Spirit of Bretton Woods, Are You There?

The challenges raised by the current global crisis are not unlike the interwar problems that led to the establishment of the Bretton Woods financial architecture. In the short to medium run, the worldwide slump might lead to conflicts over the appropriate levels of inflation and exchange rates, as well as to protectionist pressures. In the long run, one may need to think of new regulations to reduce the risk of global booms and busts in credit and asset prices. However, in the modern financial environment the appropriate solutions are unlikely to be the same as 50 years ago. For example, floating exchange rates are probably here to stay. We need to revive the spirit rather than the letter of Bretton Woods. To deal with the first challenge I propose a round of multilateral consultations under the auspices of the International Monetary Fund (IMF) on the role of monetary policy in a credit crisis. As for the second challenge, I propose (more speculatively) an international agreement for taxing “systemically risky” financial products.

International Monetary System. If one tried to define an underlying paradigm for the modern international monetary system, it would probably be a set of inflation targeting areas linked by floating exchange rates. This is, of course, not a realistic description of the system as it stands now, but it may be a good model for the end point toward which the system is thought to be converging. By contrast with the Bretton Woods system, nominal anchors are provided by independent central banks that (implicitly or explicitly) target the inflation rate, rather than nominal exchange rates.1

Will the current crisis change the paradigm? I don’t see any reason to think so. In particular, I do not think that the current crisis will put fixed exchange rates back in fashion.2 But the current paradigm leaves room for conflict between different conceptions of how monetary policy should respond to a credit crunch. And these conflicts have an international dimension that is problematic and might lead to protectionism. So while we do not need a new paradigm for the international monetary system, we may need to think about creating a system to mitigate those conflicts.

Let me explain. There is a good economic case for increasing the rate of inflation to, say, 5 or 6 percent, in a credit crunch with a large overhang of debt. First, this is a relatively efficient way of deleveraging the liabilities of debtors, by reducing the real burden of their debt or equivalently inflating their nominal equity. Second, as the literature on the Japanese liquidity trap has shown, the best way to avoid a liquidity/deflationary trap is to credibly commit to a positive level of inflation (what Paul Krugman, called “committing to being irresponsible”).3 And third, the alternative policy mix of fiscal stimulus with low or negative inflation has not worked well in Japan.

However, I do not expect a consensus on the view that inflation is an acceptable way of getting out of a credit crunch. Actually, I would expect many economists, in central banks and outside, to strongly disagree with this prescription. First, one could point to the risk of losing credibility, i.e., the risk that nominal expectations lose their anchor and long-term interest rates increase to levels that hurt the very borrowers that we want to help. I personally think that the credibility problem can be managed in the context of a credible flexible inflation targeting framework,4 but there is room for reasonable disagreement on this. Furthermore, actively pushing up the inflation rate might be inconsistent with the strict inflation targeting mandate of many central banks.

But my point is precisely that there is room for disagreement over how monetary policy should respond to a severe credit crunch. Conflicts may not stay below the surface if the credit crunch is protracted. They may occur not only between the monetary authorities and various domestic constituencies, but also between countries. For example, imagine what the protectionist pressure would be in Europe if the U.S. adopted a strategy of higher inflation that would depreciate the dollar (even though dollar depreciation would not be the primary purpose of U.S. monetary policy).

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