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Anchoring Bretton Woods III

Anchoring Bretton Woods III
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First Published: Mon, Sep 29 2008. 10 26 PM IST
Updated: Mon, Sep 29 2008. 10 26 PM IST
The US economic model was based on the philosophy that more consumption was preferable to less. When it came to regulation, less was preferred to more. The recent crisis suggests they should have it the other way around, at least in future, more so when benefits accrue to a few and costs are borne by many. That is both moral and common sense.
However, now is not the time for American households to decide that less is preferable to more. Henry Paulson and the US government want them to continue to be profligate. Otherwise, the rescue package would be an eventual failure.
The period between 1982 and 2007 is known as the period of great moderation in the West. That is, this period witnessed substantial reduction in the volatility of economic growth and inflation. Recessions were both shallow and brief and inflation remained low and stable. A considerable portion of the credit should go to the Americans’ tendency to live beyond their means. Not coincidentally, this started in 1983. From that point on, the US trade deficit steadily increased. On the two occasions the trade deficit shrank, it had unpleasant consequences for global economies and stock markets. The first time was in 1988-92 and the second time was in 2001. The reduction in trade deficit in 1988-92 coincided with and was due to the failure of thrift institutions and was known as the savings and loans crisis.
In the first episode, global stock markets suffered two-three years of stagnation in nominal terms and they declined considerably in real terms. Inflation rates even in the OECD region hovered around 6-8% in those years. The dollar strengthened during both the episodes. In 2001, the US cut interest rates drastically and quickly and the Bush administration implemented tax cuts. Americans started to spend again and a global asset price boom began in 2002. Interestingly, in the first episode, recovery was muted and slow and did not really take off until 1993, when the trade deficit began to rise again.
Hence, it is clear that, for the Paulson plan to succeed, it requires that American households borrow and consume again, notwithstanding their current low savings rate (1.2% of disposable income), heavy indebtedness and uncertain job and income prospects. If this demand response from households does not come through and the trade deficit continues to shrink, the economy would be anaemic at best and contractionary at worst. Banks would need another bailout as home prices would continue to fall. The federal funds rate would run into the lowest levels — zero — soon.
Let us hope they heed the call to shop as they have done on numerous occasions in the past. The US trade and current account deficit would start to rise again. The US would have to actively seek foreign governments to finance its current account deficit. Private capital flows into the US are negative — private foreign money is leaving. Net foreign direct investment flows are negligible. America has to turn to other official buyers of US securities as it did between 2002 and 2007.
Let us pause here to reflect. The problems that the US and the rest of the world face today with credit destruction and crisis were caused by the “Bretton Woods II” exchange rate regime. In that regime, many countries kept their exchange rates in a quasi-peg to the dollar and lent to US households, which borrowed heavily. That has to be played out all over again for the bailout plan to work. In other words, the US is expecting to repeat Bretton Woods II to solve the problems created by Bretton Woods II. That does not sound like much of a solution but more like the creation of a new, bigger problem.
How will emerging nations respond? One must watch China. It anchored the Bretton Woods II regime. Now, there are murmurs in China that the policy of export-led growth aided by exchange rate management (or, manipulation) has resulted in the country facing huge losses on its exchange rate reserves. A former adviser to the central bank in China has suggested the country must revalue its currency and focus on domestic sources of growth. If China were to do that, who would anchor the new regime of de facto dollar pegs needed for the Paulson plan to eventually succeed?
Alternatively, the dollar must be allowed to weaken substantially so that the US can export its way out of stagnation, with the developing world acting as the source of demand. That would be a remarkable reversal of historical roles.
For that to happen, the developing world must be both capable of and willing to allow domestic-led growth to take hold. Neither of the two are in place in many developing countries. It is clear that the US bailout plan brings down the curtains on one chapter but the drama is far from over.
V. Anantha Nageswaran is head, investment research, Bank Julius Baer & Co. Ltd in Singapore. These are his personal views and do not represent those of his employer. Your comments are welcome at baretalk@livemint.com
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First Published: Mon, Sep 29 2008. 10 26 PM IST