Bretton Woods, The Sequel?
The financial crisis is by no means over, but the urge to extract lessons from it already is irresistible. The Europeans have pressed successfully for a new Bretton Woods summit, modeled after the 1944 gathering that inoculated the world against a repeat of the Great Depression. Although the original Bretton Woods took place years after the Depression, Britain and France are bent on staging the new version within weeks. "Europe wants it. Europe demands it. Europe will get it," French President Nicolas Sarkozy said before jetting off to Camp David, where President Bush meekly gave in to him.
The Bretton Woods analogy is contrived, to put it mildly. That summit created the World Bank to reconstruct Europe after the ravages of World War II. Today, bombed-out infrastructure is hardly the issue. Bretton Woods also created the International Monetary Fund, to support a system of fixed exchange rates. But the world has largely abandoned that system, and today's chief exchange-rate challenge is to move even further from Bretton Woods by persuading China to float its currency.
Bretton Woods boosters assert that a global financial system needs global regulatory fixes. This claim deserves scrutiny. The fix that rightly commands widest support is moving the swap contracts between financial institutions onto centralized exchanges, so the collapse of one large player does not threaten others that entered into swaps with it. But this reform can be achieved with a minimum of international coordination. Countries can unilaterally establish swaps exchanges, and financial institutions all over the world can use them.
The second fix on most reformers' lists is to shrink the pyramids of debt in the financial system. When a bank or a hedge fund buys $100 million of assets with $5 million in capital and $95 million in debt, a 5 percent loss is enough to wipe it out, forcing liquidation of the remaining $95 million worth of stocks or bonds in its portfolio. Such fire-sale liquidation has driven part of the recent market turmoil; it forces prices down and damages other debt-laden players, which then join in the selling. Although such debt, or "leverage," is certainly dangerous, a new Bretton Woods summit is not going to tame it.
We know this because we've tried already. It took five years, not a handful of photo-op summits, to negotiate the so-called Basel II standards that govern leverage at banks, and the resulting deal proved ineffectual anyway. Daniel Tarullo, who has just published a Peterson Institute book on Basel, points out that the next attempt to control leverage may need to be broader. After the events of recent months, that is surely right. Given AIG's failure, the next round should probably encompass insurers. Given the vast growth of hedge funds, it should also cover some of them. Creating sensible leverage rules for such disparate institutions will be fiendishly complex, perhaps even impossible.
So what might a new Bretton Woods conference usefully do? Well, it could reform the IMF, which has evolved from its original role into a rescue fund for collapsing currencies. During the emerging market crises of a decade ago, the IMF was central to all the bailouts. Its status has since dwindled. As my Council on Foreign Relations colleague Brad Setser notes, the Chinese have tried to muscle in on the IMF's turf by helping Pakistan. The Russians have tried to help Iceland. The European Union has helped Hungary.
Reestablishing the IMF as the agreed provider of bailouts would be a worthwhile project. The IMF puts economic conditions on its loans while governments place political ones; we don't want to revive the cronyism of the Cold War, when countries from Cuba to Zaire could pursue absurd policies and know they would be bailed out because they were strategically useful.
The irony is that Britain and France will be the first to resist a serious effort to revive the IMF. British Prime Minister Gordon Brown talks vacuously about giving the organization the role of creating an early-warning system for crises, even though this is what thousands of economic forecasters already try to provide. What Brown does not stress is that serious IMF reform needs to begin with the modernization of its board. Rising powers such as China and India deserve more say. Declining powers need to give up some influence -- and that includes France and Britain.
Of course there is a role for global cooperation. The coordinated interest rate cuts and bank rescues of recent days have been constructive. But it's worth remembering that after the last global crisis, in 1997-98, there was lots of grand talk about a new international financial architecture. In the end, the only important reforms were national ones. Governments ran budget surpluses and built up foreign reserves to protect themselves from the next shock. That shock has arrived, and we are about to find out if those changes were enough. One thing is certain: They were not the result of any international conference.