The previous post identified three issues that are likely to figure prominently over the course of 2015.
What are those issues?
- First, the threat of sovereign debt restructuring; most immediately in Greece, where elections this weekend could result in a government committed to reducing the debt burden. Stay tuned.
- Second, exchange rate gyrations, as cleavages between monetary policies around the globe widen. Think: prospective Fed tightening, ECB quantitative easing, Swiss National Bank decoupling and a surprise interest rate cut by the Bank of Canada.
- And, third, the threat of deflation that has stalked the global economy for the past five years or more and which is today coming out of the shadows as a result of the stunning collapse in global oil prices. Look at Europe and Japan.
Together, these challenges represent a huge obstacle to global adjustment and the G20 objective of strong, sustained and balanced growth. In the past few days alone we have seen a number of signs of this obstacle: the IMF has reduced its forecast for global growth; increasing concerns of currency wars have come with, both unexpected and long overdue, policy decisions by central banks; and the prospects of debt restructuring have spread from Greece to Ukraine and Venezuela. In this environment, politics has become fragmented; more polarized. As Paul Krugman might say, we have returned to Depression Economics.
The challenges that confront policy makers pose a potential threat to the global economy.
Thankfully, the institutions that have governed the international economy for the past seventy years or so can help. This "architecture" and particularly the International Monetary Fund was constructed in the wake of the Great Depression to address the problems associated with the global stagnation of the 1930s: persistent deflationary pressures that propagated a paradox of thrift, and currency "wars" in which countries were thought to have devalued their currencies or engineered steep depreciations in order to gain an unfair competitive advantage. Although the details of this narrative are subject to debate — were monetary policy decisions taken to game the system, or simply to shed the golden fetters of the gold standard? — there is no denying that trade protectionism was the result.
And then there was global war.
By 1945, the global economy confronted huge adjustment challenges. In Europe and throughout much of Asia, governments grappled with dislocations of the population, destruction of physical capital and open or incipient financial instability. In Latin America, governments that had defaulted on international bonds in the 1930s worried that the war-led boom in commodity prices would be replaced by a post-war bust. All countries — victors and vanquished alike — struggled with high public debt burdens and a moribund global trade and payments system. In some respects, the global conjuncture of today resembles the toxic mix of stagnation, debt burdens and adjustment challenges that prevailed in that earlier age.
The Bretton Woods system was designed to promote global adjustment. It included measures for orderly, limited exchange rate adjustments (not the irrevocably “fixed” rates by which it is commonly known), which, by reducing the threat of competitive exchange rate depreciations, facilitated a gradual reduction in tariff barriers and currency convertibility for current account transactions. But the Bretton Woods system was much more than that. Capital controls finessed the trilemma of international finance, whereby a country cannot simultaneously limit exchange rate movements, pursue an independent monetary policy and maintain free movement of capital. By explicitly allowing — in fact, presuming that — countries maintain restrictions on capital flows, the system contributed to a steady reduction in public debt burdens through a mix of modest inflation, higher taxes and, most important, strong growth. Indeed, the Bretton Woods era helped foster the global growth that saw the rapid rebuilding of European and Asian economies and dispelled fears of secular stagnation, which in the late 1930s Alvin Hansen thought would impair economic opportunities in the industrial countries.
The question today is whether it is time for the international community to once more come together in a new Bretton Woods. Full disclosure: I have been slightly skeptical of past calls, which I’d argue were based on an incomplete understanding of both the economics and the politics of Bretton Woods; I admit to being more open minded today, not because there is a better appreciation of what the system was intended to achieve but, in large part, because the costs — economic, social and political — of the status quo are so high.
Fortunately, we are better positioned to deal with the threats to global prosperity that we face today because we have institutions at the ready. In some quarters, however, these institutions are perceived to be less legitimate, credible and effective as they must be if they are to assist their members in resolving the adjustment challenges in the global economy. At the same time, the policy tradeoffs on which the Bretton Woods system was erected in the mid-20th century — capital controls and managed exchange rates — may not be possible or desirable in the 21st century.
Flexible exchange rates and capital flows can help facilitate the adjustments needed and preserve the global economy as a source of growth and wellspring of prosperity. In this context, governance reforms are needed at the IMF so that its structure more closely mirrors the global economy of today and not the relative economic weights of the post-war period. Why? Absent such a realignment structure, the institution will lack the authority to effectively supervise the orderly exchange rate adjustments and assist in the effective oversight of global capital markets that are needed to promote sustained growth and to reduce the threat of financial instability. Yet, countries will not persevere with adjustment if the costs are deemed to be too high and the prospective benefits too distant in the future.
That is why the Bretton Woods system needs to be “completed.”
The starting point in that process is improving the framework for sovereign debt restructuring in recognition of the fact that, in today’s integrated global capital market, private capital flows dwarf the resources that the official can bring to bear in the event of a crisis. A Sovereign Debt Forum that promotes timely, orderly restructurings by bringing sovereign borrowers and private creditors together and reduces the obstacles for re-contracting would help. So, too, would contractual terms that extend collective action clauses, provide for the temporary suspension of payments to allow borrowers to adopt policies to “grow the pie” and preserve asset values, and clarify and refine problematic pari passu clauses. While these are important first steps, they represent only partial progress towards the goal of a more effective framework for debt restructuring. Further work is also required to ensure that the institutions needed to support better outcomes—whether formal legal arrangements through treaty law, or informal institutions embodied in the practices of international financial institutions.
In this respect, the policies that the IMF deploys in times of crisis may affect the pace and progress of sovereign debt restructurings as well. Two areas stand out for possible consideration:
- Lending into arrears policy. A key issue is the conditions under which the IMF should lend to a country that has suspended payments to its private creditors. The goal should be to promote restructurings when a reduction in net present value or a lengthening of maturity is necessary. The policy should neither punish governments making good faith efforts to preserve asset values, nor unduly tilt the balance of negotiating power in favour of recalcitrant creditors.
- Access policy. IMF lending policies were subject to scrutiny in the wake of the Asian financial crisis. At the time, this review reflected concerns that IMF lending into a financial crisis could cultivate moral hazard on the part of borrowers and lenders — borrowers defer needed adjustment, hoping for more favourable economic conditions in a gamble for redemption, while lenders continue to fund unsound policy frameworks confident in the knowledge that the IMF will provide the liquidity they need to exit when things turn sour. Following the Greek debt restructuring, concerns have focused on the effect of IMF (and other official sector) lending in subordinating private claims. Because the IMF enjoys a preferred creditor status, which ensures it is repaid in full before the claims of other creditors are serviced, an increase in obligations to the IMF means that the claims of private creditors rank lower.
Admittedly, the prospects for meaningful action on these priorities are mixed. The Fund has undertaken important work in debt restructuring, particularly in terms of supporting improved collective action clauses and revisiting its policies so that it can better assist sovereigns seeking to lengthen the maturity of its debt load. It has strengthened its multilateral surveillance, so that it is better positioned to assess the need for exchange rate adjustments. The IMF lacks effective ‘authority’ (moral or legal) over exchange rate surveillance, however, and a proposal for modest governance reforms has languished at the hands of its largest shareholder, caught up in legislative gridlock.
That being said, there is some reason to hope that progress can be made. In his recent State of the Union Address, President Obama noted that trade is one area where there is agreement between the White House and the Republican-controlled Congress. This applies to trade agreements, over the objection of Democrats in Congress, but would apply even more resoundingly, and with Democratic support in the House and Senate, with respect to perceived currency manipulation. In this regard, how is the U.S. likely to respond to perceptions of efforts to gain an unfair competitive advantage through exchange rate manipulation?
One approach, the unilateral imposition of tariffs, could lead to a destructive tit-for-tat response by those affected and, in any event, in a world of global supply chains could harm U.S. interests as much as it punishes perceived manipulators.
An alternative approach is to secure agreement over the rules of the game for exchange rate adjustment, supported by multilateral surveillance and effective enforcement through an international institution whose mandate is international monetary stability whose members eschew policies injurious to national and international prosperity. We have that institution. It is called the IMF.
America provided global economic and financial leadership to war-weary world in 1945. In doing so, it solidified its moral authority in the ensuing ideological war that followed. The world needs such leadership today. And, while Congress may not be inclined to support the IMF, we sometimes do things we don’t want to do simply because the costs of not acting are too great.
 See Canada and the IMF: Global Finance and the Challenge of Completing Bretton Woods, in Crisis and Reform: Canada and the International Financial System edited by Rohinton Medora and Dane Rowlands, Centre for International Governance Innovation, 2014.