Here are some brief thoughts on the monetary system’s role in repeated economic crisis in the last 40 years.
I am back from my winter break in sunny Mexico. And I have my thought process nearly done for the Ten Surprises of 2014 post. I know it’s a bit far into 2014 to post this but the data at the beginning of the year were so uncertain, it was hard to make any good calls. Now almost two months in, the year is taking better form. Emerging markets, China, the US and Europe all seem a bit more understandable.
And that leads me to today’s topic: crisis in the post-Bretton Woods age. During the post-World War II period, there were no major crises despite the fact that we had a nuclear standoff between the Soviet Union and the United States and despite the disintegration of the British Empire and western colonialism. A lot of things happened in the years after World War 2 like the India-Pakistan split, the Korean War, Suez, the Cuban Missile Crisis, The Gulf of Tonkin incident and the subsequent Vietnam War are just a few. As a former diplomat and political historian, I can tell you that this was an exciting period, even from a revolutionary perspective: China, Algeria, Vietnam, Cuba, US Civil rights, Hungary, Czechoslovakia and the list goes on. So, it’s not like we saw neither political upheaval nor massive change. We saw this in spades. What we didn’t see was a major global economic crisis.
Since the end of Bretton Woods, it seems we have a crisis every four or five years. The first crisis was the one which ended the Bretton Woods system after a relatively mild economic slump in the US from 1960-1970. The key here is that the economic decline had already set in and the post-War bull market peaked in 1966. By 1971, the US was running out of gold. There was only $10 billion of gold in its coffers, half the 1960 level. So the US gold peg had to end. And with it, ended the stability of the Bretton Woods system.
The global crises came hot and heavy with the 1973 oil shock and Herstatt Bank collapse, the Continental Illinois bankruptcy, the 1979 oil shock, the LDC crisis, the US S&L crisis, the Scandinavian housing market collapse, the high yield bond collapse of the early 1990s, the Tequila crisis, the Asian Crisis, the Russian default, the Internet crash, the global housing crisis, and the European sovereign debt crisis. All of these episodes had global origins or global implications and we saw recessions when they unfolded. In the US, recession came following both oil shocks. Recession again in 1991 ushered in the S&L crisis and the high yield bond collapse as the Scandinavian and British housing markets cratered. And then the global bubbles in technology and housing both saw recessions.
So the new post-Bretton Woods financial system has not only permitted a vast increase in private sector debt burdens, it has also unleashed repeated and violent financial crises that have powerful feedback with the real economy in a destructive way. How long can this continue without a monetary system reform? Irish economist David McWilliams had an interesting take on this today regarding Turkey and the building emerging markets crisis.
At the mercy of markets:
One of the interesting things about emerging market crises, is that when you are in one, it doesn’t feel like a crisis at all. Turkey has been buffeted by a political crisis and mass demonstrations, which could easily have spilled over into the nightmare playing out in Ukraine. Yet the situation has been calmed by both the protestors and the government. It doesn’t mean the problems have gone away, but it means that both sides have pulled back from the brink.
Longer term, this massive country of 80 million people – a huge regional power – is clearly on the way up. Interestingly, only a few years ago, Turkey felt so insecure that it put up with put-downs from second rate EU leaders when it was applying to get into the EU. Now joining the EU appears off the agenda because the Turks are not too bothered.
The economy grew strongly for ten years, inequality shrank and Turkish companies became regional powerhouses. But the last year has been traumatic for Turkey because, along with other large emerging market economies, it has seen itself going from flavour of the month to dunce of the class. Hot money which had flowed in, flowed out again as the shorter-term hedge fund trader bet against the country.
What is going on in Turkey is also playing out in South Africa, Brazil and, to a lesser extent, Mexico.
If the global financial system is to become an instrument of geo-political stability, it will have to be reformed so that what is happening in Turkey (and elsewhere) doesn’t become the norm.
We are seeing a market-made financial crisis and yet again, the agents of disruption – the financial markets – are passing the buck. Without some form of global capital controls which prevent money flowing in and out of a country at breakneck speed, the world will lurch from one financial crisis to the next driven by greed, fear and fashion.
McWilliams sees what’s happening in Turkey as reminiscent of what happened in Ireland a few years ago. And he doesn’t like it. Yes, the Turkish economy is unbalanced. But why is it unbalanced? What McWilliams is basically saying is that the new model of fiat currency, heavily US dollar-based foreign reserves, free capital flows, and flexible exchange rates is not as good as its proponents make it out to be. He is saying it leads to crisis that is unnecessary and destructive. I agree.
What I have said in the past is that the system now in place needs reform but that we are going to have to wait for the next crisis for reform of the monetary system to occur because there is no urgency for it without crisis. Under Nixon, the US wanted the benefits of a reserve currency without the constraints. Under the new post-Bretton Woods system, the US gets all the seiniorage, all of the credit expansion potential without the currency revulsion that others get. Turkey, for example, doesn’t have a reserve currency. When its economy looks unbalanced, after a shift in private portfolio preferences, money flees its economy And its external financing needs mean it has to either increase interest rates to attain that financing or deal with the destabilizing nature of a currency depreciation and the attendant problems in terms of foreign currency liabilities coming due.
The US doesn’t have Turkey’s problem. When the US had a massive housing bubble collapse, all of the metrics that people look to in Turkey were there in spades: high external debt financing, much of it short-term, high foreign holdings of government and quasi-government bonds, high current account deficit, high primary budget balance, excess domestic credit growth, etc, etc. But almost no one was talking about a sudden stop in the US, largely because the US holds the world’s reserve currency. As crisis took hold, the US dollar didn’t depreciate massively as the emerging market currencies have done. The dollar appreciated relative to other currencies due to its safe haven status. Money flowed into the US. So no one in the US wants to lose that exorbitant privilege.
Yet, t is clear that the US dollar’s role as the world’s reserve currency is a big part of the problem. It sets up the Triffin dilemma that puts goals for US national current account surpluses at odds with the deficits that result from having a national currency as a reserve currency. And time and again, this has led to crisis. In 1985, the Plaza Accord sowed the seeds of Japan’s economic destruction as anti-Japanese sentiment in the US due to a high dollar and trade deficits with Japan led to an agreement that undervalued the yen and created a credit bubble of massive proportions. Now the US has Germany as a whipping boy in the same role, one that China served before it. And just as the Japanese before them, China’s accumulation of dollar reserves will lead to an asset-based economy that will end with massive credit writedowns and a serious economic hangover. The Germans are on the way there as well, with a housing bubble taking form in the major German cities.
Whenever there is a crisis, the result is that countries learn they need to accumulate dollars. After the Asian Crisis in the late 1990s, crisis countries learned to build US dollar reserves as a buffer. But this just means they export like mad and someone has to import. It’s a form of vendor financing – and this kind of financing goes horribly wrong when the sums become too great.
But a larger issue exists than just the macro imbalances. As I put it in 2011, “If countries like the U.S. can create as much money as they want and run current account deficits as large as they want without any constraint, isn’t it likely that credit growth will always eventually outstrip nominal economic growth? Isn’t it equally likely that this will always lead to a destabilising financial crisis and the recrimination that global trade imbalances create?” I still believe this is the case. And we are seeing the end result now in emerging markets. The importers of capital, after years of excess credit growth, are under assault and they need to take measures to keep their currencies from imploding. Doing so causes a severe slowdown in growth with its own set of problems. McWilliams argues for capital controls. That’s part of it. It will certainly stem the flow of hot money. But it won’t prevent crisis. When Russia devalued and defaulted in 1998, I rotated through a trading desk that created synthetic GKOs in order to get around the capital control restrictions. And of course, this desk imploded with losses later, when Russia defaulted. Luckily I was elsewhere but my markets also got hit.
The lesson here is that capital controls can help but other issues are at play like financial regulation, whether and how a currency floats, the US dollar’s reserve status. The Bretton-Woods period had fixed exchange rates, capital controls and a high degree of financial regulation. Yet developed economy growth was higher in that period than the subsequent period. And we had no financial crises. That monetary regime ended because, as with most monetary regimes, it was unsustainable due to government’s desire for more credit growth. But there are facets of the Bretton Woods system which can inform our policy debates today. When the next crisis becomes destabilizing, we will have to re-visit these issues.
For now, with IMF support, we are likely to see the re-emergence of targeted capital controls as a first step. Perhaps we will see targeted central bank intervention at some point as well. But there will be nothing dramatic. Only when the system collapses, as it did during the Depression and World War 2, does one see a root and branch search for new ideas.
Economic crisis in the post-Bretton Woods age
Here are some brief thoughts on the monetary system’s role in repeated economic crisis in the last 40 years.
I am back from my winter break in sunny Mexico. And I have my thought process nearly done for the Ten Surprises of 2014 post. I know it’s a bit far into 2014 to post this but the data at the beginning of the year were so uncertain, it was hard to make any good calls. Now almost two months in, the year is taking better form. Emerging markets, China, the US and Europe all seem a bit more understandable.
And that leads me to today’s topic: crisis in the post-Bretton Woods age. During the post-World War II period, there were no major crises despite the fact that we had a nuclear standoff between the Soviet Union and the United States and despite the disintegration of the British Empire and western colonialism. A lot of things happened in the years after World War 2 like the India-Pakistan split, the Korean War, Suez, the Cuban Missile Crisis, The Gulf of Tonkin incident and the subsequent Vietnam War are just a few. As a former diplomat and political historian, I can tell you that this was an exciting period, even from a revolutionary perspective: China, Algeria, Vietnam, Cuba, US Civil rights, Hungary, Czechoslovakia and the list goes on. So, it’s not like we saw neither political upheaval nor massive change. We saw this in spades. What we didn’t see was a major global economic crisis.
Since the end of Bretton Woods, it seems we have a crisis every four or five years. The first crisis was the one which ended the Bretton Woods system after a relatively mild economic slump in the US from 1960-1970. The key here is that the economic decline had already set in and the post-War bull market peaked in 1966. By 1971, the US was running out of gold. There was only $10 billion of gold in its coffers, half the 1960 level. So the US gold peg had to end. And with it, ended the stability of the Bretton Woods system.
The global crises came hot and heavy with the 1973 oil shock and Herstatt Bank collapse, the Continental Illinois bankruptcy, the 1979 oil shock, the LDC crisis, the US S&L crisis, the Scandinavian housing market collapse, the high yield bond collapse of the early 1990s, the Tequila crisis, the Asian Crisis, the Russian default, the Internet crash, the global housing crisis, and the European sovereign debt crisis. All of these episodes had global origins or global implications and we saw recessions when they unfolded. In the US, recession came following both oil shocks. Recession again in 1991 ushered in the S&L crisis and the high yield bond collapse as the Scandinavian and British housing markets cratered. And then the global bubbles in technology and housing both saw recessions.
So the new post-Bretton Woods financial system has not only permitted a vast increase in private sector debt burdens, it has also unleashed repeated and violent financial crises that have powerful feedback with the real economy in a destructive way. How long can this continue without a monetary system reform? Irish economist David McWilliams had an interesting take on this today regarding Turkey and the building emerging markets crisis.
At the mercy of markets:
McWilliams sees what’s happening in Turkey as reminiscent of what happened in Ireland a few years ago. And he doesn’t like it. Yes, the Turkish economy is unbalanced. But why is it unbalanced? What McWilliams is basically saying is that the new model of fiat currency, heavily US dollar-based foreign reserves, free capital flows, and flexible exchange rates is not as good as its proponents make it out to be. He is saying it leads to crisis that is unnecessary and destructive. I agree.
What I have said in the past is that the system now in place needs reform but that we are going to have to wait for the next crisis for reform of the monetary system to occur because there is no urgency for it without crisis. Under Nixon, the US wanted the benefits of a reserve currency without the constraints. Under the new post-Bretton Woods system, the US gets all the seiniorage, all of the credit expansion potential without the currency revulsion that others get. Turkey, for example, doesn’t have a reserve currency. When its economy looks unbalanced, after a shift in private portfolio preferences, money flees its economy And its external financing needs mean it has to either increase interest rates to attain that financing or deal with the destabilizing nature of a currency depreciation and the attendant problems in terms of foreign currency liabilities coming due.
The US doesn’t have Turkey’s problem. When the US had a massive housing bubble collapse, all of the metrics that people look to in Turkey were there in spades: high external debt financing, much of it short-term, high foreign holdings of government and quasi-government bonds, high current account deficit, high primary budget balance, excess domestic credit growth, etc, etc. But almost no one was talking about a sudden stop in the US, largely because the US holds the world’s reserve currency. As crisis took hold, the US dollar didn’t depreciate massively as the emerging market currencies have done. The dollar appreciated relative to other currencies due to its safe haven status. Money flowed into the US. So no one in the US wants to lose that exorbitant privilege.
Yet, t is clear that the US dollar’s role as the world’s reserve currency is a big part of the problem. It sets up the Triffin dilemma that puts goals for US national current account surpluses at odds with the deficits that result from having a national currency as a reserve currency. And time and again, this has led to crisis. In 1985, the Plaza Accord sowed the seeds of Japan’s economic destruction as anti-Japanese sentiment in the US due to a high dollar and trade deficits with Japan led to an agreement that undervalued the yen and created a credit bubble of massive proportions. Now the US has Germany as a whipping boy in the same role, one that China served before it. And just as the Japanese before them, China’s accumulation of dollar reserves will lead to an asset-based economy that will end with massive credit writedowns and a serious economic hangover. The Germans are on the way there as well, with a housing bubble taking form in the major German cities.
Whenever there is a crisis, the result is that countries learn they need to accumulate dollars. After the Asian Crisis in the late 1990s, crisis countries learned to build US dollar reserves as a buffer. But this just means they export like mad and someone has to import. It’s a form of vendor financing – and this kind of financing goes horribly wrong when the sums become too great.
But a larger issue exists than just the macro imbalances. As I put it in 2011, “If countries like the U.S. can create as much money as they want and run current account deficits as large as they want without any constraint, isn’t it likely that credit growth will always eventually outstrip nominal economic growth? Isn’t it equally likely that this will always lead to a destabilising financial crisis and the recrimination that global trade imbalances create?” I still believe this is the case. And we are seeing the end result now in emerging markets. The importers of capital, after years of excess credit growth, are under assault and they need to take measures to keep their currencies from imploding. Doing so causes a severe slowdown in growth with its own set of problems. McWilliams argues for capital controls. That’s part of it. It will certainly stem the flow of hot money. But it won’t prevent crisis. When Russia devalued and defaulted in 1998, I rotated through a trading desk that created synthetic GKOs in order to get around the capital control restrictions. And of course, this desk imploded with losses later, when Russia defaulted. Luckily I was elsewhere but my markets also got hit.
The lesson here is that capital controls can help but other issues are at play like financial regulation, whether and how a currency floats, the US dollar’s reserve status. The Bretton-Woods period had fixed exchange rates, capital controls and a high degree of financial regulation. Yet developed economy growth was higher in that period than the subsequent period. And we had no financial crises. That monetary regime ended because, as with most monetary regimes, it was unsustainable due to government’s desire for more credit growth. But there are facets of the Bretton Woods system which can inform our policy debates today. When the next crisis becomes destabilizing, we will have to re-visit these issues.
For now, with IMF support, we are likely to see the re-emergence of targeted capital controls as a first step. Perhaps we will see targeted central bank intervention at some point as well. But there will be nothing dramatic. Only when the system collapses, as it did during the Depression and World War 2, does one see a root and branch search for new ideas.