The structure of the international monetary system.

• Author: Gourinchas, Pierre-Olivier
• Position: Research Summaries

Anyone looking at recent financial headlines could be forgiven for thinking that the international monetary system is under heavy strains. The People's Bank of China faces severe private capital outflows, a result of the yuan's appreciation in tandem with the U.S. dollar and the slowing of the Chinese economy. The Bank of Japan is battling persistent deflation by trying to depreciate the yen. The European Central Bank has clearly telegraphed that it would welcome further depreciation of the euro. In the United States, notwithstanding a modest "lift-off" in December 2015, the Federal Reserve is confronted with a global slowdown and a rising dollar. Policy discussions explicitly mention the possibility of negative rates in the future. Talk of "currency wars" abounds.

To understand the current environment, it is helpful to step back and consider the international monetary system circa 1960, during the Bretton Woods era.

The International Monetary System then...

Back in those days, the international monetary system was relatively simple. Market economies pegged their currencies to the U.S. dollar. In turn, the United States maintained the value of its dollar at $35 per ounce of gold. With the assistance of the International Monetary Fund, countries could obtain liquidity to deal with "temporary" imbalances, but it was incumbent upon them to implement a fiscal and monetary policy mix that would be consistent with a stable dollar parity or, infrequently, to request an adjustment in their exchange rate.

The United States faced no such constraint. The requirement to maintain the $35 an ounce parity had only minimal bite on U.S. monetary authorities, as long as foreign central banks were willing, or could be convinced, to support the dollar. By design then, the system was asymmetric and dependent on the U.S., a situation that reflected the country's economic and political strengths in the immediate aftermath of World War II. (1)

Not everyone was happy about this state of affairs. Some objected to the special role of the dollar. In 1965, France famously requested the conversion of its dollar reserves into gold, while its minister of finance complained loudly about the United States' "exorbitant privilege." (2) The Bretton Woods regime allowed the U.S. to acquire valuable foreign assets, so the argument went, because the dollar reserves required to maintain the dollar parity of foreign countries amounted to automatic low-interest, dollar-denominated loans to the U.S. (3)

Others worried about the long-term sustainability of the system. As the world economy grew rapidly in the 1950s and 1960s, so did the global demand for liquidity and the stock of dollar assets held abroad. With unchanged global gold supplies, something had to give. This is the celebrated "Triffin dilemma." (4) In 1968, Triffin's predictions came to pass: faced with a run on gold reserves, the U.S. authorities suspended dollar-gold convertibility. Shortly thereafter, the Bretton Woods system of fixed but adjustable parities was consigned to the dustbin of history.

Outside the Zero Lower Bound: Exorbitant Privilege, Safe Assets, and Exorbitant Duty

Under the new regime, countries were free to adjust monetary policy independently. Mundell's "Trilemma" required either that market forces determine the value of the currency or that capital controls be imposed. (5) In principle, this environment should be more symmetrical: no more "exorbitant privilege" for the U.S. since other countries would not be forced to hold low-interest dollar reserves to maintain their dollar exchange rate; no asymmetry in external adjustment between the U.S. and the rest of the world since exchange rates would now adjust freely; and no Triffin dilemma since dollar liquidity would be decoupled from gold supply.

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Yet, recent research illustrates that the era of floating rates shares many of the same structural features as the Bretton Woods regime. Consider the question of the "exorbitant privilege," defined as the excess return on U.S. gross external assets relative to U.S. gross external liabilities. Helene Rey and I set out to measure this excess return using disaggregated data on the U.S. Net International Investment Position and its balance of payments. These calculations are often imprecise, given the coarseness of the historical data, but they all point in the same direction: The U.S. earns a significant excess return which has increased, since the end of the Bretton Woods regime from 0.8 percent per annum between 1952 and 1972, to between 2.0 percent and 3.8 percent per annum since 1973. (6)

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A large share of these excess returns arises because of the changing composition of the U.S. external balance sheet over time. As financial globalization proceeded, U.S. investors concentrated their foreign holdings in risky and/or illiquid securities such as portfolio equity or direct investment, while foreign investors concentrated their U.S. asset purchases in portfolio debt, especially Treasuries and bonds issued by government-affiliated agencies in areas such as housing finance, and cross-border loans. (7) [See Figure 1.] The "exorbitant privilege" should be properly understood as a risk premium.

These large and growing U.S. excess returns have first-order implications for the sustainability of U.S. trade deficits and the interpretation of current account deficits. As an illustration of the orders of magnitude involved, suppose that...