1. End of Bretton Woods and rise of floating FX.
2. End of fiscal policy and rise of monetary policy.
The existing international system of floating rates doesn’t have a cool name like Bretton Woods, but it came about after the death of the former fixed rate system. The Bank for International Settlements (BIS), the central bankers’ bank, doesn’t like what its member banks are doing under the current system. While the media and politicians, especially Bernie Sanders, preach fire and brimstone damnation of Wall Street and condemn it for the Great Recession, the BIS body slams the world’s central bankers:
In this essay I shall argue that the Achilles heel of the present-day international monetary and financial system (IMFS) is that it amplifies a key weakness of domestic monetary and financial regimes – their “excess financial elasticity”. By “excess financial elasticity” I mean their inability to prevent the build-up of financial imbalances, in the form of unsustainable credit and asset price booms that overstretch balance sheets, thereby leading to serious (systemic) banking crises and macroeconomic dislocations... This could also be referred to as the failure to tame the “procyclicality” of the financial system.In other words, international capital movements are pro-cyclical in that they amplify the cycle’s highs and lows and generate greater instability. Hayek predicted increased volatility with floating exchange rates in his classic book Monetary Nationalism and Economic Instability published in 1937, which he wrote as a counter attack against the idea of floating rates:
...a system of fluctuating exchanges would on the contrary introduce new and very serious disturbances of international stability.The main cause of the instability would be massive shifts in money caused by traders attempting to escape the collapse of one currency and benefit from the gain of another:
But for the monetary problems with which we are here concerned it is mainly the short term credits which are of importance, because it is here that we have to deal with large accumulated funds which are apt to change their location at comparatively slight provocation.And the floating rate system causes central bankers to have an inflationary bias in the policies. Hayek predicted it:
The possibilities of inflation which this offers if the world is split up into a sufficient number of very small separate currency areas seem indeed very considerable... It leads to a persistent inflationary bias worldwide.And the BIS condemns it:
By highlighting financial imbalances, the excess financial elasticity view stresses the role of the capital, rather than the current, account. And by highlighting the failure to prevent their build-up, it identifies an expansionary, not a deflationary, bias in the system. That said, because the unwinding of financial imbalances results in major contractions in output, the horizon is critical: a persistent expansionary bias paradoxically induces a deflationary outcome.The second cause of financial instability is the switch in mainstream economics from fiscal policy to monetary policy as tools for engineering the economy. The BIS does not mention the change but accepts it as part of the current floating rate system. Until the 1980s, mainstream economists urged the federal government to regulate the economy by increasing spending and reducing taxes during recessions or reducing spending and increasing taxes during expansions. But the fiasco of stagflation in the 1970s caused them to trash fiscal policy and pick up monetary policy as their chief adjustable wrench for fine tuning the economy.
But as nations monkeyed with monetary policy to save their sagging economies, they had to sacrifice the sound monetary policy that had enabled them to maintain fixed exchange rates under Bretton Woods. With little thought, they threw fixed exchange rates overboard in favor of floating rates. Billionaire George Soros generated much of his wealth during this transition by selling pounds to the clueless Bank of England.
So what fixes to the system do the BIS and Hayek propose? The BIS wants central bankers to be more balanced in their policies:
If this analysis is correct, making progress calls for broad-based adjustments to domestic policy regimes and to their international interaction, impinging on monetary, financial and fiscal policies. The essence of the adjustment is to put in place policies that are more symmetric across the boom and bust phases of financial cycles. These policies would lean more deliberately against booms and ease less aggressively and persistently during busts. By so doing, they would reduce the likelihood and intensity of disruptive financial busts and avoid the current expansionary bias policies – an expansionary bias that, paradoxically, over time heightens the probability of major contractions and stagnation.Fat chance of that ever happening! Mainstream economists wet their pants at the mention of deflation and lust for inflation. Hayek was much more realistic. Either the world had to return to a system that forced them to be more balanced, such as a true gold standard in which they could not “sterilize” gold movements, or nations would have to implement controls on the flow of capital:
If this is correct it would be only consistent if the advocates of Monetary Nationalism should demand that monetary policy proper should be supplemented by a strict control of the export of capital.But he added that changes in the prices of commodities traded among nations would tend to thwart capital controls and force nations to control all international trade.
So what does all of this mean to the investor? Old investors have sometimes said that when the foreign investors get into the market it’s time to get out. The BIS paper shows there may be some truth to that. The large amounts of cash that sloshes around the world looking for safety and yield often end up in the US when things are looking worst. As the BIS said about international capital,
For one, it adds an external source of finance that boosts further domestic financial booms. In fact, almost by definition, external funding is the marginal funding source. There is ample empirical evidence consistent with this role. In particular, the cross-border component of credit tends to outgrow the purely domestic one during financial booms, especially those that precede serious financial strains.Since those money flows are pro-cyclical, they make market tops soar higher and last longer than they would under a system like Bretton Woods or a true gold standard.
Hayek’s other solution was to create a single word currency administered by a world central bank similar to the BIS, but one without an inflationary bias. The US dollar has filled that role in the decades since the demise of Bretton Woods, but the Fed’s inflationary bias has wrecked many smaller economies that depend on it as an international reserve currency.