IS THIS BRETTON WOODS 2.1 ? / BARRON´S ( RECOMMENDED READING )

Tuesday, October 20, 2009

UP AND DOWN WALL STREET DAILY

Is This Bretton Woods 2.1?

By RANDALL W. FORSYTH

Moves to constrict capital flows represents a new -- and potentially dangerous -- change in the international monetary system.

BRETTON WOODS 2 may be in the process of a revamp but it wouldn't be an upgrade.

More than a picturesque town in New Hampshire, Bretton Woods gave its name to the post-World War II international monetary system that featured fixed exchange rates for currencies versus the dollar, while the U.S. currency was anchored in terms of gold at $35 an ounce. The system unraveled when Richard Nixon abrogated that promise in 1971 to redeem dollars (to foreign monetary authorities) in gold, which then triggered the surge in oil prices and the double-digit inflation of the ensuing decade.

Bretton Woods 2 is what the name given to the current ad hoc arrangement whereby creditor nations, especially China, accumulate massive amounts of dollars and relend them to the No.1 debtor nation, the U.S. While symbiotic, creditor nations, notably but not solely China, are becoming restive about amassing greenbacks ad infinitum.

That's because they're worried about the risk their dollars will lose value, as they have been since the bull market in risk assets starting last March has obviated the demand for greenbacks as a safe haven. Moreover, buying up those dollars expands foreign creditor nations' domestic money supplies and threatens inflation unless the currency purchases are offset -- "sterilized," in the jargon -- which usually is ineffective.

But not to absorb the surfeit dollars (which they receive as the result of their trade surpluses) means these nations have to let their currencies rise in value, which would hurt the competitiveness of their exports. A real conundrum, if you'll excuse that overused term.

Some emerging-market powerhouses are mulling an alternative: restricting capital inflows.

Brazil said it would impose a 2% tax on foreign investment in the nation's stocks and bonds to slow the rise in its currency, the real. "Our concern is an excess of speculation," the Wall Street Journal's man in Sao Paolo quoted the finance minister, Guido Mantega, as saying.

The real deal is that China recently has supplanted the U.S. as Brazil's biggest trading partner. And with the Chinese renminbi anchored to the dollar since the summer of 2008, an excessive appreciation of the real would hurt Brazil's exports.

Brazil isn't alone among emerging-market nations to endorse such measures. According to Bloomberg report, Taiwan's central bank cited to local media a United Nations report that said limits on capital flows were neither "ineffective nor harmful."

In other words, governments' trust in the markets has been eroded substantially. What are the implications?

Consider that capital flows are to the 21st century economy what trade was in the 1920s and 1930s, after the infamous Smoot-Hawley tariff enacted in 1930, world trade collapsed.
Indeed, in the past year, constrictions on trade credit and the rush to shrink inventories has produced an ever steeper decline in global trade.

Capital controls designed to maintain currencies' export competitiveness would invite retaliatory measures, such as tariffs. Such tit-for-tat can escalate into a downward spiral of trade curbs as countries fight for share of a continuously shrinking market.

That is the record of the 'Thirties. The policy mistakes of the Great Depression have informed the policies of today, which have thus far prevented a replay of that disaster.

Central banks around the world have flooded the global financial system with liquidity, rather than constricting it, as they did in the early 1930s. And instead of seeking balanced budgets as the Depression spiraled downward, governments have accepted fiscal deficits on a war-time scale. As bad as the Great Recession has been, it would have been still worse without these measures.

But protectionism -- already evidenced by U.S. duties on China-made tires as well as capital controls to restrict currencies' exchange rates -- is one way history could repeat, disastrously.

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