The Revived Bretton Woods System: The Effects of Periphery Intervention and Reserve Management on Interest Rates & Exchange Rates in Center Countries

In this paper we explore some implications of the revived' Bretton Woods system for exchange market intervention and reserve management in periphery countries. Financial policies in these countries are seen as a component of a more general portfolio management policy in which the formation of an efficient domestic capital stock is a key objective. Because intervention in financial markets is an important part of their development strategy, intervention in exchange and financial markets has, and we argue will continue to be, large and persistent enough to generate predictable deviations of exchange rates and relative yields in industrial country financial markets from normal cyclical patterns. We argue that management of the currency composition of international reserves by emerging market governments and central banks is unlikely to alter these conclusions.

Interest Rates, Exchange Rates and International Adjustment

In this paper we examine the behavior of interest rates and exchange rates following a variety of shocks to the international monetary system. Our analysis suggests that real interest rates in the US and Europe will remain low relative to historical experience for an extended period but converge slowly toward normal levels. During this adjustment interval, the US absorbs a disproportionate share of world savings. After a substantial initial appreciation of floating currencies relative to the dollar, the dollar and other floating currencies remain constant relative to each other. An improvement in the investment climate in Europe during the adjustment period would generate an immediate depreciation of the euro relative to the dollar. In real terms, the dollar and the floating currencies will eventually have to depreciate relative to the managed currencies. But most of the adjustment in the US trade account will come as US absorption responds to increases in real interest rates.

Bretton Woods II Still Defines the International Monetary System

In this paper we argue that net capital inflows to the United States did not cause the financial crisis that now engulfs the world economy. A crisis caused by such flows has been widely predicted but that crisis has not occurred. Indeed, the international monetary system still operates in the way described by the Bretton Woods II framework and is likely to continue to do so. Failure to properly identify the causes of the current crisis risks a rise in protectionism that could intensify and prolong the decline in economic activity around the world.

Will Subprime be a Twin Crisis for the United States?

We identify incentives generated by the Bretton Woods II system that may have contributed to the sub-prime liquidity crisis now working its way through the international monetary system. We then evaluate the persistent conjecture that the liquidity crisis is or will become a balance of payments crisis for the United States. Given that it happens, the additional costs associated with a sudden stop of net capital flows to the United States could be quite substantial. But we observe that emerging market governments have continued to acquire US assets even as yields have fallen, and the incentives for continuing to do so remain strong. Moreover, the Bretton Woods II system, which has clearly been the most resilient of the forces driving current markets, continues to generate low real interest rates in industrial countries and growth in emerging markets that will help limit the damage from the liquidity crisis.

The Private ECU: A Currency Floating on Gossamer Wings

Today's value of the private ECU is driven by expectations that a European monetary authority will at some future date declare itself willing to convert the private ECU into the official basket at par. Until then, its value is not limited by any existing institutional arrangements in the European Communities, such as the Exchange Rate Mechanism of the European Monetary System. We address the question of what determines the exchange rate between the private ECU and the official Basket, and what determines ECU interest rates. The Bank for International Settlements sets the ECU overnight interest rate on clearing balances as a weighted and lagged average of the money-market rates in the EC currencies, thereby fixing a point on the ECU term-structure. This exogenous fixing of the ECU interest rate and the expectation of a future fixing of the exchange rate satisfy the fundamental requirements for a obtaining a determinate real value of what is otherwise an undefined private ECU unit of account.

The European Central Bank: A Bank or a Monetary Policy Rule

A European central banking institution will be an essential feature of the final stage of the European Economic and Monetary Union. The EC Committee of Central Bank Governors has recently produced a Draft Statute of the European System of Central Banks and of the European Central Bank. The draft Statute mandates the maintenance of price stability as the explicit primary objective of the ECB. and the necessary monetary functions and operations of the system are defined in accordance with standard practice. The maintenance of a stable financial and payments system, however. is not an explicit objective of the ECB. and only limited banking functions are admitted as one of the system's tasks. The draft Statute clearly subscribes to a "narrow" concept of the System of Central Banks with a single objective-monetary stability-rather than a "broad" concept with the additional objective of financial-market stability. In this paper we examine the consequences of a "narrow" central banking system for Community financial markets, We conclude that in the absence of such banking functions it will be necessary to slow or even prevent the ongoing development of Community-wide liquid. securitized financial markets, supported by a large-volume wholesale payments system. Instead, the historically prevalent bank-intermediated financial system will have to be maintained to lower the likelihood of liquidity crises that demand central bank intervention.