The fortieth anniversary this week of the end of the Bretton Woods system coincides with a time of turmoil for the world economy and international monetary system.
Like today, in 1971 the world’s most developed countries had been stuck for months, unable to resolve their differences and move back to a pattern of cooperation. At the same time the balance of payment imbalances were widening. Eventually, on 15 August 1971 President Nixon unilaterally decided to suspend the dollar convertibility into gold. This put an end to the multilateral framework that, since the Bretton Woods conference in 1944, had underpinned the reconstruction and the development of Europe and Japan. Many reasons guided the US decision, notably the rapidly growing payments imbalances and the pressure from international investors keen to the dollar devaluation.
The Bretton Woods system could not be replaced and the following decades saw the establishment of a non-system with floating currencies for the developed countries and the adherence of developing countries to dollar-pegged exchange rate regimes. As emerging markets economies, especially China, expanded rapidly from the 1990s, their chosen exchange rate mechanism gradually moved the dollar back to the centre stage. By accident, rather than by design, we now have a dollar-centred international monetary system that shares some features of Bretton Woods, especially the intrinsic bias towards building up balance of payment imbalances.
Today, as in 1971, the world economy is divided between deficit and surplus countries and features large imbalances. The current system of floating currency blocs with dollar-based trade and reserves, allows countries to run current account deficits and surpluses and accumulate net financial claims on each other. However, it does not provide a mechanism to encourage a return to more balanced positions. The result is the US’s large external deficit position. This, coupled with large domestic deficit and debt, has been denting international investors’ confidence in the greenback.
Over the last couple of years, a consensus has emerged that the international monetary system cannot withstand the strains of the global adjustment ahead. The need for reform is no longer an argument for academic discussion, but a priority on policymakers’ agendas. It is time to consider the prospects for a multi currency system where the key reserve currencies share the burden of adjustment as well as the privileges that come with the role. How the transition is managed without massive instability in the world economy, is not clear.
If there is a lesson from the end of the Bretton Woods system is that systemic adjustments carry huge systemic costs and big spillover impacts, and these have to be managed through international policy cooperation. A lack of cooperation in 1971 meant that high and variable price inflation and monetary instability became the norm in most developed countries throughout the 1970s and 1980s. Such a prolonged and painful adjustment process could have been avoided with coordinated policy action.
Today’s situation is more challenging than in the early 1970s because the world economy is now more integrated, and developing countries have a greater role. There is also the risk that deflation, rather than inflation, becomes the default position. Monetary authorities in developed countries have little scope for manoeuvring as a result of the zero-interest rate policy they have been pursuing since the beginning of the financial crisis in 2008. There are huge constraints on fiscal policy across the developed world.
As such, the argument for international policy cooperation is stronger than it was forty years ago. As the world economy remains in steady disequilibrium and prone to episodes of strong volatility and market disruption, coordinated action to manage exchange rates arrangements - while China is gradually moving towards currency convertibility - is critical. This is an area where more effort is required, and it should be an issue that the G20 tackles decisively.