of the last hundred years of international monetary experience is the regularity with which one regime (fixed and floating rates) has superseded the other.” He sets out six explanations for this rotating dominance of exchange rate regimes. All are interesting and plausible and contribute to our understanding of the system. Our answer to this puzzle is that the system has not changed but the objectives for important blocs of countries within the system have changed over time. Fixed exchange rates and controlled financial markets work for twenty years and countries that follow this development strategy become an important periphery. These development policies are then overtaken by open financial markets and this, in turn, requires floating exchange rates. The Bretton Woods system does not evolve, it just occasionally reloads a periphery. Bordo and Flandreau (2003) provide an excellent analysis of the link between financial development and the choice of exchange rate regime in the periphery. They also relate this choice to the debate on original sin, fear of floating and other recent topics related to economic policies in emerging markets. We are more concerned here about the effects of the periphery on the center. For the most part, the reigning economic analysis of the system proceeds as if the periphery does not exist or is not important enough to affect the economies of the center countries. This is, we believe, a serious omission. To illustrate this point we focus below on the emerging current account deficit in the United States. In our framework, the US is once again the center country and, as such, plays by a different set of rules. Where is the International Monetary System Driving Us? The recent weakness of the dollar against the euro seems consistent with the idea that the large and rising expected US current account deficits will become more difficult to finance as the net international investment position of the United States deteriorates. But if investors were becoming reluctant to invest in the US they would have to be rewarded with rising returns. Yet yields and spreads have generally been falling in the US, not rising. To explain this anomaly it is helpful to step back for a broad look at how the international monetary system has evolved. In general we know that the US current account would have to adjust if the international monetary system consisted of floating currencies and open capital markets. But we do not live in such a world. We have re-entered a Bretton Woods reality and have to relearn and understand the very different adjustment requirements for the center country in such a system. The view of the world monetary order that we assemble here allows for strong conclusions about where current global supply surpluses will be focused and how various participants will adjust to a very large current account deficit in the center country. It especially allows us to understand what is going on in the emerging markets and Europe, which will face the most difficult macroeconomic challenges