Smithsonian Sequels

Perhaps the most amusing bit in this morning's Martin Wolf column is how economists at Deutsche Bank call the present global monetary arrangement "Bretton Woods 2". If so, it is the worst sequel of all time. But that is because the agreement they are naming it after is the wrong one. The right agreement is "The Smithsonian Agreement". There is a reason why no one has ever erected a monument to this agreement, it was a disasterous failure, and the beginning of the end of Nixon's ability to juggle the economy by sleight of hand.

In December of 1971, the Bretton Woods system, created in the waning days of World War II as a way of creating a flow, rather than stock, based gold standard, was under heavy pressure. The US was importing more and more, and the global dollar glut was showing up both as increased inflationary pressures, and as a constantly rising price of gold. Since gold was the nominal peg of the Bretton Woods agreement – the US agreed to buy gold at a fixed price, set at $35 dollars an ounce – there was an external lever against the US currency, namely, buying gold. As more and more gold was held, the price rose dramatically. As the US continued to allow inflationary pressure, and continued to import, it was clear that something had to give way – there needed to be a greater inducement to hold dollars.

The result was, in the typical style of those who want to delay the inevitable, an agreement that attempted to block the symptom rather than cure the disease – in December 1971, slightly larger trading bands were allowed for currencies, and the dollar was moved to 1/38 of an ounce of gold. This is roughly the size of the adjustment to the Chinese Yuan that was just made. If you didn't notice that, you have some idea why the Smithsonian Agreement collapsed less than two years later. In 1972 the pound was allowed to float, and by 1973, the world's currencies were unpegged from the dollar.

Over the alst 15 years, in some part because of the role of the United States Consumer as the designated loser of the world system, by spending more than it saves, the US provides a market for dozens of other countries. These countries, in effect, have reestablished a fixed exchange rate. Most maintain this by some form of currency control and monetary policy combination which is designed to allow their central banks the ability to buy and hold dollars. The situation, as the US has spent further and further into deficit territory, is not something out of the earlier days of the IMF and the tranches of the Bretton Woods system, but similar to the holding of Eurodollars in the late 1960's and early 1970's. Then, as now, the idea of taxing holders of foreign notes by devaluation seemed the cure.

However, devaluation, fast or slow, almost never produces the effect of moving economic activity from non-tradeable to tradeable goods. Instead, as with the Argentine devaluation, or the devaluation that occurred earlier in Bush's term, it moves the country towards more protectionism. As the value of a currency drops, consumers continue to spend, but transfer money from the local economy, to exporting – deficits continue to rise, and investment in the home country falls. Or the home country proceeds to halt exports of materials far down the value chain, and attempts to add value and engage in import substitution. In effect converting inefficient non-tradeable parts of the economy to inefficient trading.

The result is a loss of the advantages to trade – as work that could be done more efficiently elsewhere is done inside the devaluing country. Since labor prices have dropped, this lower value add strategy works. This is what weak currencies really do – by lowering the relative cost of labor, they make lower value add strategies more effective. Afterall, it isn' t the efficient non-tradeable production that goes first, it is the marginal non-tradeable production that will be shifted first.

This is why devaluation only works if combined with some form of economic restructuring to radically shift incentives. Generally at the root of all overvalued currencies was an incentive to engage in the protected economy – often through excessive budget outlays, but just as often through corrupt or collusive market practices. For example, a large and unproductive war for the benefit of a few industries.

Such restructuring is painful, as people who have skills and capital lose out – just ask American high tech workers, or Argentinians of any walk of life. This is why while devaluation – which hurts mainly foreigners at first, is often a popular step in lieu of restructuring. The problem of course is that most nations import oil. For nations trying to reign in consumption, this is not a problem – making oil more expensive acts as a luxury tax. For those with enough energy to support themselves, or nearly so, it is a burden, but a manageable one. For a nation like the US, which neither wishes to change its driving habits, nor wants to even begin restructuring, it is unlikely that difficult decisions will be made.

On the contrary, the most recent action of the US government was to continue the red queen's race of cutting taxes on the wealthy here, so that they can stay even with the oil exporters that can hold dollars to prop up the US currency. Clearly the belief in Washington is that Reaganomics can be run a few more cycles, and damn the long term consequences. This is why devaluing to avoid a recession usually doesn't work, because it is the recession, with its enforced rationing, that is generally the trigger for restructuring in an economy. People in pain are more willing to make decisions that are painful, since they have come to understand that they cannot defer the pain, nor make it fall on someone else instead.

Devaluation isn't an evil in itself, however, by itself, it generally produces more evil than good. Of more use is the ability to unpeg a currency and float it when it is pegged in a manner that distorts the economy, but this too has its perils. Countries unpegged from gold in the 1930's successful, if they had an export market and an internal economy in good order. However, the floating of currencies in 1972-73 merely turned inflation into another round of stagflation. Once again, the ability to shift production is required.

Thus the current drive for "normalization" of currencies - which is to say dollar devaluation - is unlikely to do more than drive up the price of gasoline, and shift effort out of marginal service production in the US, leading to slower job creation, since marginal service jobs represent the bulk of jobs created, while the real deadweight non-tradeables - large houses - and the real sponges of US import - gas and consumer electronics - continue to spiral upwards.

That's the problem - by itself, changing marginal behavior does not deal with the core of the problem, since each consumer slagged by the loss of a service job only reduces import pressure slightly, and in a regime of rising import prices, some other consumer with more income is happy to take up the slack. Instead there needs to be a fundamental change in incentives, and in this case that will mean, sooner or later, a change in the monetary basis of the US economy and the world currency order. The sooner the IMF gets on this task, the better off the world will be.

But don't hold your breath - because before that happens we will have Bretton Woods 3 and Bretton Woods 4...