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Photo: Reuters
Photo: Reuters

Bretton Woods 3.0 puts the dollar’s dominance at risk

The Fed’s ultra easy money policy could combine with White House myopia to end its long reign

Like the proverbial foolish woodcutter chopping the branch on which he sits, the policies of the current US administration are undermining the post-World War II international economic order that it spawned and underwrote for long. This is undermining the dominance of the US dollar as the global reserve currency that underpins American power and hegemony.

This order was initially based on the Bretton Woods (BW) system of exchange rates fixed against the US dollar, in turn pegged to gold. After the US went off the gold standard and floated its currency in 1971, there was a shift to BW 2.0, comprising floating exchange rates. The dollar strengthened its global reserve-currency role as demand for it rose with an expansion in cross-border trade and capital flows on the lines outlined by Robert Triffin. This allowed it to finance large domestic (both private and government) and external deficits.

BW 2.0 started unravelling with shifts in monetary policy. Central banks have different mandates and objectives, mostly a mix of growth and price stability. The primary target of both the Bank of England and European Central Bank is price stability. Bank of Japan too targets inflation, but financial stability is almost equally important on account of its historic focus on the exchange rate. Most developing countries also have their exchange rate as an unstated objective of monetary policy, constrained by what is described as an “impossible trinity". The US Federal Reserve has twin targets, with growth and price stability given equal weightage, as captured in the “Taylor Rule" formula.

In June 2020, the US Fed issued “forward guidance" that it intends to keep its benchmark fund rate in a band of 0-0.25% for the foreseeable future. Further, the Fed chairman recently made an announcement that effectively downgraded price stability to a subsidiary objective, as markets saw it.

This shift in focus of the Fed, and indeed of other advanced-economy central banks was in the works for a long time, beginning with the “Greenspan put", even though its formal articulation is new. The long-term decline in both growth and consumer price inflation in the West underlies this shift. The reasons for the former are clear in ageing post-industrial economies. The reasons for the decline in inflation are less clear. The likely candidates are a global savings glut, consumption growth not keeping pace with productivity, and trade openness that eased supply bottlenecks. Even the sharp increase in government debt since the global financial crisis over a decade ago, and exacerbated in the wake of the strong fiscal response to the covid pandemic, has not moved inflation northwards.

Over time, as the Fed began to deviate from its twin mandate to give precedence to growth over inflation, its benchmark rate moved closer to the zero lower bound that marked the limit of conventional monetary policy. Japan had hit that limit as a result of its policy response to a protracted real estate- banking crisis in the 90s. It was here that early experiments in unconventional policy—with shades of modern monetary theory or MMT—such as quantitative easing (QE) were first carried out. Western economies hit their lower bound very soon into the global financial crisis, and resorted to large-scale QE. Their recovery from it was never robust enough for interest rates to rise much above the lower bound, or for a rollback of QE.

The flipside of this easy-money policy bias was a global investor search for yield, which propped asset markets and made them bubble-prone on one hand, and pushed capital into emerging markets, where growth rates were rising even as these were falling in the West, on the other. The monetary policy response of emerging market central banks was to expand their own balance sheets by mopping up capital inflows to keep their exchange rates from rising too far and puncturing their growth. This injected large amounts of domestic currency into domestic markets that in turn needed to be sterilized. This version of MMT preceded, and was exacerbated by, QE in the West.

As the covid crisis hit the global economy in early 2020, rich-world central banks were hurried into hitting their lower bound and resuming QE. The Fed expanded its already bloated balance sheet by over 70% in just three months ending 3 June to over 33% of US nominal output. This was even more dramatic than during the earlier crisis, and other advanced economy central banks followed suit. With the need for a second round of fiscal stimulus in response to an extended pandemic, the balance sheet could expand even more, pushing more flows our way.

The rise of QE and MMT in the advanced world marks a shift to BW 3.0, with central banks now constrained to pick up larger amounts of sovereign debt as external demand for the dollar retreats in tandem with deglobalization, and government borrowing rises. Central banks are becoming sinks for sovereign debt. Since their assets are not freely traded, there is little effect on inflation and interest rates, thereby masking the expected effects of fiscal dominance as monetary and fiscal policies get conflated.

By turning its back on globalization and institutions of the post-war global order, the Donald Trump administration is further reducing demand for the dollar, thus undermining a key pillar on which US economic hegemony rests. This is reflected in a sharp rise in the price of gold. Unless a new US administration reverts to the status quo ante, the dollar could eventually cede its status as the world’s de facto reserve currency.

Alok Sheel is RBI chair professor in macroeconomics, ICRIER

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