Bretton revisited

SERIOUS MONEY: PRICING MISALIGNMENT has become an increasingly common feature of the world's capital markets in recent years extending from the dotcom boom in the late 1990s to the housing and credit sectors in the current cycle, writes Charlie Fell.

However, much of the imbalances and subsequent turbulence of recent times can be traced to the emergence of a revised Bretton Woods system that sees the emerging countries of the Far East and the Persian Gulf tie their respective currencies' exchange rates to the US dollar, the world's reserve currency.

The endgame for the current architecture has now begun as the arrival of a US recession has seen the dollar come under increasing pressure and actions by the Federal Reserve and the Bush administration suggest that both are indifferent to the currency's plight.

Bretton Woods is the exquisite location in the White Mountains of New Hampshire where more than 700 policymakers met in 1944 just weeks after Operation Overlord began with the landing of the first allied troops on the beaches in Normandy. Their mission was to hammer out the final details of the international structure that would be put in place to govern international economic relations once the second World War ended.

The conference at a remote resort hotel at the foot of the tallest mountain in America's northeast is renowned for the battle between the two prominent economists - John Maynard Keynes, who was representing the British treasury, and Harry Dexter White, the chief economist for the US.

White held sway and secured the dollar's position as the world's reserve currency - unfortunately for him the saga did not end there as he was subsequently revealed to be a spy for the Soviet Union.

The current architecture has much in common with the original arrangements, both being composed of a core and a periphery. The core possesses the "exorbitant privilege" of issuing currency used as international reserves and tends to live beyond its meansto provide liquidity to the rest of the world.

The periphery, which is at an earlier stage of development than the centre, is committed to export- led growth fuelled by an undervalued exchange rate relative to the core's currency, and in return recycles its trade surpluses into low-yielding assets issued by and denominated in the currency of the centre currency.

This recycling keeps interest rates lower in the core than would otherwise be the case and this, combined with the periphery's undervalued currency, allows the centre country to acquire foreign assets at cheap prices, which is not greeted with resistance from the periphery due to the transfer of technological know-how and management expertise.

The old Bretton Woods system had the US as its core with Europe and Japan comprising the periphery. More than half a century later and America remains the centre country with Far East Asia, notably China, and the oil-producing Persian Gulf countries being the primary constituents of the periphery. That is where the favourable comparisons end.

The US ran persistent deficits under the original system, providing increased liquidity in the process through a greater supply of dollars. Unlike today, the trade account remained in surplus throughout most of the 1950s and 1960s and the payments shortfall arose primarily from foreign direct investment and the provision of military security, notably in Europe, against the Soviet threat.

However, America's military exploits in Vietnam, combined with loose fiscal policy via LB Johnson's "Great Society" programmes, placed the architecture under increasing strain and growing frustrations with the country's "exorbitant privilege", emanating most notably from France's Charles de Gaulle, spelled the end.

The revised Bretton Woods system has been characterised by negligible savings rates in the US in sharp contrast to the 1950s and 1960s. The lower interest rates arising from the recycling of trade surpluses from the periphery in recent years resulted in an unsustainable debt-fuelled consumption boom alongside a housing bubble that contributed to a sharp increase in unproductive investment. The periphery clearly benefited from US household demand for their cheap exports, but the collapse of America's housing bubble and the subsequent damage to the centre's financial system suggests that this game is now over.

Both the centre and the periphery remain committed to the new Bretton Woods as evidenced by the sharp reduction in official interest rates implemented by the Federal Reserve alongside the notable capital injections to America's banking system emanating from the periphery's sovereign wealth funds.

However, America's low interest rates are far from appropriate for the rapidly growing economies of Far East Asia and the Persian Gulf and not surprisingly, inflationary pressures continue to intensify. The incentive for participants to reduce their dollar exposure grows ever larger.

The greenback remains under significant pressure and, although foreign central banks from Asia and the Middle East continue to accumulate it, private investors remain unimpressed and the currency continues to fall.

Investors would be well-advised to remember the words of Nixon's treasury secretary John Connolly when he said: "The dollar may be our currency, but it's your problem."

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