Yesterday, I wrote about the similarities (and differences) between current US conditions and those in the early 1970s before the 'Great Inflation'. Today, I thought I'd follow up with a comparison of the
global monetary systems now and then. In particular, there are elements of the current financial architecture that resemble the Bretton Woods system of pegged exchange rates, which ultimately broke down in the 1970s contributing to the 'Great Inflation' in some countries.
The Bretton Woods system had been in operation since the late 1940s. In the aftermath of the second world war, the US and other major economies recognized the need for greater multilateral coordination of economic policy, to avoid any repeat of the Great Depression. Essentially, the Bretton Woods system was a framework of pegged exchange rates against
the dollar, with dollar convertibility against gold. The system worked well through the 1950s and 1960s, underpinning the reindustrialization of Europe and Japan. With fixed exchange rates, Germany and Japan used exports as a principal motor of their economic growth. The US also increased its domestic demand to absorb German and Japanese exports.
Late in the 1960s, the system came under increasing strain. In particular, the growing cost of the Vietnam war added to the US's budget deficit and a widening trade deficit. Initially, Europe and Japan were willing to accumulate dollar assets to maintain their exchange rate pegs, as this would help to support their exports. But as US inflationary pressures intensified at the end of the 1960s, this became more difficult. The dollar began to weaken, which left Europe and Japan with a stark policy choice. They could maintain their pegs by accumulating even more dollar assets, which would intensify their own domestic inflation problems. Or they could revalue to damp down domestic inflationary pressures. Ultimately, at the turn of the decade, European and Japanese policymakers accepted the need for currency revaluation.
Now, there is a shadow Bretton Woods system. Since the Asia crisis in the late 1990s, China and other Asian economies have maintained pegged exchange rates against the dollar. The objective has been to support export-led growth. In return, Asian central banks have accumulated US assets, supporting the dollar and US asset prices. This has effectively
financed the US's strong domestic demand and burgeoning current-account deficit. But the pegs are now coming under increasing strain. As the Fed has cut interest rates, the dollar has weakened markedly forcing those countries with pegs to accumulate more dollar assets and run inappropriately loose monetary policy. This is adding to domestic inflationary pressures in these economies. In effect, the currency pegs enable the US to 'export' inflationary pressure to Asia. If Asian central banks follow the example of Germany and Japan in the 1970s and decide to revalue their currencies more aggressively, this might have serious implications for US inflation prospects. China has already started to accelerate the pace of RMB appreciation to damp inflationary pressures.