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Geoeconomics: What can we learn from the end of the “real” Bretton Woods system of fixed exchange rates?

by Brad Setser
February 26, 2005

Dan Drezner started a post with the Triffin dilemma, so I figure I too can digress into the realm of history.

The Bretton Woods system of fixed exchange rates (Bretton Woods 1) collapsed, in some sense, when Western Europe decided it was no longer willing to hold its reserves in dollars, and demanded gold instead.

The Bretton Woods system was based on the gold-dollar standard: the world, or at least the free-world, pegged to the dollar, and the dollar was pegged to gold. Initially, the system worked because the US held most of the world’s gold at the end of World War 2. But dollar reserves grew quickly along with an expanding global economy, and dollar reserves exceeded the US gold stock by 1966.

No problem. The world’s central banks agreed that they would not convert their dollars into gold, and the system kept going. After all, the countries holding dollar reserves were also, by and large, allies of the United States military allies, and no one was all that keen to end an international monetary system that had underpinned Europe and Japan’s spectacular recovery from World War 2.

Alas, though, the alliance (or coalition?) supporting Bretton Woods 1 eventually frayed: the countries that defected from the financial coalition propping up Bretton Woods 1 tended to be countries that concluded their broad national interests would be better served with a higher degree of political independence. West Germany held on to its dollar until the end. De Gaulle’s France, famously, moved out of NATO’s integrated military command, and if not NATO per se; worried about the “exorbitant privilege” the US got by virtue of issuing the international reserve currency, and converted its dollar reserves into gold before Germany and the UK.

Fast forward thirty years. An influential group of economists argue that a new Bretton Woods 2 ties together the countries of the Asian-Pacific to the US. Critics challenge parts of the analogy: there are fewer constraints on the anchor currency in Bretton Woods 2 than in the Bretton Woods 1, since the dollar is no longer tied to gold; many Asian countries do not formally peg to the dollar, even if they intervene heavily; etc. But even critics of the analogy — and critics of the argument that Bretton Woods 2 provides a stable international monetary order — recognize than Asian reserve accumulation has played a critical role in the financing the US current account deficit — hell, even the AP now has noticed.

Can we also learn something from the political events that defined the end of Bretton Woods 1? After all, the system came apart because key members of the alliance supporting the dollar eventually concluded that the broader US-led system was no longer serving their political as well as economic interests.

Asian central banks, fortunately, cannot demand that the US exchange their dollars for gold — or even for another reserve currency. The US has not promised to maintain the dollar’s value vis a vis the euro, or supply euros or any other asset on demand. On the other hand, just as every individual central bank had an incentive to convert its dollars into gold before other central banks, central banks now — at least the smaller central banks – have an incentive to be among the first, not among the last, to shift the composition of its reserves. Any country that stops adding to its dollars reserves as rapidly, whether because it is diversifying its reserves or intervening less, effectively shifts the burden of financing the US onto the other members of the cartel. So there are certain parallels.

That is where things get interesting.

Japan and Taiwan are presumably the Germany and UK of this game. Tied to the US through a system of alliances, they have a strategic interest in preserving the system.

South Korea might be the new France. It is a long-standing ally of the US, but Korea and the US also seem to be drifting apart. South Korea is next to North Korea, and is a lot more vulnerable to rain of North Korean artillery shells than the US. South Korea worries that it would bear the brunt of North Korean retaliation for any US strike against the North — and their also is lingering resentment, I suspect, over Bush public dimissal of Korea’s Sunshine policy toward the North.

Russia is a bit of a wild card. It is adding to its reserves at a significant clip. Putin is no longer W’s best fried — even if they share a concern with Islamic terrorism. The US no longer seems to be following Condi’s old adage to “punish France, forget Germany and forgive Russia.” Russia and France sort of traded places. And Russia was one of the first to increase its euro holdings.

The biggest wild card of all, though, is China. It anchors the Bretton Woods 2 system, both by providing enormous amounts of financing to the US and by “punishing” any country that defects from the coalition. Opting out of the dollar financing cartel means, more than anything else, ending currency intervention and letting your currency appreciate against the dollar. But so long as China pegs to the dollar, that has an immediate cost. Changing your reserves from dollars to gold was a lot easier …

Yet if China anchors the system, along with the US, through its willingness to build up its dollar reserves to keep the renminbi-dollar stable, and to keep the renminbi weak, it hardly does so because it is a strategic ally of the US. Economically, China is the West Germany of Bretton Woods 2, but politically, China is clearly not the West Germany of Bretton Woods 2. The US — or at least some in the US — talk of the China as a strategic rival, and at least some in China think of the US in a similar terms. The analogy to France does not quite work either — France and the US were allies drifting apart, in part because French fears of Germany were waning, and it is not clear that China and the US ever fully transitioned from Cold War adversaries to allies.

That makes for an unusually strange mix. Two potential strategic rivals, at least in the Pacific, anchor two ends of an unbalanced economic relationship. Yet both would face significant economic costs if the unbalanced economic relationship broke down – or if an unbalanced relationship had to suddenly become a balanced relationship. Both think the current unbalanced relationship is increasing their strategic position: China sees its industrial might growing, its influence in Asia growing and its influence in resource rich economies growing. The US gets to finance the global war on terrorism on the cheap.

Beware, though, if either side starts to begin to seriously question the positive impact of the current unbalanced economic relationship on its global strategic position. China might read Stephen Roach and conclude that can only sustain its global hegemony on the back of the interest rate subsidy provided by the People’s Bank of China. The US might begin to view China’s willingness to do business with anyone who has oil as an impediment to its broader efforts to transform the world …

Brad DeLong consistently makes the classic economic liberal case on China. He has articulated a simple US strategic interest: the US should not take steps that impede China’s economic development. Rather, the US should be to China as Britain was to the United States after 1870. I would feel a lot more comfortable, though, if the US was financing China’s development in the way Britain helped finance the United States’ development after the Civil War. Right now, of course, the money is flowing the other way …

One asides. David Altig of Macroblog has argued central banks do not maximize their investment returns (or seek to minimize their financial losses), but rather focus on maximizing other goals — whether domestic or global macroeconomic stability. They are willing to take losses on reserves to achieve their broader objectives. That is a fair point. On the other hand, central banks are “banks” and they cannot be entirely indifferent to prospective losses either — particularly given the sheet size of the potential losses some Asian countries face and the fact that these losses ultimately will be passed on to the rest of the government. Moreover, large scale reserve accumulation can make it more difficult for the central bank to achieve their other goals — rapid money growth from reserve accumulation that is not fully sterilized is not obviously conducive to either domestic monetary and financial stability. But this is a debate for a different time …


  • Posted by godement

    It feels good for France to be compared to China, even if it’s in the time continuum. Soon, very soon now we shall rule the world again by means of the EU! Ok, couldn’t resist it.

    Now this post could benefit from a little historical addition. As you know, the eurodollar market was created in London, and there are many who think that this was the seed that collapsed BW 1 – the Fed lost control of the dollar supply. The funny twist here is that it was created as I remember by Warburg for the Banque Commerciale pour l’Europe du Nord. BCEN was wholly owned by the Soviet Union. So here is one for the conspiracy theorists. Is it 1) because they couldn’t borrow in the US and desperately needed to or is it because 2) they wanted to collapse BW 1 and were smart. I like explanation 1 even though I have no doubt they were smart and would love for explanation 2 to be correct (what a thriller that could make).

    As you probably know from my comments on Macroblog, I am not convinced by the view that all hell is about to break loose.

    Yet, I too realize that the US have a massive budget deficit as-far-as-the-eye-can-see as well as a current account deficit of pharaonic proportions.

    While I think that the protagonists have no interest in rocking seriously the boat, this applies as well to the US protagonist. The US have financed (and Japan and China have re-financed) a rather expensive war and occupation – or liberation, whatever you want to call it – in Irak. I don’t know about military capacity, but it does seem to me that financial capacity from now on is somewhat more limited, ie. they could not afford financially another one – or bigger one – than this. It would likely amount to rocking seriously the boat for the US.

    So, the real question would be, rather than conflict with China in 50 years, how about the potential willingness these days of China to re-finance a further foray in, say, Iran (much more deserving of US attention than Irak ever was if you ask me)?

  • Posted by steve kyle

    “rapid money growth from reserve accumulation that is not fully sterilized is not obviously conducive to either domestic monetary and financial stability. But this is a debate for a different time …”

    Actually, I think that is precisely the debate for THIS argument. That is, if the the debate is “what will be the trigger that ends BW2?” or put another way “is there a natural end to the current financing flow situation” or put another way “when will China hit the wall on this current policy?”

    There is a habit of thinking that surplus countries can just go on and on and on because they can just print the money and never run out of reserves as deficit countries do. This argument is OK if the deficit country on the other side of the flow does in fact face that natural barrier at some point before the surplus country feels the pain or systemic consequences kick in. But we are looking at a rather different situation this time.

    That is because the deficit country is the world reserve currency. This means the surplus country can go on accumulating reserves long after the point where sensible people would have thought it was time to slow down and reverse the flows. But there IS a natural barrier, a wall if you will, that China will eventually hit. (and other countries in an analogous situation) One of several things will happen:

    1. China wont sterilize all the inflow and inflationary pressures will eventually erode the profit margin of the export industries and their growth will slow down

    2. China will sterilize the inflows and interest rates will get so high that there will be an economic slowdown probably accompanied by major problems in the banking and finance sector

    3. The US government will come to its senses and stop running such huge deficits.

    4. China revalues

    I think 3 is unlikely to occur any time soon. 2 seems not to be occuring, at least not completely. One can wonder whether, in the Chinese economy, 2 would be all that effective in slowing things down, and whether other measures might have to accompany it. Either way, 2 involves some fairly drastic changes in current internal economic policy. That leaves 1 or 4.

    You may think that some other country will opt out of the system earlier (e.g. Korea) but all that does is redirect the flows all the more concentratedly onto China, thus speeding up the process of either 1 or 2.

    Of course 4 is possible too, but my own view is that China will in fact do it, but too little to really make a difference to their own exporters. And entirely apart from that question, 4 really doesnt belong on the list at all because it doesnt really get to the root of the problem – the US Federal deficit. Does anyone think that a Chinese revaluation will result in the US government shifting toward a surplus? Please.

  • Posted by glory

    i thought rebecca mccaughrin had a good point here…

    …on the ability of CBs to affect flows at the margin, but that the stock of cross-border securities held by private investors dwarfs CB assets, which (should) provide more of an anchor to BW2…

    i guess the implication is that, since US and EU securities are roughly equal in global private portfolios, any exchange rate losses in dollar-denominated assets would be made up in euro assets.

    so, i’m not sure how much a factor private portfolios were during BW1 (altho i assume less? :) but to the extent that BW2 represents an ‘unstable equilibrium’, doesn’t one need to also consider whether CB actions influence private flows (and vice versa) given the size and makeup of their stocks?


  • Posted by anne

    China’s Oil Diplomacy in Latin America

    BOGOTÁ, Colombia – Latin America is becoming a rich destination for China in its global quest for energy, with the Chinese quickly signing accords with Venezuela, investing in largely untapped markets like Peru and exploring possibilities in Bolivia and Colombia.

    China’s sights are focused mostly on Venezuela, which ships more than 60 percent of its crude oil to the United States. With the largest oil reserves outside the Middle East, and a president who says that his country needs to diversify its energy business beyond the United States, Venezuela has emerged as an obvious contender for Beijing’s attention.

    The Venezuelan leader, Hugo Chávez, accompanied by a delegation of 125 officials and businessmen, and Vice President Zeng Qinghong of China signed 19 cooperation agreements in Caracas late in January. They included long-range plans for Chinese stakes in oil and gas fields, most of them now considered marginal but which could become valuable with big investments….

  • Posted by hbj

    Anne, does your post imply China is using excess dollars not to diversify into other currencies, but more to purchase hard assets? That would be a very good reason to keep the dollar strong.

    Sounds like a very clever plan if that’s part of what they’re doing.

    (Wouldn’t it be nice to have a government in the -US- that planned ahead?)

  • Posted by Gerard MacDonell

    Steve: If China were to revalue enough to eliminate the need for forex intervention, then US interest rates would rise, domestic demand would get rationed down, and foreign demand would be directed into the US trade sector. This would cause the US trade and current account deficits to narrow. Yes, I do believe that. Is there something wrong with this belief in your view? To me, it is fairly standard open-economy macro.

    I think you raise a valid point, though, just not clearly enough. A SMALL revaluation move by China would have no effect on anything. I agree with you on that. And I guess that is what this debate is about. Will China do the irrelevant or not?

  • Posted by David


    If you haven’t seen it already, Foreign Affairs has an article taking a contrarian position to most participants on this blog:

  • Posted by brad

    hbj — one small point: China can purchase more assets abroad if the renminbi is strong than if the dollar is strong. China cannot print dollars to buy external assets (De Gaulle’s complaint about the US in the 60s). It has to earn them. And right now, it takes lots of chinese made DVD players to earn the dollars China needs, whether to import oil or to buy an oil company.

    Think Europe is expensive for Americans? Imagine what it is like for the Chinese …

    Steve K. Goldstein and Lardy argue that China can force the state banks to take sterilization bonds at below market prices, and, more generally, Chinese interest rates are regulated by the state. it is not (yet) a true market economy … this complicates the sterilization/ inflation story, though in ways I have not entirely got my head around. I think it effectively means more long-term losses are being hidden on the balance sheet of the state banks, in various ways, but i could be wrong.

  • Posted by Pall

    I have been wondering about what the demand for USD is and how it defines the USD rate at any given time. My question is if this dynamic is similar to that of other currencies or not. Take my currency, the Icelandic Krona for example; I have always thought the accumulated demand for Icelandic products and services were the variables that decided what the going rate for ISK. What else would anyone want to do with the ISK except decorate the occasional interior of the odd drinking establishment in the form of wall paper.

    The USD seems a bit more elusive to define the demand for. How do all these international transactions in USD, that have nothing to do with imports or exports of US goods or services, affect the USD rate? When Norway or Nigeria export crude oil, it’s invoiced in USD. When Colombians export cocaine to Britain, it’s also invoiced in USD, but how does this affect the rate of the USD?

    What my question boils down to is if the USD, being the international currency of choice for a big part of the world, dances to a different tune than the rest of the worlds currencies?

    Are the oil importing countries perhaps keeping USD reserves in order to be better able to buy oil in the future?

    I would be grateful to any of you who can help me understand this dilemma.

  • Posted by steve kyle

    Dear Gerard

    I entirely agree with you on the end game. But it would take a while to get there and the price changes needed to effect the flow adjustments would likely be fairly big – there are a couple of reasons for this apart from the fact that quite a few of our imports have few easy substitutes

    More importantly, what we would be doing is de facto deciding that rather than having the government cut its consumption and/or raise its revenue we would let the entire brunt fall on the private sector. The private sector has been extremely resistant to reducing consumption/increasing savings over the past few years. It is a judgement call, but I think it would take a large shock to effect a shift on the order of 5% of GDP. At a minimum it wouldnt happen as quickly as the exchange rate and interest rates would spike.

    Meanwhile, the federal government’s deficit could well get WORSE, not better in the short run as a sharp slowdown kicked in all of the usual automatic stabilizer reasons for it to go further into the red. This combined with the apparent willingness of the Republican leadership to jump off a cliff rather than be fiscally sane (though this scenario is one where we will wish we had more fiscal scope for expansion) makes me pessimistic about the government helping in the adjustment. This puts all the more weight on the private sector.

    Basically, what I am saying is that a Chinese revaluation will not cure the root cause of the problem (the federal deficit) very quickly (or at all in the short run). It will take a massive expenditure reduction if the whole weight of the adjustment is on the private sector – and while it could happen smoothly, there are lots of ways the thing could run off the rails.

  • Posted by brad

    steve k — you are right re: the absence of any budgetary cushions v. bad outcomes/less robust growth. Tim Geithner has made the same point. I suspect that if all the burden of adjustment falls on the private sector, pressure to do something on the deficit will emerge. We should not want to wait until then though.

    pall — if you bought euros with your dollars in 2002, you could buy more oil now than if you held onto your original dollars. So long as the euro or other major currency can be converted into dollars, I am not sure you have to hold dollars just because oil is priced in dollars — the oil/ dollar price is not stable, so dollars are not a perfect hedge v. higher oil prices.

    but the dollar’s status in trade/ finance clearly does generate ongoing demand for dollars. Dollars are used as the currency of choice for many types of transactions in many parts of the world — so there is ongoing dollar demand from the world’s need for dollars currency to do transactions. private firms that buy and sell products priced in dollars have a needs for ongoing dollar balances. central banks necessarily will want to keep some of their reserves in dollars. All these sources of demand are real. But they also all did not just materialize overnight — they have been around for some time. Central bank reserve accumulation (in dollars) went way, way up in 2003 and 2004. That is something new, not simply a product of the dollar’s status as the world’s reserve currency.

  • Posted by anne


    Brad answered the question nicely as always, but I wonder whether we understand how pleased the Chinese leadership is with the development of these years. Brad DeLong has written several times of the sense of futility of development economists with a century in which there was no catching up to rich nations by poorer nations. China is apparently catching up, and the leadership is pleased and well advised and determined to be flexible enough to continue.

  • Posted by brad

    David — your views on the foreign affairs piece? I certainly have a slightly different position.

    the article seems to me to reduce to three points:

    a) Asian CB financing will continue, so don’t worry. (I don’t agree)
    b) There is a new wave of private financing waiting to come in to the dynamic, flexible American economy to exploit new IT opportunities, so don’t worry (I don’t agree either; right now private equity capital is flowing out of the uS economy to exploit opportunities in the dynamic, flexible emerging world … maybe that will change, but right now this seems more to be an article of faith; corporate america ain’t exactly investing like mad right now)
    c) If the dollar does fall and the US has to adjust, other countries will be hurt more, so don’t worry. Again, i don’t agree. A sliding dollar doesn’t hurt the US much, but higher interest rates would — and in my view, Asian CB intervention has contributed, both directly and indirectly, to the sliding dollar/ rising trade deficit/ low nominal and real rates in the US combination. And if a falling dollar hurts Germany and Japan, that doesn’t help the uS any — it is a lot harder to export your way out of a trade deficit if your trading partners are shrinking rather than growing.

    all in all, too sanguine, in my view. yours?

  • Posted by IJ

    The IMF give lots of interesting statistics. The dollar was once backed by gold; however monetary indiscipline (politics) crept in and too many $notes were printed. Dollars unsupported by gold: in 1950 – only 20% were backed by gold; 1956 – 16%; 1962 – 11% 1968 – 5%. The relationship now?

    In fairness there are no corresponding figures for other currencies, which are probably little better. Gold has lost its usefulness as a universal currency and is unlikely to regain it.

    But it is impossible to look at global fiat money dispassionately, without also looking at passionate sovereign politics. The latter sets the global rules. Granting the Bank of England in the UK independence was a huge step forward for banking credibility. The next stage could be independent international banking, to take the politics out of money. It’ll be a fascinating G8 this year.

  • Posted by roger klein

    What about Malaysia as France (the first defector from the system)? Malaysia’s one of the few Asian countries with a dollar peg that is hard (thus more difficult to “defend”). And Malaysia has, I believe, one of the highest rates of inflation in Asia now, meaning that their dollar purchasing may cause them problems sooner.

  • Posted by jm

    But if the Asians just sell US government securities and buy some other dollar-denominated assets, their dollar exposure remains the same. To decrease their holdings of dollars, they must find counterparties with non-dollar currencies willing to exchange them for dollars. Since the Asian nations themselves all run large trade surpluses, they can’t sell the dollars to foreign holders of their own currencies, because there are none. Are they going to find some holders of Euros to take the dollars off their hands? Then what would they do with the Euros?

  • Posted by David


    My views do not line up with the Foriegn Affairs article either. I see ample evidence–including that provided by Nouriel and yourself–that there is an unsustainable ‘global imbalance’ that must be corrected one day. I only posted the link to get your take on the article.

    The only question in this debate I feel needs more treatment is what role U.S. moneary policy has played and is playing in this mess. I suspect loose U.S. monetary policy in the mid-to-late 90s fueled the beginning of an internal imbalance that Roach calls the ‘asset economy’ that affects the external imbalance, both then and now. Here are some potential reasons:

    (1) The productivity boom beginning in the mid 1990s should have been accomanied by higher rates, since higher productivity should lead to higher real interest rates. Or conversely, higher productivity should have been matched by lower prices, not lower inflation(i.e. positive price increases)as per unit production costs fell. However, Fed’s attempt to keep a modest level of inflation may have in fact generated a relative inflation (higher than it would otherwise be) that meant excess liquidity for financial markets and the beginning of the asset economy.
    (2)The subsequent(and resulting)excess aggregate demand and asset bubble alarmed the Fed who subsequently tightens and cracks the imbalance.
    (3) The Fed ‘mops up’ the mess with new and excessive liquidity (low rates) for a sustained period. Meanwhile, productivity continues to grow at record levels indicating the ‘neurtal’ rate and market rate are far apart…increased domestic leverage and more imbalance.
    (4)Now the housing market is frothing and the search for yield begins. Fears of deflation keep the Fed rate low leading to more leverage. (However, if deflationary pressures are being driven by productivity gains, fear may be misplaced and further fuel the imbalance(by keeping sustained low rates) that may one day lead to a major correction and the type of deflation that truly should be feared.)
    (5)All this excess liqudity and low rates means the countries with export-driven growth strategies and pegged ex.rates have to make sure they remain competitive. Those without pegged rates see a low yield temptation and increase their issues of debt securities. Major global imbalances.

    I am probably giving to much credit to th Fed and obviously the rest of the world does not have to go along. But, I still suspect the Fed’s role may be significant.

  • Posted by brad

    david –

    I may be missing something obvious, but why do productivity gains necessarily imply deflation?

    My sense is that in say post world war 2 europe, productivity grew very rapidly (catch up with the US, creation of a new capital stock to replace that destroyed by the war, etc). Wages also grew, as higher productivity fed into higher real wages (same i think was true in Japan). Nominal wages grew, but nominal prices were roughly stable/ not rising too fast, so real wages grew. Seems to me to be better than the alternative way higher productivity could lead to higher real wages, i.e. nominal wages stay roughly constant (or fall slightly), goods prices fall quickly with rising productivity, and real wages rise even if nominal wages stagnate …

    that said, i clearly share your basic concerns, i.e. too loose policy fueled a bit of a consumption bubble/ housing bubble/ fixed income asset bubble — though the fed’s loose money in say 01/02/03 could have led to much bigger falls in the $ (but for central bank intervention), and a much different type of recovery (more exports, less housing, more in tradables, less in interest sensitive sectors), so I would put a bit more emphasis on the reserve accumulation story.

  • Posted by mihai

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