Why a Second Bretton Woods Won't Work: The World Economy's Dire Situation Can't Be Fixed with an International Agreement

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Does the world need a new Bretton Woods meeting, as David Smick suggested in the previous issue of The International Economy? Despite the Davos hyper-optimism, the world is in a dire state and certainly needs something. But a new global monetary system run by governments not that this was what Smick was advocating) or, heaven forbid, NGOs and cabals of businessmen and bankers, might be the last thing it needs.

The "non-system" that has been in place for the past four decades has had a mixed record. The 1970s were pretty awful. But they were awful because of failures of policy, not failures of the "non-system." The ossification of many developed economies via government regulation, control, and intervention, substantial union power, high taxes, capital controls, and a rigid financial and industrial technostructure produced a decline in trend productivity. Preserving employment would have required real wages lower than otherwise. And loose monetary and fiscal policies in the final days of the Bretton Woods system, especially in the United States, sparked a commodity price boom that intensified the downward pressure--if employment were to be preserved--on real wages. But unions and governments attempted to resist that downward pressure and many central banks validated that resistance. NAIRUs rose sharply almost everywhere and there was widespread, prolonged, and substantial stagflation. That some countries--notably Germany and Switzerland--performed better than others in this period was largely because they ran monetary policies different from the international consensus. In Germany's case, it was not until the misconceived "coordination" of policies in the Bremen and Bonn summits of 1978 that the country was sucked into the kind of mess already suffered by many others. It is very hard to see, given the intellectual climate of the time and the widespread economic misconceptions and the misdirected political pressure, how some sort of global economic and monetary "system" would not have made things even worse. (At a regional level, the "system" represented by the European "snake" simply could not hold together in those intellectual, economic, and political circumstances).

In the 1980s and 1990s, the "non-system" worked very well. The dramatic changes in economic structure brought about by the tremendous, if not untarnished, efforts of Reagan and Thatcher (not forgetting, of course, the pioneering Roger Douglas in New Zealand) had worldwide demonstration effects. And, just as important, the heroic work of Michael Milken smashed the technostructure, facilitating the productivity revolution of the early 1990s. Globalization and financial liberalization spread capitalism to virtually all parts of the world, lifting hundreds of millions out of poverty. True, there were financial crises in this period, most of them in emerging markets and some of them very serious. But none derailed the march to greater prosperity--except in Japan. That country suffered from its acceptance of international "coordination" in the infamous Louvre Agreement (a certain Jean-Claude Trichet was a crucial player), which not only led very directly to the Wall Street crash of 1987 but also, much more damagingly, gave additional impetus to the final stages of the Japanese bubble. And, of course, the Exchange Rate Mechanism created instability and significant economic damage in Europe.

This was not an ideal world, even aside from the Louvre Agreement and the ERM. But at a global level, it was probably better than anything else the modern world has seen. (What about the final third of the nineteenth century? I'll come back to that.)

Why did things go so badly wrong from the mid1990s? There were three main problem areas and a unifying intellectual mistake. First, U.S. Federal Reserve Chairman Alan Greenspan totally misread the policy implications of the productivity surge in the United States. Second, the monetary union in Europe magnified the faults of the ERM dramatically, with implications not only for its unfortunate members but also for economies such as Britain's with strong trade links with the union. …