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U.S. one hundred dollar notes are seen in this picture illustration taken in Seoul February 7, 2011. (LEE JAE-WON/REUTERS)
U.S. one hundred dollar notes are seen in this picture illustration taken in Seoul February 7, 2011. (LEE JAE-WON/REUTERS)

Economy Lab

Why the currency markets are in an ‘age of improvisation’ Add to ...

Currency wars have been fought for about as long as there has been international trade.

But unlike now, global leaders also made serious attempt to negotiate peace. The armistice that looms largest is the 1944 agreement struck at Breton Woods, New Hampshire, a spread in the White Mountains that consists of little more than trees, rock and a massive white Spanish Renaissance-style hotel called the Mount Washington.

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More than 700 delegates from 44 countries gathered to agree on a plan for calming volatility in exchange markets and dissuading governments from seeking trade advantages by devaluing their currencies. The program recognized the U.S. dollar as the central means of exchange, and other nations agreed to tie their currencies to the dollar. The Americans, in turn, would link the dollar’s value to gold. The system worked for a while, but ultimately fell apart – as rigid structures are wont to do when left to the ravages of chaotic environments.

With the financial press again rife with rumours of currency wars, it might seem an opportune time to attempt again a new financial order. Don’t count on it. Amidst all the turmoil in global financial market, Benn Steil, the director of international economics at the Council on Foreign Relations, went back to Bretton Woods. His new book The Battle of Bretton Woods is perhaps the most accessible study yet of a key moment in world economic history that nonetheless is poorly understood.

Then as now, the economic case for a system of fixed – or at least a semi-fixed – exchange rates is sound enough. Yet there is little point talking about currencies outside a political context. And Bretton Woods, as Mr. Steil eloquently shows, was about the United States imposing its will on the rest of the world – which, of course, at the end of the Second World War it was uniquely placed to do. Geopolitics today end in one place and one place only: stalemate. The U.S. still is an unmovable force, but it no longer can force its will on countries such as China, Brazil and Turkey, nor can it bully a united Europe. “It’s difficult to identify a political mechanism today that would satisfy all the major countries that are currently experiencing economic problems,” Mr. Steil said last week in a telephone interview from New York.

Here are some more highlights of that conversation about what lessons Bretton Woods holds for policy makers today.

Is the “currency war” metaphor useful in today’s context? You wrote of a time when countries were making a point of devaluing their currencies. That’s not technically happening now.

The situation in the 1930s was far more serious than what we are witnessing today. Remember, in the early 1930s the world was still on the fraying remnants of the gold-exchange standard. Fixed exchange rates were still considered to be the norm. So as one country after another dropped out of that system, it was never clear to anyone where the bottom was.

Since everyone was unmooring from gold and the dollar at the same time, nobody was ultimately able to use competitive devaluation as a tool for increasing net exports. So what did they do? They turned to the next step, which was systematic protectionism. And that’s what led to the collapse of global trade.

We’re not seeing anything of the sort, yet, going on around the world. We are just seeing concern, rightful concern, expressed about where these unusual forms of monetary accommodation will lead down the road. There are reasons to be concerned. If countries are determined to devalue their currencies and can’t because others are pursuing the same policies, then they may turn to trade measures as the next logical step. But we are quite a ways away from that.

How would describe what we’re witnessing in currency markets?

I would say we are in an age of improvisation. Before the crisis, we were in a period that Ben Bernanke coined as the `Great Moderation.’ It seemed that for all intents and purposes central bankers had discovered the Holy Grail. You just target a low and stable rate of inflation and if you stick with that course you will have accomplished all that a good central bank can do, at least in normal circumstances. Unfortunately, now that we are not in normal circumstances, the rule books have been ditched and nobody knows what the rule book is.

Can a broad commitment to flexible exchange rates work as an international monetary system?

In the 1930s, nobody really considered that to be a system. Flexible exchange rates were considered to be a failure of alternative systems, like the gold standard, like the gold-exchange standard, or like the dollar-based gold exchange standard that was agreed at Bretton Woods. In the early 1970s, when we moved to that system (of flexible exchange rates), although it did have some prominent supporters like Milton Freidman, this was not a policy decision as it were, that the world took to move from a system of fixed, but adjustable, exchange rates to a new system of flexible exchange rates. It was something that was forced on the world by the failure of the Bretton Woods monetary system…I really don’t believe the (Group of 20) as an institution has in any sense coalesced around what might be an appropriate mix of policies for the world’s major countries from the perspective of global stability and global growth. There really is no consensus.

Do you see a day when there might be a return to a stricter global monetary system?

I don’t.

In the 1940s, there was a deal to be struck between the U.S. and the world. The U.S. really was the world’s only credible international creditor. The only way you could trade internationally other than barter was with gold and dollars. Both were in very short supply in the 1940s, so the U.S. offered the world a deal: We will provide you with short-term balance of payments assistance through our new International Monetary Fund, in return for which you pledge not to devalue your currency without the acquiescence of this new fund, which of course would be American dominated. The world wasn’t wild about the deal, but it was the best on offer…

Compare that to the situation between China and the United States today. The U.S. now is the world’s largest international debtor; China is the world’s largest international creditor. Chinese holdings of dollar-denominated securities amounts to $1,000 (U.S.) per Chinese resident. If China were to provoke a dollar crisis by trying to nudge the world to an alternative monetary system in which the dollar was not central, China would risk a collapse of the purchasing power of its vast hoard of dollar-denominated assets. The U.S. for its part sees little motivation to change this system. It still raises debt in a currency that it mints…There isn’t the political basis for a deal to be struck between China and the United States right now. I don’t any new Bretton Woods emerging out this situation. I can see circumstances under which this system collapses.

Talk about that.

If global imbalances continue to get worse, and those imbalances are mainly created by two countries, the U.S. and China, I can envision a circumstance in which the world does begin to lose confidence in a fiat dollar. But I would argue that would lead into a collapse in confidence in fiat currencies generally…

What would be the alternative to the U.S. dollar? One alternative I would highlight is gold. Central banks have been rebuilding their gold stocks after selling them off aggressively in the 1990s. I can see a circumstance in which those gold stocks were sufficiently rebuilt where countries might be motivated to start using them once again to start settling trade balances. I can also imagine a circumstance in which gold banks emerge. You already see the beginnings of this where people will own digital representations of gold and they can pay for goods and services across borders using transfers of gold, digital transfers. If this became popular, there is no reason such banks couldn’t issue smart cards so you could go into a café and pay for your cappuccino by swiping your card for a tenth of a gram of gold. I don’t think this is science fiction at all. So I can foresee circumstances in which gold would re-emerge as the foundation of the world monetary system without any government wanting it to happen or trying to make it happen.

What is your preferred option?

My preferred option is for the Federal Reserve to be more cognizant in carrying out its policies, the effects on other major nations. I feel the United States is often willfully blind to the fact that much of the world has to import its monetary policy because of the fact most of the world trades using U.S. dollars, whether they like it or not.

Do you the Fed is targeting the currency?

Concentrating would be too strong a term. I don’t think it’s a firs-order target. But I do think it’s a third- or fourth-order target. There is no doubt in my mind that the Fed chairman views a lower dollar as a useful vehicle with which to promote a revival of growth in the U.S. economy. It’s not something we would expect him to emphasize publicly for reasons domestic and international. It would be naïve at best to assume that because he doesn’t speak about it that it’s not very much on the Fed’s radar…Chairman Bernanke’s view, which he has stated repeatedly, is the Fed is pursuing not only the right policy from the perspective of the United States, but it is pursuing a policy that is consistent with reviving global growth. The problem is the rest of the world doesn’t accept that. Brazil, Korea, China, Japan, all of them can be expected to take actions to mute the effect of a rapidly growing supply of dollars.

(The interview has been condensed and edited.)

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