"Dollar’s last lap as the only anchor currency"

Wolfgang Munchau has a very good editorial comment which discusses the latest Treasury International Capital report (see here for another, more detailed treatment). He focuses on the net purchases of long-term securities and concludes that the sharp drop this year, which is very unfavorable to the dollar, is a sea change, not a mere short-term move. But Munchau gives some useful historical context, and unlike other commentators, sets forth some of the possible currency regimes as the dollar slips from reserve currency standing.

From the Financial Times:

It has been one of the most influential theories about exchange rates in the age of globalisation and it may be about to go up in smoke.

In 2003, the economists Michael Dooley, David Folkerts-Landau and Peter Garber* proposed what has since been known as the Bretton Woods II theory. The idea is based on the observation that newly industrialised countries peg their currencies to the dollar at an undervalued exchange rate in pursuit of export-led growth. In return, they reinvest their loot back into the US, which acts as an anchor and consumer of last resort.

In 2006, the US ran a current account deficit of more than 6 per cent of gross domestic product, a level that would normally be considered excessive. The Bretton Woods II theory says that this state of affairs is both desirable and sustainable. To say that not everybody agrees with this theory would be an understatement. It now appears that no matter whether you find this state of affairs desirable or not, it probably is not sustainable.

One piece of statistical evidence – though certainly not conclusive – is the latest data on global flows of funds. The financial flows back into the US appear to have come to a sudden stop this summer. The US Treasury International Capital System (TIC) data show a massive drop in net foreign purchases of US long-term securities since the end of June.

To get an idea of the magnitudes involved: foreign net purchases of long-term US securities – the difference between foreign purchases of US securities and US purchases of foreign securities – had been running at an average of about $70bn a month in 2005, and a little higher in 2006. The monthly net inflow in June this year was still a strong $99.9bn but that figure dropped to plus $19.5bn in July, minus $70.6bn in August and back to plus $26.4bn in September.

If you take the 2005 and 2006 data as roughly what you need to sustain the US current account deficit at 2006 levels – give or take a few billion dollars – this sudden decline looks very much like a big structural shift.

As the US capital account surplus is falling, then so, logically, must be its current account deficit. However, that suggests that the Bretton Woods II system is no longer working the way it is supposed to work.

In some respects, Bretton Woods II appears like a giant money laundering cartel. You buy my goods and, in return, I give you the money back in the form of a loan. It is, perhaps, no surprise that it took a credit market crash to bring that macroeconomic scam to an end.

What will come next? Global currency regimes tend to come and go in long cycles, with fixed-rate and floating-rate regimes following each other with a surprising degree of regularity.

The end of Bretton Woods I was followed by a period of floating exchange rates. Europe started a long process towards monetary union, via an exchange-rate mechanism, which resulted in a single and free floating currency 30 years later. So what will follow Bretton Woods II?

I can think of two scenarios. The first is that the dollar’s global monopoly will give way to a duopoly of the dollar and the euro. It is impossible to predict the timing of any such shift. Over time, as countries replace a dollar peg with a mixed basket peg, they are likely to readjust reserve portfolios as well.

An important reason why they want to change the dollar peg is the threat of imported inflation, which has become a problem in China and the six countries of the Gulf Co-Operation Council (GCC) after the dollar’s devaluation. There have been a number of signals recently that the dollar peg is about to be dropped, for example, in the United Arab Emirates.

Of course, if that were to happen, the dollar would almost certainly fall further and this might induce others to drop their pegs as well. It is not difficult to imagine a situation in which Bretton Woods II could unravel in a disorderly fashion.

Another, at least theoretical possibility is the emergence of regional exchange rate regimes, along the lines of what happened in Europe after Bretton Woods I. There has been a lot of talk for a long time about Asian monetary union, with little progress so far.

Either way, we are probably in the last long lap of the dollar as the world’s only anchor currency. We do not yet fully comprehend the new era, but it is fair to say that it is probably not going to be Bretton Woods III.