Why agreeing a new Bretton Woods is vital

By Martin Wolf
Published: November 4 2008 19:35 | Last updated: November 4 2008 19:35


We have arrived at the point in a crisis when ambitious leaders call for a “new Bretton Woods”. It is easy to mock such language. Yet it is easy to see why this crisis should make people think in such heroic terms.

First, the world economy has come full circle, with a massive financial crisis emanating from the US, then and still the world’s dominant financial power. The Great Depression of the 1930s was accompanied – and aggravated – by failures of economic co-operation, disintegration of the global economy and resurgent nationalism. But it also led to a revolution in economic thinking. “Never again” was the aim of the negotiators in Bretton Woods, New Hampshire. Mired in the worst financial crisis since the 1930s, we have good cause to say the same.

Second, it is unnecessary to wait for calmer times before thinking afresh. The Bretton Woods conference culminated in July 1944, while the second world war was far from over. If they could fight a war and redesign the global economy at the same time, so can we fight a crisis and redesign global institutions simultaneously.

Third, today’s global financial system is dysfunctional. What is at stake in reform is maintenance of the open world economy that offers opportunities to so many. Also at stake is sustained co-operation among states. Nothing is less likely than effective co-operation among inward-looking states presiding over frightened, even xenophobic, societies.

Finally, what is happening lies at the intersection between global macroeconomics – money, the exchange rate and the balance of payments – and global finance: capital flows, financial fragility and contagion. The imperative of co-operation remains. But as Robert Zoellick, World Bank president, said on October 6: “We must modernise multilateralism and markets for a changing world economy.”

So how is this to be done? We must start with the underlying challenges.

The first is the inability to gain a purchase on the policies of countries that run huge and persistent current account surpluses. That was a dominant concern of John Maynard Keynes in 1944. Ironically, the problem then was US surpluses. Today, it is the collapse in the ability of US households and those of a few other high-income countries to offset the vast current account surpluses generated by China, Germany, Japan and oil-exporting countries. Surplus countries love criticising those who spend what they wish to lend. The former will soon discover they cannot do without the profligacy of the latter.

The second is that of financing countries subject to “sudden stops” in capital inflows of the kind we are seeing, as banks and other foreign-currency lenders cut off financing to a wide range of borrowers, particularly in emerging countries. Many of the latter have made an immense and costly effort to reduce vulnerability by accumulating foreign currency reserves (see chart below). By August of this year, the total foreign currency reserves of emerging countries had reached $5,500bn, dwarfing the $260bn available to the International Monetary Fund. Yet self-insurance is inefficient and, as it has proved, too unequally distributed.

The third challenge is that of making the financial system less unstable and, above all, less vulnerable to such huge swings in risk appetite – from financing anything, however ridiculous, to financing nothing, however meritorious. At present, moreover, as Stephen King of HSBC has pointed out on the FT’s economists’ forum, the efforts of governments to force rescued banks to finance domestic borrowers are bound to come at the expense of their lending to emerging countries.

The final challenge is that of making the global institutional architecture less illegitimate than today. The Bretton Woods institutions – the IMF and the World Bank – are dominated by the western powers: in the case of the Fund, the US still had 17.1 per cent of the quotas (which largely determine votes) and the European Union another 32.4 per cent in May 2007. Meanwhile, China had just 3.7 per cent and India 1.9 per cent. These are simply anomalous. So, too, is the persistence of the group of seven high-income countries as the co-ordinating group for the world economy, particularly as three of them – Germany, France and Italy – do not have independent currencies. The group of 20, whose summit will take place in Washington on November 15, looks too large. Mr Zoellick suggests a G14, which would add Brazil, China, India, Mexico, Russia, Saudi Arabia and South Africa.

What is interesting about this agenda is how familiar much of it would seem to the participants at Bretton Woods, with one exception. Keynes would be horrified that the world has let the genie of free capital flows out of the bottle. This, he would note, is why more external financing is needed than ever before, why vast foreign currency reserves have been accumulated and why financial crises are once again global, rather than local. He would add that “a sound banker, alas, is not one who foresees danger and avoids it, but one who, when he’s ruined, is ruined in a conventional and orthodox way along with his fellows, so that no one can really blame him”. We have far too many such bankers. He would surely add that these undercapitalised and illiquid institutions are little short of financial time-bombs (see chart below).

Yet can anything useful be done to meet such challenges? It is certainly possible – and indeed necessary – to change the global architecture, not least in response to changing economic weights. It is equally necessary to give the IMF more financial resources in support of its new short-term lending facility. But it is surely too optimistic to believe that the Fund would ever be able to provide reliable warnings of looming crises. Even if it did, it is even less likely that the countries which matter would do anything in response.

Nor am I optimistic that we can sever the links connecting banking as a stodgy utility that provides essential services to the economy to banking as a casino offering opportunities for taking huge bets. Bankers have been given a licence to gamble with taxpayers’ money. That is a wonderful business to be in. It is also one we seem unable to bring to heel.

Yet I wish to be proved wrong. I hope that the summit of the G20 will set the agenda for serious reform, by creating working groups that prove able to produce radical and effective proposals. For what is happening now may well be the last chance for an open and dynamic world economy. First, we have to get through the present crisis. Then we have to have to make such catastrophic financial collapses vastly less likely. If not us, who? And if not now, when?

martin.wolf@ft.com