The revived Bretton Woods system, liquidity creation, and asset price bubbles.

• Author: Dellas, Harris

In this article, we argue that the present constellation of exchange rate arrangements among the major currencies has led to the creation of excessive global liquidity, which has contributed to asset price bubbles. Although the exchange rates of many of the major currencies--including the U.S. dollar, the euro, the yen, and the pound sterling--float against each other, the currencies of many Asian emerging market economies and oil-exporting economies are pegged to the dollar. Dooley, Folkerts-Landau, and Garber (2004a) labeled this system "Bretton Woods II" (BWII). (1) The original Bretton Woods regime (BWI) lasted for about a quarter of a century. Dooley, Folkerts-Landau, and Garber (DFG) argue that the present regime, despite its large global imbalances, will also be sustainable.

We have a different view. In what follows, we argue that the original Bretton Woods system comprised two fundamentally different variants. The first variant lasted from the inception of the system in 1947 until around 1969. The second variant had a much shorter life span, lasting from about 1970 until the collapse of the system in 1973.

Whatever may have been the underlying stability characteristics of the initial part of that system, the variant that emerged around 1970 was fundamentally unstable--it was conducive to high global liquidity creation and asset price bubbles. We argue further that, to the extent that the global financial system has metamorphosed into a revived Bretton Woods regime, that regime resembles BWI from 1970-73, so that BWII is also prone to high global liquidity creation and asset price bubbles.

The remainder of this article is structured as follows. First, we compare both variants of BWI with the BWII regime that emerged in the early 2000s, Next, we discuss the relation between international liquidity creation under the latter stages of the original Bretton Woods regime and the new Bretton Woods regime. We then present some concluding observations.

Bretton Woods: Old and New

The original Bretton Woods regime was a fixed exchange rate system in which Western European countries and Japan maintained undervalued exchange rates against the dollar, thereby accumulating large amounts of dollar reserves in the pursuit of export-led growth. The United States was at the center of BWI, playing the role of world banker, running balance-of-payments deficits, and supplying dollar reserves to other countries. As the world's banker, the United States engaged in maturity transformation, accumulating short-term dollar liabilities while lending long-term, on net, to the rest of the world.

Other countries pegged their currencies against the dollar. The United States, for its part, fixed the price of the dollar at $35 per ounce of gold, freely buying gold from, and selling gold to, official bodies at that price. During the 1960s, however, the U.S. Federal Reserve began pursuing expansionary monetary policies for domestic reasons, paying little attention to growing balance-of-payments deficits, especially at the end of the decade. As a result, the growth of global liquidity surged beginning in 1970, commodity prices exploded, and the Bretton Woods system broke down.

Now, consider what DFG have dubbed the "new Bretton Woods system." The revived Bretton Woods metaphor runs as follows:

* As was the case under the earlier Bretton Woods regime, the present regime consists of a center country and a group of economies comprising a periphery. The center country has been the United States under both regimes. Under the old Bretton Woods system, the Western European countries and Japan were the periphery; the emerging economies of Asia, including China, are the new periphery.

* Under both regimes, there is asymmetric monetary policy, with the Federal Reserve ignoring external factors in setting interest rates, while policymakers in the periphery focus on external factors.

* Under both regimes, the periphery follows export-led growth strategies based on undervalued currencies pegged against the dollar.

* Under both regimes, the undervalued currencies give rise to a massive accumulation of foreign exchange reserves mainly in the form of low-yielding U.S. dollar-denominated financial instruments.

* Under both regimes, the United States provides the main export market for the periphery, validating the export-led growth strategies of that group of countries.

* As was the case in the earlier regime, the United States plays the role of world banker, providing financial intermediation services for the rest of the world, especially the periphery.

* The earlier regime lasted for 25 years. DFG argue that the present system, which they say began in the...