The beginnings of the old global financial system came about in the closing months of World War II, following three weeks of negotiation by 730 delegates from 44 nations in the mountains of New Hampshire.
That system came to an end 40 years ago after a weekend of secret deliberations by President Richard Nixon and several aides at Camp David, Md. He announced the decision with a nationwide broadcast on a Sunday night: The United States would no longer back the dollar with gold. The postwar financial system created in Bretton Woods, N.H., was effectively finished.
We are still living with the consequences.
The improvised, on-the-fly financial system that replaced Bretton Woods after 1971 has failed. The great challenge facing the world leaders gathering for the annual World Bank-International Monetary Fund meetings in Washington this weekend is to figure out what will replace it.
For the past 40 years, capital has moved freely around the globe, with currencies fluctuating according to market forces and countries intervening to affect those flows according to their domestic interests.
It has all proved remarkably prone to financial crises: in northern Europe in the early 1990s, Mexico in 1994, several East Asian nations in 1997, Russia in 1998, Argentina in 2001. And, most disastrously, nearly the entire planet in 2008.
This is no way to run a global economy. But it’s not clear whether there is enough political will to find a new framework, because it would require many countries to sacrifice something dear to them.
A new system could mean limits on the kind of gaps that can arise between what countries produce and what they consume. For the United States, that would mean giving up the gusher of borrowed money that has allowed the country to live beyond its means. For China, it would mean giving up the export-driven approach to growth that has brought hundreds of millions of people out of poverty. In Germany, it would mean living without the high savings levels that comfort its residents, and in Britain, it would mean finding a new economic model that doesn’t rely so much on gigantic banks.
This stuff is hard.
The Bretton Woods system sprung from the legacy of the Great Depression and World War II.
The world leaders who assembled in the White Mountains of New Hampshire — most notably the British economist John Maynard Keynes — understood that the earlier world economic order had gone horribly wrong, and they set out to create a fundamentally different and more resilient system, even when it might mean their own countries would have to give up prerogatives and priorities.
When the panic of 2008 happened, policymakers on all corners of the globe responded in ways that reflected the lessons of the Great Depression and prevented a far worse outcome for the economy. They bailed out banks instead of letting them fail, eased monetary policy rather than tightening it, opened the spigots of fiscal stimulus and avoided any temptation to put in place tariffs to disrupt trade flows.
They succeeded at what they set out to do: They averted the calamities that followed the panic of 1929, namely 25 percent unemployment and a catastrophic global war. But that success is the reason there has not yet been a new Bretton Woods. Things haven’t gotten bad enough to spur nations to make the sacrifices involved for an over-arching remake of the world financial system.
This weekend the world’s leaders are more focused on responding to the emergency of the moment — the ongoing European debt crisis. Even on a longer time horizon, countries are finding it more convenient to muddle along with weak growth than to make more fundamental adjustments. As bad as things seem in most of the world’s advanced economies, conditions haven’t become bad enough to prompt a global grand bargain that might create a more durable economic system.
This dynamic is most vivid — and most crucial — between the United States and China. These economies, the world’s largest and second-largest (with a strong likelihood of swapping places in a decade or two) constitute the most important economic relationship in the world.
The pattern for the past decade has been this: The Chinese spent much less than they earned, in the process accumulating trillions of dollars in savings. They used it to buy, among other things, U.S. Treasury and mortgage-related bonds. This steady inflow of money into dollars has kept the value of the Chinese currency down and propped up the value of the dollar, making Chinese exports more competitively priced than they otherwise would be compared with other developing countries. This development strategy has brought vast numbers of people from dire poverty into the global middle class.
The United States has taken advantage of the vast sums of cheap money gushing in, using it to run large budget deficits year after year, build houses by the millions, marshal the most powerful military the world has known, and maintain relatively low taxes in the process.
But this symbiotic relationship cannot last forever. The United States is not as rich as Americans assume, essentially living large thanks to a Chinese-issued credit card.
In a perfect world, the United States would have used the debt it accumulated for things that would strengthen the economy: factories, roads, airports and education to make citizens more productive. Then the adjustment period would be cushioned by the faster economic growth allowed.
We didn’t. Instead we spent the money on houses in the exurbs of Sun Belt cities, on inefficient health care and consumer goods.
In a perfect world, the adjustment to get American spending in line with American economic output would occur gradually, over many years, with exports and business investment rising gradually at the same speed that consumer spending and housing investment would drop.
That’s not the world we’re living in. Instead, economic policymakers are trying to make this adjustment while the country struggles to recover after a deep recession. It’s hard for exports to rise when the entire world is mired in an economic slump, and it’s tough for businesses to ramp up investment when the consumers who would buy their products are busy paying down their mortgage and credit card debt.
In the United States, the bare-knuckled battles over reducing the budget deficit are one manifestation of the challenge: Cutting the U.S. deficit from 10 percent of economic output to something more manageable — perhaps south of 3 percent — at a time when there’s 9 percent unemployment is straining the nation’s social fabric.
And China has its own problems. One side effect of all that intervention to keep the currency cheap is inflation. The price of food and fuel keeps rising, and Chinese leaders are so wedded to the growth model of pushing exports that they don’t want to allow the currency to rise by buying fewer U.S. assets.
But that opens up its own set of issues. China’s focus on exports has been a successful growth strategy, possibly doing more to reduce the number of people in dire poverty than all the foreign aid ever deployed. Anything that might slow the country’s growth juggernaut is risky, and strong political constituencies in China — namely exporters — are arguing against it.
There’s a more subtle risk from a U.S. perspective. Right now, U.S. borrowing rates are extremely low despite high budget deficits. If China and other Asian nations started buying fewer Treasury bonds, the U.S. economic situation could become worse. If the housing market seems terrible now, wait until mortgage rates hit 8 percent instead of 4 percent.
So creating a more durable global economic system would be hard enough if it included just the United States and China. But most of the world’s major economies will have to make similarly difficult transitions.
In Europe, for example, Germany may gripe about profligate spending by southern European nations, but there are two sides to that coin: When Spain and Italy spend beyond their means, they are buying goods made in German factories, and using money that the savings-oriented Germans have been happy, until recently at least, to lend them.
What would a new global financial system look like? World leaders are gradually hammering out an approach to reduce imbalances that rests on putting international pressure on countries that run persistently large surpluses or deficits.
It will be hard enough to move toward agreement while the world is still in crisis-fighting mode; European leaders are understandably more focused on their immediate debt crisis and risks to their common currency than setting up a new financial framework for the decades ahead.
But the more fundamental problem is enforcement. Suppose the international community decides that countries that spend more than 3 percent on top of what they make are in violation of the norms of the new economic order. What then? The German chancellor cannot order the U.S. president to go sit in a corner as punishment.
Other ideas could address certain aspects of the failed post-Bretton Woods economic order. For example, if all countries enacted a small tax on financial transactions, it might cool down the hot money that has made countries more vulnerable to rapid inflows and outflows of capital. It would even help lower budget deficits.
But for it to work, it would need to be truly global. If Germany enacted the tax but Britain didn’t, much of the financial activity in Frankfurt would migrate to London, and so on. And U.S. government has consistently opposed such a tax, viewing it as unlikely to succeed. It would also be highly damaging to an industry at which the United States excels, which is to say high finance.
That weekend in 1971 when Nixon ended Bretton Woods, the president and his aides knew it would roil markets immediately and have long-lasting consequences. Paul Volcker, then a Treasury Department official and later the Federal Reserve chairman, joked that if he were he free to trade in markets to take advantage of the move the government was about to make, he could earn enough to pay the federal government’s entire budget deficit for the year.
At a conference in Bretton Woods this past spring, Volcker mused about those days, when the old international monetary regime was crumbling and the world’s leaders sought a new order for the economy. A civil servant named George Willis, Volcker recalled, had been at Bretton Woods 40 years ago and was the most knowledgeable person in the U.S. government on international monetary affairs.
“All the wisdom of the U.S. Treasury was in that one man, George Willis,” Volcker said. “And he had gotten on in age and was kind of a crusty old guy anyway. . . . I would adjourn these meetings, and we would discuss what to do about the monetary system. . . . Whatever the proposal was, at the end, I’d ask George, ‘What do you think, George?’ And he would say, ‘It won’t work.’
“Well, I finally got a little exasperated and said, ‘George, what will work?’
“ ‘Nothing,’ he said.”
“And,” Volcker added, “that’s where we still are today.”