“If understanding is impossible, knowing is imperative, because what happened could happen again.”[1]
Early in life we all become aware that there is no such thing as free money. And yet, it appears that in the last three decades, money has become freer. Money can now move freely around the world to chase cheaper goods and investment opportunities.
As long as the dollars remains the key international currency and the main source of liquidity, the global economic order will continue to revolve around the United States. But the United States has lost interest in playing the role of leader and is becoming a force of disruption.
Unconstrained capital movements and the associated financial instability – with the related excessive risk on the back of light-touch regulation – have distorted the allocation of resources and the distribution of income between labour and capital.
A more resilient institutional framework should enhance regional cooperation. Regional cooperation should help countries to manage or even limit the extent to which capital may be mobile.
The Bretton Woods conference in 1944 focused on building a postwar economic and monetary order that revolved around the idea of a rule-based international monetary system to buttress a rule-based international trade system. It is difficult to have a peaceful world when countries compete for markets and resources.
We’ve never had it so good
The postwar era looked like the ideal world of linear progress, where the trend in living standards and economic conditions was an upward one. The success of this period was based on cooperation of countries. Western Europe and the US growth rate was steady 5 %. Unemployment was very low; in Europe it was 1.5 %.
Capital controls have a long history, but their prevalence was cemented in the post-Second World War era, as they became a structural element of the global economic order.
Never before in the history of humanity has there been as many people living in a country other than their own as there are now. But mobility was limited after the War, also due to Iron curtain situation. Barriers to mobility started to crumble around the time of the fall of the Berlin Wall in 1989.
Since 2000, developing countries have grown at an average rate of almost 6 per cent while the advanced economies have grown at 1.9 per cent. Capital flows, even more than trade, have grown robustly since 1990. That is true for both portfolio investments and foreign direct investments. At its peak in 2014, the overall value of international merchandise trade was 19 trillion USD. In the mid-1990s, gross cross-border capital flows accounted for approximately 5 per cent of world GDP, at their pre-crisis peak in 2007 they were about 20 per cent.
Like all other international currencies, the dollar is fiat money. This means that US government declare it legal.
US Secretary of the US Treasury John Connaly Jr speaking in 1971 to the European finance ministers who were concerned about the rising US inflation said: “The dollar is our currency, but your problem.”[2]
In The General Theory of Employment, Interest and Money, Keynes suggested that “the competitive struggle for markets” within an international monetary system that put countries in competition with one another was the main economic cause of war. This, he argued could be eliminated and “unimpeded” trade could be a mutual advantage if countries could pursue national policies for full employment within an international monetary system designed to avoid achieving the external balance through deflationary domestic policies.
In 1948 the General Agreement on Tariffs and Trade (GATT) came into effect in twenty-three countries. In the last trade rounds, 123 countries joined in. Tariffs dropped from average 22 % to % 5 during this time.
The WTO was established in 1955. The WTO currently has 164 members.
The WTO and GATT have transformed the landscape of international trade. In 1960 international trade accounted for just over 24 per cent of global GDP, but by 2000 it had reached over 51 % and is currently at 59 %.
The treaty of Rome in 1957 established the European Economic Community. The Single European Act that was signed in 1987, giving the EEC’s ultimate objective – the creation of a single market – a new lease of life.
Why do we need a rules and institutions to manage international trade?
- First, we need them to develop a level-playing field and to avoid unfair advantages for some.
- Second, to ensure that interaction of national economies within global market does not result in policies that have a “beggar-thy-neighbor” impact.
- Third, to reconcile global markets with nation states.
When we introduce rules, we need to answer the question who gets to decide the rules that govern global market place and who enforces and monitors their implementation.
Everything started at Bretton Woods
In July 1944, 730 representatives of all 44 allied countries met at the Mount Washington Hotel in Bretton Woods. The proceedings were led by the British economist John Maynard Keynes and US Treasury Undersecretary Harry Dexter White.
Keynes wanted a system where countries could pursue external adjustment – meaning, they could, for example, expand their exports by reducing their relative prices – only if other countries were prepared to absorb such exports – they were not protections.
Bretton Woods was possible due to US abandon its isolationist policies.
During the second half of nineteenth century and until the First War, currencies were tied to the Gold Standard. The system worked as long as wages and prices were flexible enough to allow adjustments and maintain the external balance. The system was not suitable for an expanding world economy.
When productivity falls, internal adjustments can be either wage cuts or increase in unemployment.
Keynes and White wanted to build a new system with the flexibility to pursue domestic full employment policies, strengthen domestic economies and reduce the vulnerability to external shocks.
There was another problem that kept the Bretton Woods architect busy during the planning phase: adjustment and how to redistribute this burden between deficit and surplus countries. Keynes proposed adjustment mechanism, but the idea was rejected.
Bretton woods’ full convertible phase lasted a bit more than a decade, from 1959 to 1971. The US provided liquidity by allowing convertibility of national currencies into dollars while maintaining gold reserves. The dollar encapsulated the three features of an international currency – it acts as a unit of account, a means of exchange and a store of value.
In February 1975 US made and agreement with Saudi Arabia that OPEC countries would invoice and be paid for all oil in dollars.
About 62 % of total foreign exchange reserves are held in dollars. EURO only accounts for 20 %.
Unlike the Gold Standard, which was a “spontaneous order”, the Bretton Woods system was predicated on rules and institutions that would monitor and enforce those rules. IMF was designed as a financial safety net. The World banks was founded to provide softer loan conditions to the poorest countries.
The problems of Bretton Woods were:
- The problem of adjustment of countries with persistent deficit in the balance of payment, as was the case for Britain.
- An increased risk of a run on the dollar.
Gap between dollars in circulation and gold reserves was getting bigger. So, the confidence in the value of dollar was declining. The situation in the US after 1970 was rapidly declining. Nixon decided to fold the system on 15 August 1971, with suspending the convertibility of the dollar into gold. After 1973 the world slide into a non-system where fixed and floating exchange rates coexist.
Thus, the end of Bretton Woods was more than just the end of dollar convertibility: it ushered in a new light-touch policy framework focused on deregulating domestic financial systems and limiting fiscal policy so to minimize political discretionarily and attempts to manipulate the economy.
Capital become global and deregulated. It was the beginning of the financialization of the world economy. The decision-making process in democratic countries was under a lot of challenges due to a pressure from global capital.
A world of crises
Greenspan’s era was that in which the belief in globalization turbo-charged by large capital flows triumphed. Reliance in market rationality came to replace government intervention and international policy cooperation – the main features of the Bretton Woods system.
In 2005 the overall value of financial assets worldwide was approximately 165 trillion USD, the equivalent of 331 % of GDP, in 1980 it was 120 %.
Mexico tequila Crisis in 1994. The biggest issue was that vulnerability to foreign investments is much bigger when those are in the form of portfolio investments and not direct.
The crises showed how countries that are depended on foreign investments are very vulnerable, especially if they didn’t introduce some capital out-flow controls.
The EMS was established in 1979, with the European Exchange Rate Mechanism (ERM) at its core. Brittan joined ERM only in 1990. In 1992 on 16 September the United Kingdom was forced to suspend its membership with the ERM and was not able to defend its currency any more. Norma Lamont said that UK will set their own policy – economic and monetary.
In the mid-1990s, the tiger economies of Asia – such as Thailand, Indonesia, Malaysia and South Korea -were growing at an average annual rate of 7.5 % compared to world average of 3.5 %. As long as money was flowing in, the system was kept in equilibrium. In 1996, Thailand inflow equal to 14 per cent of its GDP. In 1998 all those countries GDP dropped substantially. At that moment money fled.
- Financial globalization and the liberalization of capital movement without an appropriate regulatory framework put the financial stability of many countries at risk.
- The speed and impact of financial contagion among economies interconnected through capital flows can generate vicious cycle of debt, and hit the real economy.
- Rebuilding and expanding foreign exchange reserves in countries that were affected by crisis is seen as a form of self-insurance against further crises.
- There is a need for greater financial cooperation within the region in face of a common crisis.
All those were learnings from Asian crisis.
Playing the dollar game
The G20 London Summit in 2009, Zhou Xiaochuan made a public call for reconsidering the role of national currencies in the international monetary system.
China was accumulating dollars due to strong exports. Domestic policy of US was impacted by that.
Many developing countries cannot generate capital at a pace that matches that of their expected economic growth. When a country borrows in a different currency, it creates a currency mismatch between revenues generated in the domestic currency and liabilities denominated in an international currency. Financial maturity is a big divide between developed and developing countries. Since developed countries don’t take an exchange risk to get to capital needed for their growth.
Quantitative easing or QE focused on actively purchasing assets such as bonds and other securities in order to reduce the cost of borrowing, stir market activity and increase the money supply.
QE triggered a global search for yield, with significant capital flows being channeled towards the developing countries. In 2013, corporate bond issuance in developing countries reached 630 billion USD, in 2000, they had amounted to just 13 billion USD.
China’s official reserves were 4 trillion USD in June 2014. But this money is not used for domestic development. Healthy buffer is 3-4 months of imports. China’s central bank – the PBoC is trying to convert USD to renminbi and are giving liquidity to local banks. Renminbi has limited international capabilities; its convertibility is small.
Swap agreements are used to lower the exchange cost between currencies. The FED accept some swap deals with other countries.
Debt is another big problem of international monetary system. Some of the big countries like Japan, US and China are above 200 % of GDP with their debt. Also, the total size of global debt is too high. In 2017 it was around 184 trillion USD. Corporate debt also grows significantly. Especially problematic was bond debt, that accounted to almost 20 % of all corporate debt.
Europe struggles with integration
Life is full of trade-offs.
Members of a monetary union such as the EMU cannot have inflation targeting separately and cannot have floating exchange rates among themselves.
It is in good years that resilience should be built and structural weaknesses addressed, but often we are oblivious to problems until disasters strike.
The current state of play and the measures taken to manage the euro crisis have eroded the integrity of political systems. In the 2009 crisis, the majority of burden fell on debtors. Germany surplus in 2015 was 8.9 per cent of GDP.
Putting on the monetary straightjacket without a long-term strategy to address structural issues, such as a rigid labour market and demographic imbalances with an ageing population, resulted in sluggish growth.
There is an objective need for Italy to increase its public spending to support domestic demand and prevent its population from experiencing deteriorating living standards, but how to square this with the requirements for the EU Fiscal Compact? Italy desperately needs reform to modernize its economy and improve its overall situation. The combination of Italy’s debt with stagnant economic growth and ineffective politics could be lethal for Europe as a whole. If Italy went through the same convulsions as Greece in 2010-12 it would trigger the collapse of the euro and possibly the collapse of the entire European project.
Greece called IMF when they get in trouble. Calling on the IMF is never good for a country’s confidence, but it is particularly humiliating for a European one.
Since it was not Greece that was in trouble but also Euro, EU would set up EFSF (European Financial Stability Facility) that could be extended to other vulnerable European countries. Later it was replaced by ESM (European Stability Mechanism).
Looking at Italy and Greece, the moral of the tale is clear: dealing with debt can disrupt domestic politics, especially when the adjustment required as part of the debt-management strategy disproportionally hits the most vulnerable in society.
Showing the cracks
For years, even non-liberal and authoritarian countries have opted to engage with the international economic order instead of being excluded and confronted. But now that the benefits of such an order are under question, we are seeing more contested geopolitics and the resurgence of state-based threats.
The defining characteristic of the international order is openness.
The Brexit epitomizes the tension between openness and national sovereignty in areas such as trade policy and migrations. Two main principles of EU are free movement of goods and people.
The idea that traditional political systems should be ditched in favor of direct democracy is attracting more and more people.
Is the European project actually sustainable in the long run without deeper political integration and concrete steps towards a more federal framework.
In the world that has also China and Russia, the concept of multipolarity, should not be overlooked.
Pressures from US (especially after sanctions in connection with Crimea annexation) created the conditions for cooperation between China and Russia.
Being China
BRICS has transformed the landscape of international relations and international business. BRICS is based on the intuition that the large developing countries will contribute to the transformation of the global economic order.
A large population means two things for economic development: a large labour pool and the potential for a large domestic consumer market.
It is really China, that is the main player in BRICS. In the early twentieth century China was a large economy, accounting for roughly 9 per cent of global GDP. As of 2019, its share is 16 %.
As the world economy was becoming ever more integrated, China was able to easily cash in by exporting the cheap goods produced by its state-owned enterprises.
1979 the Chinese government ratified the law of Chinese-Foreign Joint Ventures, which allowed partially foreign owned companies to operate in the country.
In China the motivations to save are strong. 23 % of GDP are household savings. 15 percentage points higher than the global average.
State-owned enterprises and the big banks are linked strongly together in China. This link is softening a little. There are five strong banks in China and three “policy banks” – Agricultural, Development and Export-Import bank.
Going out strategy also reflected banking behavior and China become one of the largest providers of development finance and the world’s second largest exporter of capital.
One Belt, One Road initiatives was announced in 2013. The BRI has been described as a modern Asian equivalent of the Marshall Plan.
China seems determined to considerably expand its footprint in international development finance.
Special Drawing Rights (SDRs) are a supplementary reserve asset used internally by the IMF. The dollar’s share of the SDR is roughly four times of the renminbi’s.
A reasonably liquid and diversified market for renminbi assets now exists in Hong Kong, London, Singapore and most other international financial centers around the world.
Made in China 2025. The idea was to upgrade China’s industry and increase its technology footprint, improve international labour productivity, reduce energy consumption and achieve overall international competitiveness, taking the country from a manufacturing giant into a world manufacturing power.
US trade deficit with China grew from 83 billion to 234 billion. The trade imbalance with China widened the US current account deficit from 3.9 % of its GDP in 2000 to 5.8 % in 2006.
In 2018 the US imposed three rounds of tariffs on China. The trade war was on.
Building a resilient framework
To some extent the rise of socialist China has been undermining the post- Bretton Woods non-system.
Resilience needs to be created through measures of crisis prevention and crisis resolution. These, in turn, need to be underpinned by international institutions through the provision of global public goods – an open trade system, international development finance and an international financial safety net.
The multilateral trade agenda and the global financial safety nets are critical to the relevance, effectiveness and even survival of the current global economic order.
44 % of the loans to the thirty-two developing countries with unsustainable levels of public debt in 2017 were provided by China – up from 30 % in the years between 2013 and 2017.
There are four reasons for framework for multilateral lending:
- Borrowing from multilateral institutions is a way to smooth rivalries.
- Uncoordinated bilateral lending can have an adverse impact on financial stability and trigger measures of crisis resolution.
- Multilateral lending as a tool to overcome political and diplomatic consideration.
- Multilateral international institutions have a large amount of data and can provide technical support to assist the decision-making process on lending and monitor government policies in recipient countries.
International debt mechanism is really needed.
There are three broad lines along which the governance of the Bretton Woods institutions needs to be reformed: the developing countries need to be better represented, they need to be given an adequate voice in decision-making processes and the leadership needs to be appointed on the basis of merit and through a transparent process.
For the Bretton Woods institutions to continue being credible, their governance needs to be inclusive and their funding needs to be enough to pursue their objectives – lending for development and providing financial support at times of crisis.
The US is now the major barrier to the governance reform.
An Alternative System
Bretton Woods has outlived its purpose. China’s willingness to create regional institutions to plug into the demand for finance for infrastructure, coupled with the US open hostility, has created a narrative that sees China as ready to build an alternative institutional framework.
In 2015 UK decided to join the newly established China-led AIIB. ADB – Asian Development Bank is another institution, established in 1990 in Japan, about which US are cautious. NDB is another institution that was establish to improve capital flows in the Asia. But the projects so far have been relatively small.
The Asian countries also created a regional network of bilateral swap and repurchase agreement facilities (CMI, later upgraded to CMIM).
By the end of 2017 at least five countries – Argentina, Mongolia, Pakistan, Russia and Ukraine – had activated their lines for short-term liquidity needs.
Poles apart
The rules-based international order was possible because of the decision made by the US to take on the mantle of leadership.
In 1929 depression, there was no international leader and that is why the depression was so long, since all the interests were private. The conditions now are very similar to 1930.
America first’ set the clock back to an era of nationalism and competition in international markets and legitimates the weaponization of trade and money.
Inevitably, there will come a time when dollar-holders will lose confidence in the value of the American money, taking it to be less predictable and less secure.
The end of the story
Making more resilient institutional framework that accounts for the changing dynamics of the world economy framework that accounts for the changing dynamics of the world economy on the back of the rise of China will help resetting a fundamentally imbalanced economic and monetary system every time it short-circuits.
As the world is changing, the US, Japan and Europe need to engage with China and the other large developing countries to recast the global order and ensure its legitimacy in the future.
[1] Primo Levi, in the book on page 1
[2] In the book on page 25
