A Map to the Revived Bretton Woods End Game
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A Map to the Revived Bretton Woods End Game
Michael Dooley
Peter GarberGlobal Risk StrategistJune 4, 2004
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Standard View
US Current Account Deficit at 5% of GDP
Normal upward pressure on the euro and other floaters
Undervaluation of Fixed Asian Currencies
Asia overheating adjustment through inflation
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If it goes on, it will end badly
Currency crises
Banking crises
Rapid rise in US yields
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External pressure to appreciate Asian currencies
Especially from Europe
Protectionist jargon: burden sharing, currency manipulation, undervaluation, beggar-thy-neighbor.
But US Treasury, Fed unconcerned
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What force drives the global system?
The key economic problem of our time:
– To manage the economic emergence of China
– Employ 200 million underemployed workers
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China’s demographics: Urban population growth = 20 million p.a.
Sources: CEIC and DB Global Markets Research
Note: Urban population as % of total.
15
20
25
30
35
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45
1970 1975 1980 1985 1990 1995 20000
2000
4000
6000
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10000Urbanization(lhs)p.c. GDP
% of pop'n RMB
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The international monetary system is determined by the basic economic problem to be solved
Bretton Woods was an explicit compromise between the US and UK to solve the perceived problems of the depression and WW2
The current ad hoc system exists temporarily to solve the problem of the emergence of Asia
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The political economy tradeoffs
China chooses an export driven development strategy
It wants to move workers into industrial sector rapidly but faces increasing costs
At the end of the game, it wants a viable capital stock
This leads to a clash with trading partners
Displaced US workers have to be compensated
Failure to deal with this externality blocks development.
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Solution:
Set real exchange rate so that initial real wage generates surplus for capital
Direct investor uses part of the surplus to keep import market open.
If the real exchange rate generates a net capital outflow this is a small price to pay
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Exhaustible resource model
Extraction (employment) cost has two parts
Increasing cost of investment in rate of investment
Increasing cost of adjustment of US labor force in rate of import growth
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Two benefits of extraction
Labor in idle pool requires expenditure of –r per period
Labor moved to employed pool yields b per period
Can think of these as political costs or transfers and tax receipts
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Alternative adjustment paths
Real Wage
Time
W
W1
W2
B D
T1 T2
A
C
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Central insight of ER framework
The optimal change in the real wage balances the government’s desire to employ labor quickly against the increasing cost of providing capital and market access
This requires a rising real wage/appreciating real exchange rate at rate r + b
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Stock equilibrium condition
The full solution to the Hotelling (1931) problem requires that the government set the initial wage so that the initial stock of labor is employed when the domestic wage rises to the world wage.
Large initial stock implies low initial wage.
Large initial stock implies long adjustment period
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Can this real exchange rate path be maintained?
Effective capital controls
Trade surplus must be sterilized
Domestic financial repression
BUT ER model implies the need for these controls will fade over time.
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The current global monetary system is the apparatus to implement this solution
Asia fixes exchange rates at “undervalued” levels
Especially against industrial center country with more flexible labor market
Other industrial countries and some emerging market countries float, appreciate, and have their goods pushed out of US markets
Generates export growth and current account surpluses, development strategy is to lend to rich countries
Encourages large scale FDI to assure quality of goods, capital, and to secure export markets
Intervenes heavily in fx reserves to channel domestic saving through foreign balance sheets
Gradually lets real exchange rate appreciate, either through inflation or controlled nominal appreciation