In a recent lecture delivered at the BBC, the head of the International Monetary Fund, Christine Lagarde, invited the audience to “rekindle the Bretton Woods spirit that has served us so well”, adding that “at such a momentous time… we need to choose the ethos of 1944 over 1914”.
Madame Lagarde’s strong defense of multilateralism is a welcome reminder of where we are and where we come from. As political and economic uncertainty has been growing in the first two months of 2014, there is a palpable risk that the world might be leaning towards 1914 rather than towards 1944.
The Bretton Woods conference in July 1944 inaugurated an era of multilateralism that despite many downsides and difficulties remains the best, and possibly the only way to manage the complexity of our world.
It laid out the arrangements and the institutions that up to these days underpin international cooperation. But it also devised a system of fixed exchange rates and capital controls to avoid the "beggar your neighbour" policy responses of the depressed pre-war years.
This system no longer exists. The United States unilaterally brought it to an end in 1971. Ever since, the world economy has been struggling with a non-system of flexible exchange rates. This has been particularly punitive for developing economies with limited capital markets and limited ability to absorb external shocks.
We are seeing the effects of this non-system in the latest financial turmoil. The unfolding is familiar. Better investment opportunities in advanced economies, in particular the United States, have resulted in funds moving out of less promising and more risky emerging markets economies. Countries with weakening fundamentals—twin fiscal and current account deficits, rampant inflation, falling growth rates, exposure to volatility in commodity prices and political risks—are the first in the line of fire.
India, Indonesia, Brazil, South Africa and Turkey—the Fragile Five—have been on the roller-coaster since last spring, when the Fed went public with its plan to taper the purchase of securities and reduce the pace of QE. Whose fault is this? Is it the Fed's, China's, or industrial countries'?
The reality of our post Bretton Woods era is that we have the institutions for multilateral action and cooperation, but do not have the system to manage the adjustment. There are significant asymmetries in economic policy frameworks between systemically important countries such as China and the United States. For example, China retains controls on capital flows and a pegged exchange rate to the dollar, albeit with greater flexibility, constraining adjustments through the balance of payments. Global imbalances and financial fragility are the outcomes of this non-system.
When, in the aftermath of the global financial crisis, monetary policy reached the zero-bound and the Fed resorted to unconventional policies such as QE, the spillover impact of such policies became evident.
Throughout the last four years, since the Fed launched the second round of QE, emerging market economies have swung from currency wars caused by capital inflows to the interest rate wars caused by capital outflows.
The situation, however, remains the same: developing countries with open capital accounts and flexible exchange rates find it difficult to cope with short-term capital movements—with the outflows being excruciatingly harder to manage than the inflows.
This is because, in the current non-system, countries have only one instrument to achieve two or more goals, and thus face a difficult policy dilemma. If capital flows out and the currency plummets because of adverse demand or terms-of-trade shock, should the interest rate be hiked to avoid undermining financial stability and stem inflation? Or should interest rates be cut to support the domestic economy?
For example, having seen the rand losing more than 19 per cent against the US dollar in 2013 while inflationary pressures built up, at the end of January South Africa’s monetary authorities caved in and raised interest rates by 50 basis points to 5.5 per cent. It was the first hike in five years, and it was a difficult and surprising decision where lackluster growth (2.8 per cent expected in 2014), and its corollary of twin deficits, high unemployment and poverty, was assessed against high inflation.
Where do we go from here? As long as asymmetries persist in how systemically important countries adjust to shocks, then policy cooperation is necessary to rebalance the world economy and reduce the effect on innocent bystanders.
The IMF, while reforming its own governance, should embrace the spirit of Bretton Woods—as evoked by Christine Lagarde—and assess whether policy spillovers are an implicit form of "beggar your neighbour".
This means going deeper in and beyond the technical analysis of the spillover report that the IMF has produced in recent years. If not, then Lagarde’s quest for a “new multilateralism for the twenty-first century” might be just rhetoric.
In this case a better description of the prevailing dynamics within the global economy would be the one that Raghuram Rajan suggested: “We [industrial countries) will do what we need and you [developing countries] do the adjustment.” But this seems more the ethos of 1914 than that of 1944.
Paola Subacchi is Research Director of International Economics at Chatham House
The global non-system
February 20, 2014
