Jeffrey Frankel Harpel Professor of Capital Formation and Growth, Harvard University

The World Monetary System: Time for a “New Bretton Woods”? Jeffrey FrankelHarpel Professor of Capital Formation and Growth, Harvard University HM Treasury London, 16 June, 2010

July is the 66th anniversaryof the 1944 meeting in New Hampshire

President M. Nicolas SarkozySpeech at Davos WEF 27 Jan., 2010 • “Today, we need a new Bretton Woods…. France, which will chair the G8 and the G20 in 2011, will place the reform of the international monetary system on the agenda.” • I have a story • about Bill Clinton, Tony Blair, and proposals for a new Bretton Woods.

Design of a global monetary system, as Bretton Woods, addresses several features: • Exchange rate regime • Fixed (but adjustable) at BW • International reserves • Gold at BW, but $ de facto • Institutions of global governance • IMF, IBRD, & eventual WTO. Post-1973: G7 de facto. • Trade account regime • Open • Capital account regime • Closed then; open after 1973.

Classical trilemma: Adjustment, Liquidity & Confidence Source: http://web.mit.edu/krugman/www/triangle.html#triangle [Incl. capital controls]

President Sarkozy’s thoughts – some of which I approve and some not – make a good organizing principle. • “Let us be clear about this: we're not asking ourselves what we will replace capitalism with, but what kind of capitalism we want.”

Free trade • Looking back on the 2007-09 recession, in retrospect, • despite some slippage in trade policy, • e.g., US tariffs against Chinese tires • and failure to ratify FTAs with Colombia & Korea. • we did pretty well, considering: • Despite severity of the recession, • we did not repeat auto quotas of 1981 • nor steel tariffs of 2001 -- • let alone Smoot-Hawley ! • But the stalled Doha Round suggests the bicycle theory of trade policy is dead: • We might have been better off if we hadn’t tried.

Followed by some non sequiturs • “We will never put an end to hunger, poverty and misery in the world if we do not succeed in stabilising the prices of raw materials, which at present are completely erratic.” • Price stabilization schemes never work. • Commodity producers need institutions that accommodate price fluctuations. • JF, “The Natural Resource Curse: A Survey” June 2010; forthcoming in Export Perils, B. Shaffer , ed. NBER WP 15836.

Adjustment:The global current account imbalances problem • Countries with trade surpluses must consume more and improve the living standards and social protection of their citizens. Countries with deficits must make an effort to consume a little less and repay their debts.” • Yes, Chimerica should adjust: • China should shift from manufacturing/exports, • to domestic demand, services, safety net, etc. • America should save & export more, spend less. • This should be coordinated between equals; • US attempts to scape-goat China and impose adjustment in the name of international fairness are ill-advised.

Global current account imbalances – China’s surplusandAmerica’s deficit – narrowed ≈ ½ in the 2009 recession. 10

Global current account imbalances – China’s surplus and America’s deficit – are expected now to widen again some, with recent recovery in US income & the $.

Exchange rate regime • “Currency is central to these imbalances. It is the principal instrument of the policies that perpetuate them. • We cannot put finance and the economy back in order if we allow the disorder of currencies to persist. Exchange rate instability and the under-valuation of certain currencies militate against fair trade and honest competition. … • The prosperity of the post-war era owed a great deal to Bretton Woods, to its rules and its institutions.” • Nonsense ! • If a new Bretton Woods means exchange rate stability, this is the opposite of ending China’s undervaluation !

My view is that intermediate exchange rate regimes are the right answer for countries like China • The corners hypothesis is dead. • Free floating or firm fixing are in fact not the right answer for many countries, perhaps for most. • In my view the version of Inflation Targeting that pretended smaller countries would ignore exchange rate fluctuations is also dead. • JF, “Experience of and Lessons from Exchange Rate Regimes in Emerging Economies,” in Monetary & Financial Integration in East Asia: The Way Ahead (Palgrave Macmillan) 2004. • JF "The Renminbi Since 2005,“April 2010,in The US-Sino Currency Dispute: New Insights from Economics, Politics and Law, Simon Evenett, ed. (VoxEU), 51-60. IT

IT • In my view, Inflation Targeting, the orthodox monetary regime, was dealt blows by the global financial crisis of 2008-09, • much as exchange rate targeting was dealt blows by the emerging market crises of 1994-2001. • IT told central banks to ignore fluctuations in asset prices & terms of trade. Both were mistakes. • JF, “Monetary Policy in Emerging Markets: A Survey,”NBER WP, June 2010. The Handbook of Monetary Economics, edited by Benjamin Friedman and Michael Woodford, forthcoming, 2011. • My proposal for small countries: Product Price Targeting, rather than CPI targeting.

Exchange rate regimes, continued • It turns out that those countries who built up reserves in the boom of 2003-08 did better in the global crisis of 2008-09 than those who did not. • JF, withG. Saravelos, “Are Leading Indicators of Financial Crises Useful for Assessing Country Vulnerability? Evidence from the 2008-09 Global Crisis” June 2010.NBER WP 16047.

Were current account imbalances the cause of the global financial crisis? • “Let us look at the root of the problem: it was the imbalances in the world economy which fed the growth of global finance…” • Here M.Sarkozy is in very good company. • But, reluctantly, I have to disagree.

Economists were (are) split between Ken Rogoff * Maury Obstfeld Larry Summers Martin Feldstein Nouriel Roubini Menzie Chinn Me Lots more Ben Bernanke Ricardo Caballero * Richard Cooper Michael Dooley Pierre-O. Gourinchas Alan Greenspan Ricardo Hausmann Lots more those who saw the US deficit as unsustainable, requiring a $ fall, and those who saw (see) no problem. 17 *Some claim that the financial crisis of 2007-09 fits their theories.

Were current account imbalances the cause of the financial crisis? continued • Those of us who predicted an unsustainable US current account deficit and a $ hard landing were proven wrong by the 2008 movement into $. • Meanwhile, those who said the US CA deficit was sustainable because of the superior quality & desirability of US assets were also proven wrong. • corporate governance, rule of law, • accounting system, • securities markets, rating agencies… MSN Money & Forbes

Were current account imbalances the cause of the financial crisis?continued • The financial excesses of 2001-2007 would have been pretty much the same even if each country’s inflows & outflows had netted out. • The US ran current account deficits (financed by foreign official $ purchases) as a side efffect of excess liquidity and overspending, not primarily as a cause. • Gross foreign private purchases of US assets fell from $1.6 trillion in 2006 & 2007, to zero from 2008 II. • In net terms, private foreigners have been financing less of the US CA deficit than foreign central banks ever since 2003. • The story is in the volume of gross financial transactions, and in the price. Not in the net.

Then what was the cause of the crisis? • “…the use of leverage, to an unreasonably disproportionate extent, created a form of capitalism in which taking risks with other people’s money was the norm…” • “The other question we can no longer avoid is that of the role banks must play in the economy. The banker's job is not to speculate, it is to analyse credit risk, assess the capacity of borrowers to repay their loans and finance growth of the economy. …[M]any banks were no longer doing their job.”

Congress is about to pass a surprisingly good (all things considered) financial reform bill. • Mortgages • Fix “originate to distribute” model, • so lenders stay on the hook. • Consumer protection agency, • including standards for mortgage brokers • I would not let the Fed have this one. Latest: it may be independent after all. • Remove policy bias toward housing debt. • Fannie Mae, Freddie Mac, income-tax-deductibility of real estate taxes and, especially mortgage interest. • Sadly, politicians won’t hear of it.

Financial reform, continued • Banks: • Regulators shouldn’t let banks use their own risk models; • should make capital requirements higher & less pro-cyclical. • Is “too big to fail” inevitable? • Yes, unless resolution authority. • The worst is to say “no” and then do “yes.” • Tax banks, so that they pay for rescues in long run, • internationally coordinated; • But don’t earmark the revenues for a bailout fund.

Financial reform, continued • Banks, continued: • Extend bank-like regulation to “near banks.” • Segmentation of function: • Volcker rule, banning proprietary trading? • It looks like we will get it. • Perhaps even with Sen.Lincoln rule: • banks have to spin off swaps trading desks(FT , 14 June) • All the way back to Glass-Steagall? • I don’t think so.

Financial reform, continued • Securities • Credit ratings: • Reduce ratings agencies’ conflicts of interest. • Reduce reliance on ratings: • “AAA” does not mean “no risk.” • Derivatives: • Create a central clearing house for CDSs . • Possibly central exchange as well • Don’t ban short sales, as the Germans are doing.

Financial reform, continued • Executive compensation • Compensation committee not under CEO. • Maybe need Chairman of Board ≠ CEO, • as in UK. • Discourage golden parachutes & options, • unless truly tied to performance. MSN Money & Forbes

Global Governance • “The G20 foreshadows the planetary governance of the 21st century. … • In just one year, we have seen a genuine revolution in mentalities. For the first time in history, the Heads of State and government of the world's 20 largest economic powers decided together…” • Yes ! Long overdue.

Multiple International Currency System • We cannot have, on the one hand, a multipolar world and, on the other, a single benchmark currency across the globe. …

Multiple International Currency System • I retract my 2005 econometric projection that the € could challenge the $ by 2022 in CBs’ reserve shares. • The SDR has come back from the dead in 2009. • Gold has made a comeback as an international reserve too. • Someday the RMB will join the roster with ¥ & ₤. • = a multiple international reserve currency system. SDR

SDR SDR • More surprising: the SDR’s comeback from near-oblivion. • The G20 & IMF decided to create new SDRs ($250b). • Shortly later, PBoC Gov. Zhou proposed replacing the $ as lead international currency with the SDR. • The IMF is now borrowing in SDRs. • The proposal has been revived for an international substitution account at the IMF, • to extinguish an unwanted $ overhang in exchange for SDRs. • The SDR has little chance of standing up as a competitor to the € or ¥, let alone to the $. • Still, it is back in the world monetary system.

Gold • Until very recently, central bank holdings of gold was considered an anachronism. • Central banks were gradually selling it off. • Now gold is back on the list of international reserve assets • China bought gold in early 2009. • India bought 200 tons in November. • Sri Lanka…

A multiple reserve currency system is inefficient, in the same sense that barter is inefficient: money was invented in the first place to cut down on the transactions costs of exchange. • Nevertheless, if sound macro policies in the leader country cannot be presumed, the existence of competitor currencies gives the rest of the world protection against the leader exploiting its position by running up too much debt and then inflating/depreciating it away.

Historical precedent: £ (1914-1956) The 2001-2020 decline in international currency status for the $ would be only one small part of a loss of power on the part of the US. But: • With a lag after US-UK reversal of ec. size & net debt, $ passed £ as #1 international currency. • “Imperial over-reach:” the British Empire’s widening budget deficits and overly ambitious military adventures in the Muslim world. A loss of $’s role as #1 reserve currency could in itself have geopolitical implications.

Global Climate Change • “In Copenhagen, quantified commitments on climate change were made by all the big countries. …How can we not see that the possibility of adopting a carbon tax at orders against environmental dumping would, without any doubt, constitute a strong incentive to respect the common rule?” • No; commitments have not advanced far enough: • US, China... • Although border taxes on carbon can be part of a regime, top priority should be setting guidelines for national border measures. • G20, or US-EU-China or WTO Secretariat. • Otherwise, national politicians’ measures will be discriminatory.

Jeff Frankel website: www.hks.harvard.edu/fs/jfrankel/ • "What’s 'In' and What’s 'Out' in Global Money," in Finance and Development, 46, no.3, Sept. 2009, 13-17. At:www.imf.org/external/pubs/ft/fandd/2009/09/pdf/frankel.pdf. • “Global Macroeconomic Address: The Impact of Current Economic & Regulatory Policy on Economic Recovery -- Where Does the Financial Crisis Leave the U.S. Economy in Global Terms?” June 3, 2010. Slides at:www.hks.harvard.edu/fs/jfrankel/SuperJune2010incIntAp.ppt.

Jeffrey Frankel Harpel Professor of Capital Formation and Growth, Harvard University