The Bretton Woods system, named after an idyllic ski resort in New Hampshire, was the international exchange rate system that was in place until the early 1970s. Essentially, the US dollar as the anchor currency was backed by gold at a rate of USD 35 per ounce, and all the world's important currencies at the time were pegged to the US dollar at fixed exchange rates. During its lifetime, some currency adjustments were made to reflect changes in the competitiveness of different countries, but overall the system was stable for a quarter of a century.
There are several reasons why the Bretton Woods system eventually collapsed. Many American historians and economists believe that, starting in the early 1960s, Europe (France and Germany, in particular), were 'pillaging' the US gold reserves that backed the US dollar by systematically exchanging their accumulated dollars for the yellow metal. At one stage, US gold reserves were no longer sufficient to back the US dollars outstanding. This loss of confidence ultimately led to the collapse of the whole system.
European historians and economists (especially those in Germany), although acknowledging the systematic exchange of US dollar holdings for gold by France and Germany, counter that the US in the 1960s was living beyond its means by fighting the war in Vietnam and by implementing an increasing number of ambitious social programs, which led to both unsustainable government and trade deficits.
As is often the case, the truth lies somewhere between the two explanations. Following World War II, Western Europe and Japan rebuilt their economies between the 1950s and the 1970s, catching up with the world's leading economy, the US, by achieving higher productivity growth. Such a catch-up implies an appreciation of the real exchange rate, i.e., the exchange rate adjusted for foreign and domestic prices. This is an unavoidable law of economics. In a system of fixed exchange rates such a real appreciation, because it cannot be absorbed by a nominal appreciation of the currency, will lead to inflationary pressures. In the early 1970s, those inflationary pressures had become increasingly unbearable for inflation-adverse countries like Germany, but also Switzerland and Japan, leading to the collapse of the Bretton Woods system.
Bretton Woods II and its challenges
The post-Bretton Woods system, in place for some 15 to 20 years, was one in which exchange rates were more or less free-floating until the Asian crisis in 1997. During that crisis, many overvalued Asian currencies crashed and fell below their fair value versus the US dollar. Then, following the crisis, many emerging countries in Asia, including China, unilaterally pegged their undervalued currencies against the US dollar.
Through foreign exchange interventions, those countries were able to alleviate the appreciation pressures on their currencies, despite generating large trade and current account surpluses. That, in turn, enabled those countries to build up massive foreign exchange reserves.
In 2003, three economists, Michael Dooley, Peter Garber, and David Folkerts-Landau, referred to this new environment, in which many emerging markets were de facto pegging their currencies to the US dollar, as 'Bretton Woods II'. This regime had worked well until the recent financial crisis. On the one hand, it allowed emerging markets to experience rather strong export-led growth, while, on the other hand, US households could consume, and build and buy houses on cheap credit offered by those same emerging markets, which wanted to have their currencies pegged.
Bretton Woods II is also a good explanation for Alan Greenspan’s interest rate “conundrum” (long-term US interest rates having become rather insensitive to Federal Reserve actions), or Ben Bernanke’s “saving glut” theory (the US having to absorb the worldwide excess savings). However, by 2005, the first cracks in this new foreign exchange regime appeared.
As was the case with the original Bretton Woods system, the catching-up by emerging markets, especially China, put increasing pressure on a real appreciation of the emerging market currencies. As indicated above, such a real exchange rate appreciation can occur in one of two ways: 1) the nominal exchange rate appreciates, or 2) inflation rises in the country with real exchange rate appreciation pressures. With hindsight, one can also state it like this: both Germany and Italy experienced real exchange rate appreciation pressures in the 1960s and 1970s. However, while for Germany it was a surge in the Deutschmark accompanied by low inflation, for Italy it was a constantly depreciating Lira accompanied by high inflation.
By 2005, many emerging markets in Asian had reached the same crossroad as Italy and Germany had in the 1970s: they could either let their currencies appreciate (Germany's approach), or they could let inflation surge (Italy's approach). Facing increasing inflationary pressures and surging commodity prices, China chose, for a while, to abandon the US dollar peg and let its currency appreciate against that currency. By mid-2008, in the wake of the financial crisis, China re-pegged its currency, which had appreciated by roughly 20% since 2005, to the US dollar.
Towards Post-Bretton Woods II
This re-pegging has certainly helped China to weather the global financial crisis much better than if its currency had appreciated. Thanks to this, as well as to a strong fiscal stimulus package, the Chinese economy is now running at full speed. However, China and other Asian countries are once again confronted with the old dilemma: the catching-up of their economies will likely lead to an appreciation of their real exchange rates.
The question now is which approach each emerging market will choose:keeping its currency close to the US dollar and letting inflation surge (the Italian approach), or keeping inflation under control with an appreciation of the currency (the German approach). There is no good economic advice one can give here. Ultimately, it boils down to a social or political choice. However, one should be aware that (as always in economics), there is an inescapable trade-off.
Investment implications
It should be noted that the collapse of the first Bretton Woods exchange rate regime led to extremely volatile exchange rate markets as well as sharp rises in commodity prices and overall inflation. It was also the time of an overall depreciation of the US dollar and the British pound, the currencies of the two leading economies at that time. A collapse of Bretton Woods II could lead to a return to the 1970s market environment: i.e., a surge in inflation, higher commodity prices and highly-volatile exchange rates.
It will most certainly lead to a real appreciation of those emerging market currencies that are pegged to the US dollar, not only versus the US dollar, but also versus the euro, the yen and the pound; the currencies of the world's current leading economies. This real appreciation of emerging market currencies could occur either because of a nominal appreciation (the German experience) or because of accelerating inflation (the Italian experience); most likely, though, by a combination of both.
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