Monday, July 7, 2008

History is Repeating Itself

In thinking about today's global inflation problem and the role U.S. monetary policy is playing in it, it struck me that we have seen this story before. The collapse of Bretton Woods system--the global monetary system from the end of WWII through the early 1970s-- was due to the United States abusing it role as the anchor currency. During this time, many countries outside the communist block pegged their currencies to the dollar, which was ostensibly backed by gold. Consequently, these countries were willing, initially, to take dollar and dollar-denominated assets for international payments. The United States, however, had pressing domestic spending objectives--the Vietnam War and the Great Society--that required foreign financing. This meant foreign countries took increasingly more dollar and dollar-denominated assets as payment. After some time, these countries began to question whether the U.S. really could back up all of these dollars it was exporting with gold. The answer, of course, was that it could not and eventually the system collapsed. Along with the collapse came a surge in global inflation--the delayed consequence of the U.S. exporting its loose monetary policy to the rest of the world for so many years.

Today, we see the same thing happening. Nouriel Roubini has a post yesterday that makes this very point:
Will the Bretton Wood 2 Regime of fixed and/or heavily managed exchange rates in many emerging market economies collapse in the same way as the Bretton Woods 1 regime (the “dollar standard” regime that ruled after 1945 in the global economy) collapsed in the early 1970s? What are the similarities and differences between those two regimes? It is interesting to note that the same factors – U.S twin deficit, U.S. loose monetary policies and fixed pegs to the U.S. in the dollar standard regime of Bretton Woods (1945-1971) - that led to the commodity inflation and goods inflation in the early 1970s and thus to the demise of the Bretton Woods 1 regime (in the 1971-73 period) are also partially the same factors that are leading now to the rise in commodity and goods inflation in emerging markets that are pegging to the U.S. dollar and/or heavily managing their exchange rates.
Suffice to say history seems to be repeating itself. Maybe this time around the world will become once bitten twice shy about the dollar.


  1. Hi Professor,

    Glad to see you are still around for the summer with your thoughtful articles.

    Nouriel and Brad ate some humble pie for most of '06 and '07 for supposedly being wrong about the outcome of their 2005 paper. It turned out their "mistake" was one of timing; by Brad's own admission, they didn't think that BW2 would last as long as it has.

    To resolve this crisis, is it just a matter of the U.S. Fed raising interest rates? It seems to me that Bernanke is waiting until after the elections.

    But how much must rates rise? And what will happen to our economy and specifically the homeowner sector that is tied to ARM's? My recollection is that these types of loans were not popular in the 70's so the hit of higher rates is going to be more painful to the average borrower.

  2. Salvatore:

    The Fed is in a delicate situation and I do not envy the tough choices Bernanke and Co. face.

    Your election comment is an interesting one I had not considered before. I do think the Fed has become incredibly sensitive to political pressures so your theory makes sense.

    The Fed needs to bring the rate back to a neutral level somewhere near the growth of nominal GDP.