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Economists know the fatal flaw in our international
monetary system — but they can’t agree on how to fix it.
John B. Judis is a senior editor at the New Republic
and a visiting fellow at the Carnegie Endowment for
International Peace.
T
he past few months have been a crash course
in the abstract and obscure instruments and
arrangements that have derailed the world’s
economy. From mortgage-backed securities to credit
default swaps, the international monetary system is in big
trouble.
For decades, the United States has relied on a
tortuous financial arrangement that knits together its
economy with those of China and Japan. This informal
system has allowed Asian countries to run huge export
surpluses with the United States, while permitting the
United States to run huge budget deficits without having
to raise interest rates or taxes, and to run huge trade
deficits without abruptly depreciating its currency. Quite
a few bankers, international economists, and high officials
such as U.S. Federal Reserve Chairman Ben Bernanke
think this informal system contributed to today’s financial
crisis. Worse, they fear that its breakdown could turn the
looming downturn into something resembling the global
depression of the 1930s.
The original Bretton Woods system dates from a
conference at a New Hampshire resort hotel in July 1944.
Leading British and American economists blamed the
Debt Man Walking
John B. Judis
In 1944, the United Nations Monetary and Financial Conference at Bretton Woods, New Hampshire, decided that the dollar
would replace the British pound as the accepted global currency.
©APImages
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Great Depression and, to some extent, World War II on
the breakup of the international monetary system in the
early 1930s, and they were determined to create a more
stable arrangement in which the dollar would replace the
British pound as the accepted global currency.
The dollar became the accepted medium of
international exchange and a universal reserve currency.
If countries accumulated more dollars than they could
possibly use, they could always exchange them with
the United States for gold. But with the United States
consistently running a large trade surplus — meaning that
countries always needed to have dollars on hand to buy
American goods — there was initially little danger of a
run on the U.S. gold depository.
Bretton Woods began to totter during the Vietnam
War, when the United States was sending billions of
dollars abroad to finance the war and running a trade
deficit, while deficit spending at home sparked inflation
in an overheated economy. Countries began trying to
swap overvalued dollars for deutschmarks, and France
and Britain prepared to cash in their excess dollars at Fort
Knox (the United States’ gold depository). In response,
President Richard Nixon first closed the gold window and
then demanded that Western Europe and Japan agree to
new exchange rates whereby the dollar would be worth
less gold, and the yen and the deutschmark would be
worth more, relative to the dollar. That would make U.S.
exports cheaper and Japanese and West German imports
more expensive, easing the trade imbalance and stabilizing
the dollar.
By imposing a temporary tariff, Nixon succeeded in
forcing these countries to revalue, but not in creating a
new system of stable exchange rates. Instead, the values of
the currencies began to fluctuate. And as inflation soared
in the late 1970s, the system, which still relied on the
dollar as the universal currency, seemed ready to explode
into feuding currencies.
BRETTON WOODS II
That’s when a new monetary arrangement began to
emerge. Economists often refer to it as “Bretton Woods
II,” but it was not the result of a conference or concerted
agreement among the world’s major economic powers.
Instead, it evolved out of a set of individual decisions
— first by the United States, Japan, and Saudi Arabia,
and later by the United States and other Asian countries,
notably China.
Bretton Woods II took shape during President
Ronald Reagan’s first term. To combat inflation, Paul
Volcker, then the chairman of the Federal Reserve, jacked
interest rates above 20 percent. That precipitated a steep
recession — unemployment exceeded 10 percent in the
fall of 1982 — and large budget deficits as government
expenditures grew faster than tax revenues. The value of
the dollar also rose as other countries took advantage of
high U.S. interest rates. That jeopardized U.S. exports,
and the U.S. trade deficit grew even larger as Americans
began importing underpriced goods from abroad while
foreigners shied away from newly expensive U.S. products.
The Reagan administration faced a no-win situation: Try
reducing the trade deficit by reducing the budget deficit,
and you’d stifle growth; but try stimulating the economy
by increasing the deficit, and you’d have to keep interest
rates high in order to sell an adequate amount of Treasury
debt, which would also stifle growth. At that point, Japan,
along with Saudi Arabia and other OPEC (Organization
of Petroleum Exporting Countries) nations, came to the
rescue.
At the end of World War II, Japan had adopted a
strategy of economic growth that sacrificed domestic
consumption in order to accumulate surpluses that
it could invest in export industries — initially laborintensive
industries such as textiles, but later capitalintensive
industries such as automobiles and steel. This
export-led approach was helped in the 1960s by an
undervalued yen, but, after the collapse of Bretton Woods,
Japan was threatened by a cheaper dollar. To keep exports
high, Japan intentionally held down the yen’s value by
carefully controlling the disposition of the dollars it reaped
from its trade surplus with the United States. Instead of
using these to purchase goods or to invest in the Japanese
economy or to exchange for yen, it began to recycle them
back to the United States by purchasing companies, real
estate, and, above all, Treasury debt.
That investment in Treasury bills, bonds, and notes
— coupled with similar purchases by the Saudis and
other oil producers, who needed to park their petrodollars
somewhere — freed the United States from its economic
quandary. With Japan’s purchases, the United States
would not have to keep interest rates high in order to
attract buyers to Treasury securities, and it wouldn’t
have to raise taxes in order to reduce the deficit. As far
as historians know, Japanese and American leaders never
explicitly agreed that Tokyo would finance the U.S. deficit
or that Washington would allow Japan to maintain an
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undervalued yen and a large trade surplus. But the
informal bargain — described brilliantly in R. Taggart
Murphy’s The Weight of the Yen — became the cornerstone
of a new international economic arrangement.
Over the last 20 years, the basic structure of Bretton
Woods II has endured, but new players have entered the
game. As Financial Times columnist Martin Wolf recounts
in his book Fixing Global Finance, Asian countries, led by
China, adopted a version of Japan’s strategy for export-led
growth in the mid-1990s after the financial crises that
wracked the continent. They maintained trade surpluses
with the United States. And instead of exchanging
their dollars for their own currencies or investing them
internally, they, like the Japanese, recycled them into
Treasury bills and other dollar-denominated assets. This
kept the value of their currencies low in relation to the
dollar and perpetuated the trade surplus by which they
acquired the dollars in the first place. By June 2008,
China held more than $500 billion in U.S. Treasury debt,
second only to Japan. East Asia’s central banks had become
the post-Bretton Woods equivalent of Fort Knox.
UPSIDES AND DOWNSIDES
Until recently, there have been clear upsides to
this bargain for the United States: the avoidance of
tax increases, growing wealth at the top of the income
ladder, and preservation of the dollar as the international
currency. Without Bretton Woods II, it is difficult to
imagine the United States being able to wage wars in
Iraq and Afghanistan while simultaneously cutting taxes.
For their part, China and other Asian countries enjoyed
almost a decade free of financial crises. And the world
economy benefited from low transaction costs and relative
price stability from having a single currency that countries
could use to buy and sell goods.
But there have been downsides to Bretton Woods II.
A nation could conceivably blackmail the United States
by threatening to cash in its dollars. Of course, if a nation
such as China actually began to unload its dollars, it
would jeopardize its own financial standing as much as it
would jeopardize America’s. But economists Brad Setser
and Nouriel Roubini argue that even the implicit threat
of dumping dollars — or of ceasing to purchase them —
could limit U.S. maneuverability abroad. “The ability to
send a ‘sell’ order that roils markets may not give China
a veto over U.S. foreign policy, but it surely does increase
the cost of any U.S. policy that China opposes,” they
write.
In Japan, China, and other Asian countries, there has
also been a downside to the grand bargain. The surplus
dollars gained from trade with the United States have not
been used to raise the standard of living, but rather have
been squirreled away in Treasury securities. Writes Martin
Wolf: “China has about 800 million poor people, yet
the country now consumes less than half of GDP [gross
domestic product] and exports capital to the rest of the
world.”
Of more immediate concern, Bretton Woods II
contributed to the current financial crisis by facilitating
the low interest rates that fueled the housing bubble.
Here’s how it happened: In 2001, the United States
suffered a mild recession largely as a result of overcapacity
in the telecom and computer industries. The recession
would have been much more severe, but, because
foreigners were willing to buy Treasury debt, the Bush
administration was able to cut taxes and increase spending
even as the Federal Reserve lowered interest rates to 1
percent. The economy barely recovered over the next
four years. Businesses, still worried about overcapacity,
remained reluctant to invest. Instead, they paid down
debt, purchased their own stock, and held cash. Banks and
other financial institutions, wary of the stock market since
At a U.S. Senate hearing in 1945, foreign currency is displayed.
©ThomasD.McAvoy/TimeLifePictures/GettyImages
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the dot-com bubble burst, invested in mortgage-backed
securities and other derivatives.
The anemic economic recovery was driven by growth
in consumer spending. Real wages actually fell, but
consumers increasingly went into debt, spending more
than they earned. Encouraged by low interest rates —
along with the new subprime deals — consumers bought
houses, driving up their prices. The “wealth effect” created
by these housing purchases further sustained consumer
demand and led to a housing bubble. When housing
prices began to fall, the bubble burst, and consumer
demand and corporate investment ground to a halt. The
financial panic quickly spread not only from mortgagebacked
securities to other kinds of derivatives, but also
from the United States to other countries, chiefly in
Europe, that had purchased these American financial
products.
And that’s not all. As American demand for Chinese
exports has stopped growing, China’s economy has begun
to suffer. China would experience the equivalent of a
recession, with repercussions throughout Asia. More
importantly for the United States, China would no longer
have the surplus dollars to prop up the market for U.S.
Treasury bills.
NEEDED ADJUSTMENTS
The consequences could be even more dire. In the
past, countries in recession could count on countries with
growing economies to provide outlets for their exports and
investments. The hope this time is that economic growth
in Asia, and particularly in China, can backstop a U.S.
and European recession. China depends on exports to the
United States, and the United States depends on capital
from China. If that special economic relationship breaks
down, as it seems to be doing, it could lead to a global
recession that could morph into the first depression since
the 1930s.
Policy makers have to recognize that while Bretton
Woods II is not the product of an international
agreement, it is not a “free-market” system that relies
on floating currencies, either. Rather, it is sustained by
specific national policies. The United States has acquiesced
in large trade deficits — and their effect on the U.S.
workforce — in exchange for foreign funding of our
budget deficits. And Asia has accepted a lower standard of
living in exchange for export-led growth and a lower risk
of currency crises.
China, Japan, and other Asian countries — either
on their own or with prodding from the Obama
administration — will also have to play a part. Indeed,
China may have already begun to do so by announcing
last fall a $586 billion stimulus plan of public investment
in housing, transportation, and infrastructure. If China
plows its trade surplus back into its domestic economy, it
will increase demand for imports and put upward pressure
on the yuan, reducing China’s trade surplus with the West.
This kind of adjustment — in which the United
States commits itself to reducing its trade deficit, and
China, Japan, and other Asian countries move away
from their strategy of export-led growth — is what
many American policy makers favor. But there is also
growing sentiment, particularly in Europe, that beyond
these measures, the world’s leading economies have to
agree on a new international monetary system — or at
least dramatically reform the existing one. British Prime
Minister Gordon Brown has explicitly called for a “new
Bretton Woods — building a new international financial
architecture for the years ahead.” Brown would strengthen
the International Monetary Fund so it functions as “an
early warning system and a crisis prevention mechanism
for the whole world.” He would also have it or a new
organization monitor cross-border financial transactions.
But adjustments to the dollar’s role are certainly
needed. The era of the dollar may not be over, but the
special conditions under which it reigned during the
last decades are being dashed on the rocks of the current
recession and financial crisis. The original Bretton Woods
was the product of deliberate agreement and laid the basis
for stable growth. A new Bretton Woods agreement will
depend a good deal on the choices of the international
community.
This article is excerpted from an article of the same title that appeared in
The New Republic, December 3, 2008. Copyright © 2008 The New
Republic, LLC.
The opinions expressed in this article do not necessarily reflect the views or
policies of the U.S. government.