Wednesday, November 10, 2004

Bretton Woods II

My description of why Asian central banks are supporting a strong dollar and hence financing US budget and current account deficits is apparently referred to as the Bretton Woods II hypothesis in policy/econ circles. The current arrangement is reminiscent of the old Bretton Woods regime of fixed exchange rates that lasted from 1945 to 1973.

There are some important differences, though.

Europe, not being as export-driven as Japan/Korea/Taiwan, nor under the same pressure to develop (absorb excess labor) as China, is not as incentivized as Asia to support this system. Nevertheless, the European Central Bank (ECB) may soon be forced to intervene to preserve competitiveness if the Euro continues to rise, thereby joining the cartel supporting the dollar.

One event we should all be on the lookout for is the first defection of an Asian central bank from this cartel. Any one of the smaller economies could diversify its foreign reserves into Euros (hedging against a dollar crash) without driving up the dollar appreciably. However, if each of them do so, the crash would be realized. This is obviously an unstable situation - can it last?

Who are the winners and losers under this regime? The US can continue its deficit spending while keeping interest rates low, benefiting consumers and financial institutions engaged in the carry trade, but risking the creation of asset bubbles (housing). On the other hand, US manufacturing companies will be forced to move production to Asia in order to survive.


Carson Chow said...

Suppose Japan defects in four years, when do we hit hyperinflation?

steve said...


BoJ would only give up on the dollar if the Japanese economy were quite healthy and not reliant on exports to the US. Pehaps this can happen in the future if China continues to grow as a market for Japanese prodcts, but probably not in the near term.

If the BoJ stops buying at Treasury auctions, interest rates here would skyrocket and we would have a recession - probably not hyperinflation!

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