Monday, October 11, 2010

Bretton Woods 2 vs. QE 2: Smackdown of the Decade?

My thinking on QE 2 has always been from a cyclical perspective. Thus, in my view calls for the Fed to do more to shore up aggregate spending and stabilize nominal expectations occur because these things had fallen off their long-term trend during the past recession.  I had not been envisioning QE 2 as ushering in a structural shift in the U.S. economy, let alone the global economy.  But according to both Ambrose Evans-Pritchard and Tim Duy I may be missing something here.  These two observers are making the case that QE 2 will turn out to be nothing less than a crude but effective assault on the Bretton Woods 2 system.  Here is Evans-Pritchard:
Asian investment in plant has run ahead of Western ability to consume. The debt-strapped households of Middle America, or Britain and Spain, can no longer hold up the dysfunctional edifice. Asians must take over, or it will come down on their own heads.

The countries actively intervening in exchange markets to suppress their currencies – China, Japan, Korea, Thailand, even Switzerland, to name a few – are all too often the same ones that have the biggest trade surpluses with the US...

Yet this is an intolerable situation for the US. It should be no surprise that Washington has begun to retaliate in earnest...The atomic bomb, of course, is quantitative easing by the Federal Reserve. America has in effect issued an ultimatum to China and G20: either you stop this predatory behaviour and agree to some formula for global rebalancing, or we will deploy QE2 `a l’outrance’ to flood your economies with excess liquidity. We will cause you to overheat and drive up your wage costs. We will impose a de facto currency revaluation by more brutal and disruptive means, and there is little you can do to stop it. Pick your poison. 
Wow, QE 2 will be the atomic bomb that ends Bretton Woods 2.  Evans-Pritchard has always had a way with words. Tim Duy agrees and is concerned that international tensions could escalate:
The time may finally be at hand when the imbalances created by Bretton Woods 2 now tear the system asunder. The collapse is coming via an unexpected channel; rather than originating from abroad, the shock that sets it in motion comes from the inside, a blast of stimulus from the US Federal Reserve. And at the moment, the collapse looks likely to turn disorderly quickly. If the Federal Reserve is committed to quantitative easing, there is no way for the rest of the world to stop to flow of dollars that is already emanating from the US. Yet much of the world does not want to accept the inevitable, and there appears to be no agreement on what comes next. Call me pessimistic, but right now I don't see how this situation gets anything but more ugly.
Note that this line of thinking recognizes the Fed as a monetary hegemon.  Its monetary policy get exported to the much of the world and thus, QE 2 will get exported as well.  Consequently, many countries will have to either (1) let their currency appreciate against the dollar and lose some external competitiveness or (2) intervene in foreign exchange markets to prevent this appreciation from happening.  The latter option, however, comes at the cost of an increase in their own money supply that will, as Evans-Pritchard notes, lead to a massive stimulus in their own economy. (They could sterilize this increase in the money supply, but it too  creates a quasi-fiscal cost.) Might this latter development become too much to bare and lead to the break-up of the Bretton Woods 2 system? Maybe, but given the scope and reach of  the U.S. dollar as a reserve currency this would be quite the feat.


  1. The question is, what would cause BW2 to finally break?

    The weak dollar transmits deflation directly to Europe. A Euro of 1.5 would call into question the PIIGS's ability to service their debts by tapping external demand. This presents the ECB with a stark choice: join the parade of large-scale QE, or risk financial instability. A recalcitrant ECB might commit the policy error that crashes NGDP expectations there. On the flip side, what would happen to commodity prices tomorrow were the ECB to signal a similar QE program as the (expected) U.S. one?

  2. This is more or less the model I've had in mind for the last couple of years, in large part thanks to reading Brad Setser's blog (who I should note now works for Tim Geithner).

    My description of the US under BWII is that of a country suffering from Reserve Currency Dutch Disease.

    Lately, there's been an interesting dynamic with opponents of QE, like Rajan and Stiglitz, pointing to the liquidity effects abroad as reason to oppose. While those advocating a soft approach on China, such as Ryan Avent and Sumner, have advocated more QE instead with Avent pointing out that such a move may force China to revalue.

    My feeling is that if there is a 'structural' element to this crisis it's not housing but the international currency system.

  3. The connection is tenuous at best. Setser and Rubini inaccurately predicted BWII breakdown for years. A few more bonds purchased by the Fed isn't going to cause some sort of "big one". Too many moving parts to the world economy.

  4. This is a fascinating commentary.

    BTW, let me toss a anecdotal nugget into the pond.

    I work in cabinets and furniture. An industrial neighbor of mine (in Los Angeles) works for a large cabinet maker, that has been getting cabinets made in China.

    he China contractor used to take orders as small as six units. Then 20. The latest minimum is 50 units.

    Okay it is an anecdote, but my neighbor said it is reflective of a trend. Costs are rising in China. They are not so hungry for business. The really low volume stuff will have to go to another manufacturing platform--or back to the US.

    Chinese is rapidly moving along the arc set by Japan. It won't be long before they migrate into higher value-added goods.

    But, in the immediate prospect, their businesses are feeling the heat, and are probably fighting tooth and nail any currency appreciation.

    All the same, we need QE2 now, and bad.