Thursday, October 23, 2008

Brad Setser: "The end of Bretton Woods II?"

Brad Setser is an economist at the Council on Foreign Relations. He keeps a blog here.

The following is an excerpt from a blog post he titled 'The end of Bretton Woods II?' "Bretton Woods" refers to the paradigm that has governed the world economy since WWII. In particular, Bretton Woods II refers to the post-1971 paradigm in which "China and then the oil-exporters provided (subsidized) financing to the US to sustain their exports."

Dr. Setser considers the current crisis to be nothing less than the rupturing of world-economic stability and likely the end of the Bretton Woods aggreement. The paradigm of the last two to three decades all the way up to the present moment was: Chinese growth subsidizes American consumption. This led to unsustainable imbalances in the world economy. A new paradigm will thus need to emerge. It is safe to say that this new paradigm will include a great deal less easy money and credit available to hedge funds, organizations, and American households.

Here's Dr. Setser:

The end result of this crisis . . . could be: a sharp contraction in credit, a fall in US economic activity, a fall in US imports and a fall in the amount of foreign financing the US needs. The US government is (possibly) trying to offset the fall in private demand by borrowing more and spending more — but as of now there is realistic risk that the fall in private activity will trump the fiscal stimulus.

Consequently, this still strikes me a crisis of the Bretton Woods 2 system. In retrospect, Bretton Woods 2 depended on two things: ongoing flows from the emerging world’s governments to the US Treasury and Agency market, and the ongoing ability of the US financial system (broadly defined to include the dollar-based “shadow” financial system operating in London and other offshore centers) to transform these flows into loans to ever-more indebted US households. US investors effectively sold their holdings of Treasuries and Agencies to the world’s central banks, and then redeployed their funds into private-label mortgage-backed securities. Between the end of 2003 and q2 2007 (three and a half years), the stock of mortgages held by private issuers of asset-backed securities rose from about $1 trillion to around $3 trillion. That demand meant that credit was available to any household that wanted it – even those without much ability to pay if the housing market ever turned.

Or, to put it more succinctly, Bretton Woods 2, as it evolved, hinged both on the willingness of foreign central banks to take the currency risk associated with lending to the US at low rates in dollars despite the United States large current account deficit AND the willingness of private financial intermediaries to take the credit risk associated with lending at low rates to highly-indebted US households.

. . . .

I hope that the process of adjustment now underway isn’t as sharp as I fear. The US economy gradually can shift from producing MBS for sale to US investors flush with cash from the sale of safe securities to China and Saudi Arabia to producing goods and services for export – but it cannot shift from churning out complex debt securities to producing goods and services overnight. Indeed, in a slowing US and global economy, improvements in the US deficit will likely come from faster falls in US imports than in US exports – not from ongoing growth in US exports.

But right now it looks like there is a real risk that the adjustment won’t be gradual. And it certainly looks like the flow of Chinese (and Gulf) savings to US households over the past few years has produced one of the largest misallocations of global capital in recent history.

If I read Dr. Setser correctly, he is suggesting this misallocation of Chinese savings to US households effectively is over.

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