Monetary policy

The Spirit of Bretton Woods

Reuters (M)
Mario Draghi (ECB) and Janet Yellin (the Fed) would do much for both their economic areas if they could meet eye to eye. Source: Reuters (M)

At the end of the Second World War, the victorious powers met in Bretton Woods, at a sweeping luxury hotel in the mountains in New Hampshire, and created an order for peaceful cooperation after the war. The summit led to the establishment of the International Monetary Fund and the World Bank.

The stable monetary order that was established in Bretton Woods lasted until the 1970s. Above all, the attendees were motivated by the realization that cooperation in the economic sphere is necessary to prevent the kinds of tensions that had largely contributed to the war.

We need more of the spirit of Bretton Woods today. This doesn’t mean copying the monetary order of the postwar period, but governments and central banks need to work together more closely. The example of the euro zone shows that intensive trade always leads to intensive financial relations. If this is ignored, it will not lead to another European war, but it will result in a crisis. And the example of central banks also shows that monetary policy can no longer be pursued with tunnel vision relative to national economies – acting purely in the interest of those economies.

It is now becoming clear that the US central bank (the Fed) and the European Central Bank (ECB), as well as the Japanese central bank, are finding it very difficult to bring inflation to the desired level of 2 percent. And long-term interest rates remain stubbornly low in the United States, so that the Fed’s efforts to tighten the reins have not been truly successful.

National interest demands that we expand our point of view.

There can be many reasons for this. Perhaps monetary policy is no longer as effective as it once was, because much of it fizzles out in the financial markets. Perhaps, as Japan suggests, the shrinking of the population and thus of demand creates a kind of natural tendency towards falling prices, which the banknotes tend to counterbalance in what is essentially an uphill battle, always running the risk that, as in the myth of Sisyphus, the boulder will eventually roll back down the mountain.

There are, however, undoubtedly underestimated effects due to the international dovetailing of capital markets. Critics such as hedge fund manager Samir Shah accuse the Fed and other central banks of still clinging to the models of the 1930s, when economies were relatively closed. This may be exaggerated, but it is true that the Fed has only been paying more attention to the international environment for a few years now. Before that, the typical response to questions about the global impact of Fed interest rates was: “We are making monetary policy for the United States.” Implicitly, this meant, “We are not overly concerned about the implications for other regions, such as emerging economies.”

But national interest demands that we expand our point of view. The Fed and the ECB operate in cycles that are displaced relative to one another. While the Fed tightens the reins, the ECB refuses to release them. The effect is clearly evident: European investors, in the search for yield, buy long-term US securities and thus keep their returns low, even as the Fed increases short-term interest rates. This is not a good development for the US. Conversely, this also means that money flows out of Europe instead of providing for more demand and growth.

There has been a similar dynamic in recent decades between the United States and Japan. This has led to the feared “carry trades,” where speculators have borrowed money in yen at low rates and invested the money at higher interest rates in the United States. These capital flows can result in monetary policy having a different effect than planned. Low interest rates drive away money, while high interest rates attract international money and drown the economy in liquidity, as was the case in the United States until just before the financial crisis.

These phenomena make monetary policy even more complex than it already is. The only remedy is  improved coordination among the central banks. At the moment, this would mean that the Fed should proceed more cautiously and the ECB more boldly, so that the two central banks do not interfere with each other for too long. In taking this approach, both central bank would also be accommodating some of their critics.

Raghuram Rajan, currently a professor in Chicago and previously the head of the Indian central bank, has long called for better coordination of monetary policy. The emerging markets suffer in particular when the Fed ignores the side effects of its interest rate policy. They always run the risk of being used as a sort of dollar store of the international capital markets, filled up and emptied as needed. This can cause tremendous damage to individual countries. At least the Fed has been very cautious recently and has avoided such damage. But if it begins to reduce the size of its balance sheet, this could lead to unpleasant side effects once again.


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