I don’t think that Nouriel Roubini and I ever argued Bretton Woods 2 – an international monetary system based on central bank financing of the US deficit — would absolutely collapse by the end of 2006. But we did say that there was a “meaningful risk” that the Bretton Woods 2 system would “unravel before the end of 2006.” It is quite fair to say that our tone suggested far bigger risks than have been realized, and that Bretton Woods 2 has been far more stable than we expected.
The dollar has not fallen significantly against most currencies since we wrote our paper warning that Bretton Woods two might prove to be unstable: the dollar rallied against the euro in 2005 before falling in 2006, rallied v. the yen and stayed basically stable v. most emerging markets. All signs indicate that central bank reserve accumulation has remained quite strong, and that the lion’s share of those funds are still lent to the US.
Simon Derrick of the Bank of New York – in his note yesterday — rather graciously decided not to dwell on the fact that my timing was off. He instead opted to highlight that the various forces that Nouriel and I argued might make Bretton Woods unstable are still in play. They just may have a longer fuse than we thought at the time.
Back in February of last year the Federal Reserve Bank of San Francisco hosted a seminar entitled “Revised Bretton Woods System: A New Paradigm for Asian development?” Among the speakers at the event were Nouriel Roubini from the Stern School of Business at New York University and Brad Setser from University College, Oxford who together presented their paper “Will The Bretton Woods 2 Regime Unravel Soon?” In the paper they highlighted the fundamental reasons why they believed the “Bretton Woods 2 international monetary system” is unstable and would unravel “before the end of 2006.” What are particularly interesting to note now (as the end of 2006 approaches) are the potential sources of instability they identified nearly two years ago that they believed would feed through into the systems potential break-up. These were:
1. “The intrinsic tension between the United States’ growing need for financing to cover its current account and fiscal deficits and the large losses that those lending to the US in USDs are almost certain to incur as part of the adjustment needed to reduce the US trade deficit.”