Thursday, June 07, 2007

Bretton Woods II

Randall Forsyth writes the Up an Down Wall Street column for Barron's during the week (and sometimes in the weekly issue as well). Today his column is about the potential unraveling of the so called Bretton Woods II currency arrangement.

IS BRETTON WOODS II heading for the same fate as its predecessor?

Bretton Woods is shorthand for the postwar international monetary system, named for the New Hampshire resort town where its blueprints were laid out by the Allies in the latter days of World War II. The rules called for currencies' exchange rates to be fixed against the dollar, whose value in gold was set at $35 an ounce.

Bretton Woods broke down essentially because our government couldn't decide between guns (Vietnam) and butter (the Great Society). Foreign governments eventually cut off the credit and Nixon removed the last vestiges of the gold standard from the US monetary system. The result was a decade in the economic wilderness known as the 1970s. Dollar collapse, high inflation, gas lines, etc.

Now some believe that the informal system in place since the Asian crisis back in 1998 is also coming unglued.

Central banks have been forced to step into the breach, buying the dollars needed to fund the U.S. current-account deficit, which is equal to about 7% of gross domestic product. In other words, America spends $1.07 for every dollar it earns. Foreign central banks lend us the difference, a form of vendor financing for all those goods produced abroad, especially oil.

In the process, China has accumulated $1.2 trillion of foreign-exchange reserves. Rather than keep piling up Treasuries ad infinitum, China will invest $3 billion of that in Blackstone, which sounds like a lot but equals 0.25% of its reserves.

Less well-publicized is that central banks are just saying "No" to piling up greenbacks. Not selling, mind you, as the disaster-movie scenario envisions; just accumulating at a slower rate.

There are signs that's beginning to happen, as the Bridgewater duo detail. In just the latest, this week Syria became the second Middle Eastern nation to abandon its currency's peg to the dollar, which followed a similar move by Kuwait last month. Meanwhile, a parade of countries has directed an increasing portion of their reserves away from dollars and euros. Among them, the United Arab Emirates, Switzerland, plus America's good friends, Venezuela and Russia. And China announced this week said it, too, will increase the euro's share of its currency cache -- not reducing dollars, but not adding to them as much.

This is the nightmare scenario for US financial markets. If foreign central banks won't take dollars, we've got a big problem. The result would probably be a collapse of the dollar and inflation a la the 1970s. A recession would also be quite likely; a very nasty recession. I don't believe that this will happen because frankly it is not in the best interests of these foreign central banks for it to happen. But if it does.....look out below.

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