Chris P. DialynasManaging Director, PIMCO

Renegade EconomicsThe Bretton Woods II Fiction

Marshall AuerbackConsultant to PIMCO

Executive Summary

The world economy is on the threshold of

significant upheaval because of the substantial

structural change in the global financial

architecture, now popularly known as

“Bretton Woods II.”1 Proponents of this

so-called “Bretton Woods II” system argue

that there is nothing inherently unsustainable

about it. It simply represents the reemergence

of a new Bretton Woods regime of global fixed

exchange rates, based on structural current

account deficits in the U.S. and structural

current account surpluses in Asia, with the

Asian current account surpluses recycled to

provide cheap financing for the U.S. current

account deficits. The U.S. gets to consume more

than it produces and finance budget deficits

cheaply, while strong export growth drives East

Asian growth rates and rapid industrialization

absorbs the labor surplus created by China’s

underemployed rural population. In this view,

this new BWII regime will allow the U.S. to

finance its large current account deficit at a low

cost for a long time; consequently, the United

States’ growing external indebtedness poses few

immediate concerns. In the paper below,

we disagree.

In contrast to its forebear, BWII is not global in

scope; nor does it retain any vestigial linkage to

gold, nor any contractual obligations. It is less a

monetary “system” and more monetary fiction,

articulated to rationalize the dollar’s perverse

resilience in the face of America’s increasingly

parlous debt build-up and America’s seeming

immunity to Third World style debt-trap

dynamics. It artificially distorts risk premiums

and encourages destabilizing financial practices

such as the so-called “yen carry trade.” A

misleading snapshot, it ignores the harmful

impact of today’s exchange rate anomalies,

rather than seeing them for what they are: the

roots of a convoluted financial architecture,

which have—and continue to create—great

imbalances that ultimately threaten global

stability and freedom.

All parties that have embraced the conventions

of BWII have had good short-term reasons for

doing so. The U.S. has acceded to this arrange-

ment because it has served to boost U.S. asset

prices and lower risk spreads, thereby helping

to facilitate America’s “guns AND butter”

foreign policy. In the absence of its Asian credi-

tors acting as “dollar sub-underwriter of last

resort,” it is hard to envisage a chronic debtor

– � –

country like the U.S. mounting successive wars

with little financial strain and an absence of tax

increases.

Similarly, from the Asian perspective, BWII

seems to make good short-term sense in that

the consequent build-up of foreign exchange

reserves has enabled them to avoid a repeat

of the economic calamity that afflicted the

region ten years ago. Virtually all of the

governments in the region have sought to

keep their currencies cheap, developing Asia’s

total reserves have jumped from $250 billion

in 1997 to $2.5 trillion this year. The desire

to build up reserves is understandable in light

of the Asian financial crisis of 1997 and is a

direct result of the massive devaluations in the

region at that time, but they are now excessive.

Furthermore, they do not actually give the

Asians the insurance they seek to avoid another

disruptive financial crisis. On the contrary,

they actually add to the potential for another

one. By keeping their currencies artificially low,

recycling the resultant current account surplus

savings back into dollars, they are driving down

risk premiums and subsidizing uneconomic

lending. The creditor nations all face capital

losses on their reserves as the dollar declines,

while running the economy according to an

exchange rate target means abandoning control

of domestic policy. This is the price they are

willing to pay to put otherwise idle resources to

work to build investment internally from cash

flow as long as current systems persist. But in

contrast to 1997, the initiative rests with them,

not the Americans.

Most analysis of the Asian financial crisis has

tended to ignore the role played by China’s

policy of “beggar thy neighbor” devaluations,

which began in the late 1980s and later set the

stage for the loss of East Asia’s export com-

petitiveness. But it is the ongoing fear of losing

competitiveness relative to China that has

played a big role in these countries’ reluctance

to allow their exchange rates to appreciate any

more rapidly. If China allowed its currency,

the Yuan, to rise, they would have less need to

intervene. China, more than its neighbors, may

have drawn the wrong lesson from the crisis.

In effect, China created the crisis in the first

place and learned the power of exchange rate

manipulation as a development tool.

As China’s current inflationary pressures

illustrate, the policy generates unsterilisable

increases in foreign currency reserves, which in

turn causes excess monetary growth, domestic

asset price bubbles, overheating, inflation and

the loss in competitiveness that governments

had tried to prevent by suppressing the rises

in nominal exchange rates. It distorts domestic

financial systems, by pushing interest rates

below equilibrium levels. It floods the market

with an excessive supply of goods and then

subsidizes purchases by subsidizing credit. It

generates a waste of resources in accumulation

of low-yielding foreign currency assets exposed

– � –

to the likelihood of huge capital losses—losses

on reserve which would not have existed if

China had revalued its currency in the first

instance. The benefit that accrued to China was

a much more rapid development of its capital

base, industry, and infrastructure. But retain-

ing the policy today makes all Asian economies

excessively dependent on demand from outside

the region. It exacerbates U.S. protectionism.

A perpetuation of existing exchange rate poli-

cies, then, based on flawed economic analysis,

is creating broadly similar conditions to those

that prevailed before the Great Depression.

History suggests great economic hardship will

follow and that it will be proportionately borne

greatest by the debtor nations. But the creditor

nations will be afflicted as well as they suffer

the loss of their largest export market, and the

risk of an economically aggrieved America

increasingly prone to resolve its difficulties

through the embrace of military unilateralism.

Failure to implement policies that alter the

otherwise inevitable expansion of these deficits

will result in a very bad outcome—one whose

form is impossible to predict. For context of the

unpredictable, it is useful to recall Princeton

economist Frank D. Graham’s 1943 essay titled,

“Fundamentals of International Monetary

Policy.” He states, “In international affairs we

must therefore strive to reconcile the liberty of

the individual, the sovereignty of states, and

the welfare of the international community.”

Graham understood that poorly crafted sets of

economic policies and rules in a global economy

would lead to great imbalances that threaten

stability and freedom. His analysis and insights

applied to the two world wars of the last century

as well as to the Great Depression. They also

apply to global circumstances today. More

specifically, Graham argues that a poorly regu-

lated fixed-exchange rate regime is inherently

unstable. Countries will cheat by setting their

currency at rates that promote national agendas,

ignoring the instability imposed upon the global

economy. They become “renegade nations” in

effect practicing “renegade economics.”

Rather than capitulate to the false logic of

Bretton Woods II, we propose a Japan-style

zero interest rate policy (ZIRP) for the U.S. in

combination with strategic and iterative fiscal

tightening as a targeted response to global

imbalances, creating a “synthetic” trade tariff

for foreign exporters of capital, and effecting a

redistribution of wealth from asset-rich savers

to debt-laden consumers in the U.S. Along

with this, a substantial revaluation of the Asian

currencies, led by China is in order. The desired

policy objective is to eliminate the U.S. twin

deficits and reduce U.S. debt levels without

inducing an asset-deflation driven economic

recession, explicitly legislating protectionism or

encouraging heightened militarism, all of which

threaten to reverse the progress of globalization

and rising global economic prosperity.2

– � –

RENEGADE ECONOMICS3 The Bretton Woods II Fiction“In a capitalist world, free trade is the cement which holds together the idea of peace…” Joseph Schumpeter, 1921

IntroductionDo today’s lopsided financial imbalances

in the global economy pose a grave threat

to long-term prosperity and political

stability? Apparently not, if one accepts the

logic behind “Bretton Woods II.” Messrs.

Dooley, Folkert-Landau, and Garber,

who first coined the term, argue that it

represents a continuation by other means

of the dollar-centered international order

that prevailed in the post-war decades.

They maintain that a new exchange rate

regime has emerged from the ashes of the

original Bretton Woods accord (that lasted

between 1945 and 1973), one that will allow

the U.S. to finance its large current account

deficit at a low cost for a long time. If one

accepts their thesis, neither the United

States’ growing external indebtedness,

nor China/East Asia’s mounting external

surpluses pose any immediate threat.

We disagree and express concern.

Per Webster’s dictionary, a system is de-

fined as “a complex unity formed of many

often diverse parts subject to a common

plan or serving a common purpose.” It

would be charitable in the extreme to con-

fer this definition on BWII, which is to the

gold standard what a five-year old finger-

painting child is to Monet. The hallmark of

the classical gold standard was the prompt

adjustment of international payments im-

balances. The hallmark of the pure paper

standard is the indefinite postponement of

international payments imbalances, all the

more so when its major violator possesses

sufficient military “currency” to prevent

its creditors from punishing it for ongoing

profligacy. Under the gold standard, a

deficit country, if it persisted in its deficit,

would eventually run out of gold. Under

Bretton Woods II, a deficit country, if it is

the U.S., can keep right on printing money,

especially if its creditors on the other side

are equally determined to perpetuate poor

economic policies that enable them to

avoid the obligations otherwise imposed

on them by an externally imposed and

neutral system such as the gold standard.

The gold standard prohibited consuming

more than the stock of gold in the Treasury

and since it was beyond the control of any

one nation, it made serial abuse of the

system virtually impossible.

If BWII is indeed an offspring of Bretton

Woods I, then, it can best be described as a

bastard child. In contrast to its forebear, it

is neither global in scope, nor does it retain

any vestigial linkage to gold, nor any

contractual obligations. It is less a mon-

etary “system” and more monetary fiction,

articulated to rationalize the dollar’s

perverse resilience in the face of America’s

increasingly parlous debt build-up and

America’s seeming immunity to Third

World style debt-trap dynamics.

A misleading snapshot, it describes the

structure now in place, but neither gives

“The hallmark of the pure paper standard is the indefinite postponement of international payments imbalances.”

– � –

any indication of how the foundations

came to be constructed, nor whether they

create the basis for rational economic

policy-making in the future. And most

significantly, it ignores the deleterious

effect of today’s exchange rate anomalies,

rather than seeing them for what they

are: the roots of a convoluted financial

architecture, which have—and continue to

create—great imbalances that ultimately

threaten global stability and freedom.

“Renegade Nations”As long ago as 1943, Princeton economist

Frank D. Graham recognized that a poorly

constructed exchange rate regime was

inherently unstable. In his essay, “Funda-

mentals of International Monetary Policy,”

Graham spoke of so-called “Renegade

Nations,” defined as any country

“…which insists upon keeping the exchange

rate of an inconvertible currency out of corre-

spondence with its internal value (as measured

in relative national price levels) and, in order

to do so, is prepared to inject disorder into

international transactions or to establish such

rigid controls of foreign trade as will prevent

the disequilibria in price levels from coming to

expression in a lop-sided balance of payments.”

In the context of Bretton Woods II, it is

easy to see how countries such as China,

India, Russia, the nations of East Asia, and

Japan would all appear to fall under this

definition of renegade nations. Japan has

largely managed to avoid being the focus

of policy pressures to revalue the yen in

part because Wall Street has made copious

use of Japanese cheap short-term financing

through the so-called “yen carry trade.”

This monetary laxity on the part of the

Bank of Japan (facilitated by the Ministry

of Finance’s somewhat contractionary

fiscal policy, which enabled the BOJ’s

monetary policy to remain more accom-

modative than might have otherwise been

possible) has served to boost U.S. asset

prices and lower risk spreads, thereby

helping to facilitate America’s “guns AND

butter” foreign policy. In the absence

of the Bank of Japan acting as “dollar

sub-underwriter of last resort,” it is hard

to envisage a chronic debtor country like

the U.S. mounting successive wars with

little financial strain and an absence of

the kinds of tax increases, which might

otherwise politically constrain the country.

Indeed, part of Japan’s own national debt

is itself a product of its efforts to help prop

up America’s global imperial stance.

Great Britain is sometimes called

America’s “51st state.” If so, then Japan is

most certainly the 52nd. Both Tokyo and

Washington view their monetary/military

alliance as the best means of forestalling

Beijing’s dominance of Asia and beyond;

both have exploited the North Korean

nuclear issue and the delicate question of

Taiwan’s future political status as a covert

means of adopting a more assertive, con-

frontational military strategy in the Asia

Pacific region—much to Beijing’s chagrin.

These strategic considerations above all

else have enabled Tokyo to evade criticism

or shame for its part in creating today’s

huge financial disequilibria. It has also

– � –

enabled the U.S. to finance its militarism

on the cheap, since the constant recycling

of Japan’s current account surpluses into

dollars has reduced the cost of America’s

debt, in spite of the latter’s ongoing

profligacy.

What about China? Whereas one could ar-

gue that Japan at least offers America some

sort of strategic “burden sharing” in the

global war on terror as mitigation for the

abdication of its international monetary

responsibilities, it is hard to make the same

case for the People’s Republic of China. If

anything, the PRC in particular furnishes

the underlying “glue” to BWII and most

explicitly (in the words of Professor

Graham) “insists on keeping the exchange

rate of an inconvertible currency out of

correspondence with its internal value (as

measured in relative national price levels),”

thereby “inject(ing) disorder into interna-

tional transactions.” Such renegade nations

in effect practice “renegade economics.”

Although today’s focus on China tends to

highlight its huge and growing bilateral

trade surpluses with the U.S. (and to a

lesser extent, the Euro bloc), less appreci-

ated is the degree to which its exchange

rate policies have historically impacted

on its Asian neighbors and continue to do

so to this day. As recently as 1994, Beijing

precipitously devalued the renminbi

against the greenback, taking it from

5 to 8.4, a 60%+ devaluation. Even this

action understates the magnitude of the

change, since it was preceded by a period

during which the country’s monetary and

financial authorities embraced a policy in

which the yuan declined some 60 percent

against the dollar (see Appendix). So much

for the need for policy incrementalism, as

the Chinese persistently argue today when

confronted with the need of a substantial

yuan revaluation. The devaluations engen-

dered minimal disruption domestically.

On the contrary, the ultimate impact was

to “export” economic dislocation to East

Asia and Japan; the cost advantage it con-

ferred on China’s exporters significantly

eroded the trade competitiveness of other

East Asian and Japanese exporters, thereby

throwing their collective current accounts

into substantial deficit by the mid-1990s,

and setting the stage for the Asian finan-

cial crisis of 1997 and Japan’s “lost decade”

(and the corresponding implementation in

Japan of a zero-interest-rate policy, which

ultimately provided the foundation for the

so-called “yen carry trade”—another grave

source of future financial instability).

The Asian Financial CrisisThe 1997 Asian financial crisis is highly

instructive in terms of illustrating the

malign effects of perpetuating poorly

regulated fixed-exchange rate regimes in

the face of mounting financial imbalances.

Much of the analysis of the 1997 debacle

has focused on its after-effects, in particu-

lar, the role of the International Monetary

Fund (whose misdiagnosis of the crisis

led them to offer bad policy advice that

exacerbated it), the impact of dollar-de-

nominated debt, the corresponding role

played by structured financial derivatives

“Less appreciated is the degree to which its exchange rate policies have histori-cally impacted on its Asian neighbors and continue to do so to this day.”

– � –

which were tied to this foreign debt, and

the damage caused by rapid withdrawals

of capital on the part of Western banks and

fund managers as devaluations spread

across the region.

The end result of the crisis was that

around 50 million of the combined over

300 million people of Indonesia, Korea,

and Thailand fell below the nationally

defined poverty line between mid-1997

and mid-1998. Many millions who were

confident of middle class status felt robbed

of lifetime savings and security. Public ex-

penditures of all kinds were cut; creating

“social deficits” that matched the economic

and financial ones. Nature was pillaged as

people fell back on forests, land, and sea

to survive. Indonesia’s real GDP shrank 17

percent in the first three quarters of 1998,

Thailand’s 11 percent, Malaysia’s 9 percent,

and Korea’s between 7 and 8 percent. It

took nearly two years to reach the bottom.

Although not initially apparent, China’s

“beggar-thy-neighbor” devaluation poli-

cies sustained throughout the early part of

the 1990s ultimately played a significant

role in destabilizing and devastating East

Asia’s populations. According to the data

provided by the Asian Development Bank,

Malaysia began experiencing substantial

problems with her current account

position by 1991 (when Beijing initiated

the first in a series of devaluations against

the dollar), culminating with a deficit

equivalent to −9.78 percent of GDP in 1995

and −6.0 percent of GDP between 1991 and

1997 on average. The Philippines’ average

current account deficit for the same period

of 1990–1997 was −4.2 percent of GDP

whereas Thailand’s deficit for the five years

preceding the Asian crisis was estimated

to be around −5.6 percent of the country’s

GDP. In contrast, by 1990 China’s trade

balances were already almost 3 percent

of GDP. By 1994, these had grown to 4.2

percent; there was no compelling need for

further currency depreciation. Yet by 1997,

following a further 60 percent devaluation

of the remninbi against the dollar, China’s

trade balances as a percentage of GDP had

rocketed to 6.7 percent. Whilst many have

lauded Beijing’s “statesmanlike” actions

in holding the line against the wave of

competitive currency devaluations that

swept across East Asia in 1997 (thereby

preventing a worsening of the financial

contagion), such praise ignores China’s

earlier role in initiating the crisis in the

first place. Consequently, even as China

continues to closely manage its currency

against the U.S. dollar today and limits

its appreciation, other Asian competitors

feel compelled to do likewise, particularly

Japan, in order to retain relative com-

petitiveness and avoid a repetition of the

calamity that befell the region a decade

ago. But this factor has been virtually

ignored in the economic literature assess-

ing the period. Therefore, most analysis

tends to miss the key lesson to be learned

from the crisis—namely, how economic

misdiagnosis can lead to the wrong set of

policies being adopted and the calamitous

after-effects. This has implications for the

global economy today.

– � –

Based largely on their experience in Latin

America, the IMF imposed on Thailand,

Indonesia, and Korea, a prescription of

high real interest rates and fiscal restric-

tion. Historically, fiscal deficits tended

to be large and inflation chronic in Latin

America. Currency devaluations therefore

set off hair-trigger inflationary expecta-

tions. So IMF-style austerity in that context

seemed plausible. In Asia, however, lack of

export competitiveness (initially brought

about by China’s extraordinary 1990s

devaluation) meant that weaker currencies

were precisely what were required, absent

a Chinese revaluation, to render their

tradeables sector competitive with China

again and bring their collective current

accounts back into balance.

Unfortunately, like the IMF, East Asia’s

financial and monetary authorities also

drew the wrong conclusions from the

crisis. The Fund wanted higher interest

rates and stronger currencies to forestall

inflationary pressures and mitigate capital

flight. East Asia’s monetary authorities,

however, concluded the opposite: the

problem was not pegged, but overval-

ued, exchange rates. The correct policy

response, they collectively determined,

was to maintain perpetually competitive

exchange rates, pegged against the dollar

well below levels prevailing before the

crisis. They wanted to retain their tradi-

tional development model of export-led

growth and huge accumulations of foreign

currency reserves, irrespective of the

broader global economic implications.

Although the embrace of weaker curren-

cies made sense in 1997/98 to help restore

the region’s growth and lost savings, the

indefinite perpetuation of massive under-

valuation in the face of rapidly changing

external circumstances did not. As a rule

of thumb, a country should have enough

reserves to cover its short-term foreign

debt. On the eve of the crisis in June 1997,

for example, South Korea’s reserves were

only one-third as big as its short-term debt.

But today the position is substantially

different: As of June 30, 2007, the foreign

currency reserves of the Asia/Pacific

had reached $3,280 billion, up by $2,490

billion since the beginning of 1999. China’s

foreign exchange reserves alone reached

$1.33 trillion, up by over $1.2 billion over

the same period. Japan’s forex reserves

have expanded from around $125 billion

in 1994, to $225 billion by 1997, and $924

billion today.

So whilst a substantial accumulation of

reserves seemed a justified (if expensive)

form of insurance in the aftermath of the

Asian financial crisis (although totally

unnecessary for a mature economy like

Japan), today’s levels are excessive, particu-

larly as the exchange rate policies do not

actually give the Asians the insurance they

seek to avoid another disruptive financial

crisis. On the contrary, they actually add

to the potential for another one. Exchange

rates are once more, in effect, tied to the

dollar. The ongoing embrace of mercantil-

ism risks creating a new, but different

financial crisis—not a balance-of-payments

shock like last time, but booms and busts

“The ongoing embrace of mercantilism risks creating a new, but different financial crisis—not a bal-ance-of-payments shock like last time, but booms and busts in asset markets.”

– � –

in asset markets. By keeping their curren-

cies artificially low, recycling the resultant

current account surplus savings back into

dollars, the nations of China, East Asia,

and Japan are driving down risk premi-

ums and subsidizing uneconomic lending

of the sort that leads to asset bubbles.

Furthermore, these kinds of imbalances

would have never been possible under a

gold reserve system, under which money

supply (and therefore credit) was limited

by the quantity of gold reserves. To take

an example from the early 20th century:

suppose technological innovation brought

about faster real economic growth in the

United States. With the supply of money

(gold) essentially fixed in the short run,

this would have caused U.S. prices to fall.

Prices of U.S. exports would then fall rela-

tive to the prices of imports. This in turn

would cause the British to demand more

U.S. exports and Americans to demand

fewer imports. A U.S. balance-of-payments

surplus was created, causing gold (specie)

to flow from the United Kingdom to the

United States. The gold inflow increased

the U.S. money supply, reversing the initial

fall in prices. In the United Kingdom, the

gold outflow reduced the money supply

and, hence, lowered the price level. The

net result was balanced prices among

countries. This type of situation clearly

does not pertain under BWII. In addition, it

provides no long-term “insurance” policy

for East Asia, Japan, or China. However

much these nations adopt exchange rate

policies geared to insulate their respective

economies from the risk of disruptive

capital outflow, their insistence on keep-

ing the external value of their respective

currencies out of correspondence with

its internal value (to paraphrase Professor

Graham) is injecting great disorder into

the global economic order.

Chinese policy itself specifically remains

captive to the renminbi-dollar exchange

rate; therefore, East Asia and Japan follow

in kind. They all face capital losses on

their reserves as the dollar declines, while

running the economy according to an

exchange rate target means abandoning

control of domestic policy. As China’s cur-

rent inflationary pressures illustrate, the

policy generates non-sterilizable increases

in foreign currency reserves, which in

turn causes excess monetary growth,

domestic asset price bubbles, overheating,

inflation and the loss in competitiveness

that governments had tried to prevent by

suppressing the rises in nominal exchange

rates. It distorts domestic financial

systems, by pushing interest rates below

equilibrium levels. China’s stock of foreign

exchange reserves has exploded: in 1990,

these were around $35 billion. By 1994,

they were just over $50 billion. By 1997,

they were approaching $150 billion. Today,

they are over $1 trillion. The resultant

liquidity surge has flooded the market

with an excessive supply of goods and

then subsidizes purchases by subsidizing

credit. It generates a waste of resources

in accumulation of low-yielding foreign

currency assets exposed to the likelihood

of huge capital losses—losses which

would not have existed if China had

– 10 –

pursued a gradual revaluation of its

currency much, much earlier. Of course,

if not for the mercantilist exchange rate

policy, the accumulated reserves would be

much smaller. Policy should not concern

itself with potential losses on this stock

of reserves, but should seek a balance in

future flows. It makes all Asian economies

excessively dependent on demand from

outside the region. It exacerbates U.S.

protectionism.

The 1920s Parallel and the Lead Up to the Great DepressionBretton Woods II simply rationalizes and

perpetuates the problems, rather than

offering a genuine palliative. And given

today’s turbulent geopolitical backdrop,

it is worth recalling that it was a world

of global imbalances that eventually

proved very vulnerable to the protection-

ism, economic barriers and, later, global

military conflict, that characterized rela-

tions amongst several nations during the

1930s and 1940s. Summarizing the period

preceding the Great Depression, PIMCO’s

Chris Dialynas and Saumil Parikh note

ominous parallels with today’s world:

“During the 1920s, Great Britain suffered a

decade of deflation and capital shortage thanks

in no small part to World War I. Estimates

suggest that Great Britain paid a quarter of

its wealth to the United States during World

War I, and the ensuing decade produced

listless growth as a result of economic and

currency policies that were misdirected at

the real problems facing the British economy.

Germany suffered even worse. The 1919 Treaty

of Versailles, dubbed by an already prominent

British economist by the name of John Maynard

Keynes as ruinous to German and global

prosperity, eventually resulted in the German

hyperinflation of 1922-23, and economic

decimation of a rising German middle class

in the decade that followed. Germany, which

had already borrowed significantly to finance

its operations in World War I, had abandoned

the gold standard for its currency in 1914. By

1919, with the war having prolonged for longer

than German expectations, and costs out of

control, price levels in Germany had already

doubled from 1914. A fragile Weimer Republic

was faced with external and internal turmoil

thereafter. Primarily as a means of calming

social dissonance within Germany, the Weimar

government ramped up social transfer pay-

ments, which combined with a failed tax hike

in 1920 caused the fiscal deficit as a percent of

GNP to reach 99 percent in 1923. At the same

time, Germany was running a current account

deficit to the tune of 7 percent of GNP, financed

primarily in German marks by capital inflows

from bank accounts in the United States and a

weakening exchange rate. In 1923, Germany

defaulted on war reparations to the League of

Nations, which eventually led France to occupy

the most productive industrial region of Ruhr

in Germany and a concurrent final depreciation

of the German mark due to current account

imbalances. Passive resistance in the Ruhr

and general strikes by miners and industrial

workers meant further economic stagnation

for Germany. Significant shifts in global trade

dynamics dominated this period as Russia and

China were effectively closed to the West, and

“It was a world of global imbal-ances that eventu-ally proved very vulnerable to the protectionism, eco-nomic barriers and, later, global military conflict, that char-acterized relations amongst several nations during the 1930s and 1940s.”

– 11 –

Great Britain and Germany suffered in their

post-World War I hangover. The U.S. export

machine was becoming dominant and the U.S.

trade surpluses in 1920 exceeded 9 percent of

GNP. Japan also achieved a global net creditor

status during this decade, thanks mostly due to

the consumption demand from Europe during

World War I, and also due to the descent of

Great Britain and Germany, two of its largest

competitors in global markets, a decade later. It

was a world of global imbalances that eventu-

ally proved very vulnerable to the protectionism

and economic barriers undertaken in Europe,

Great Britain and the U.S. by the early 1930s.

The summer of 1932 marked the trough for

U.S. economic growth, which was well in the

midst of the Great Depression starting in 1929.

Global sovereign defaults were well underway

by 1936. Turkey, China, Bolivia, Peru, Cuba,

Brazil and Colombia all defaulted on their debts

in 1931. Hungary, Yugoslavia, and regrettably

Greece defaulted in 1932. In 1933, Austria

and Germany joined the club. And, by 1934,

all debtor countries except Argentina, Haiti,

and the Dominican Republic had suspended

debt service. Are we to accept the conventional

wisdom that a mistaken, overly restrictive

monetary and fiscal policy in the U.S. created

the Great Depression and led to these global

sovereign defaults? It seems equally, if not

more likely, that an imbalanced global trade

system jarred by restructuring in Germany and

Great Britain, and by prior revolutions against

free markets in Russia and China may have

been the initial and crucial culprit. The global

constriction of trade was the result of several

dependent and independent political and

economic upheavals during the decade follow-

ing World War I. It is a massive presumption

to state that a more stimulative Federal Reserve

(a la 2001-2002) could have prevented the

course of events in the early 1930s.” (“A Zero

Interest Rate Policy (ZIRP) Remedy to Global

Imbalances,” Chris P. Dialynas and Saumil H.

Parikh, April 2006)

A Rebuttal of Bretton Woods IIWhat about the U.S. role? Less appreciated,

but also noted in the foregoing PIMCO

paper, the U.S. also deserves this “ren-

egade” status, “in that its fiscal deficit and

private debt are in such disequilibria that

its national savings rate is negative.” An

overvalued dollar means little in the way

of national savings (since there is a natural

preponderance to consume in an overval-

ued currency on the future expectation

that it drops in value). And there is little

political appetite for tax increases to fund

the military option, given the ongoing

willingness of East Asia, Japan and China

to fund American wars on the cheap.

Since the U.S. first became a debtor nation

15 years ago, it has accumulated almost

$3 trillion in debt obligations abroad.

The U.S. current account deficit itself is

now in excess of 6.5 percent of GDP, and

Wynn Godley of the Levy Institute tells

us that this level puts the U.S. economy

at risk of debt trap dynamics with an

accelerating deterioration in its net foreign

asset position and its overall current

balance of payments going negative (as

net income paid abroad begins to explode

and overwhelms export revenues). Further

reinforcing America’s renegade status

– 1� –

is an increasingly militaristic foreign

policy; unlike the British Empire, which

ran substantial current account surpluses

during its imperial heyday, there is simply

no historic precedent for a country playing

the role of global superpower whilst being

the world’s largest debtor nation.

Bretton Woods II implicitly repudiates the

risk of debt trap dynamics. Its champions

argue that the U.S. current account deficit

can increase without limit. They maintain

that many foreign central banks, particu-

larly the large savings surplus countries

in East Asia, are willing to absorb all the

foreign currency earned by their exporting

sectors that is not willingly held by their

private sector in U.S. dollar-denominated

assets. They further state that foreign

central banks are willing to take losses

on their U.S. dollar-denominated holdings,

if that is what is necessary to maintain

stable or slowly appreciating foreign

exchange rates, which in turn are crucial

to achieving high domestic income growth

rates and the rapid accumulation of a

globally competitive, domestic capital

stock in their nations.

In this configuration, the apologists for

BWII argue external debt trap dynamics

are ignored by central banks that are not

acting as profit maximizers with respect to

their own portfolios, but rather acting in

the interest of maximizing the growth of

their domestic capital stock. The balance

of payment constraint cannot apply to

U.S. growth until foreign central banks

perceive they no longer need to assist the

game of catch up. Asia is pursuing, and

can afford to shift away from neo-mercan-

tilist (export-led) growth models to one

driven by domestic middle class consumer

spending paths.

In a more recent iteration of the BWII

hypothesis, the authors behind the thesis

offer a new rationale that is aimed at

explaining the large accumulation of

forex reserves by Asian central banks. The

essence of their argument is that China

and other emerging market economies

(i.e., the “periphery economies”) have

poor, illiquid domestic financial markets

and it is therefore better if their savings to

investment projects are not intermediated

by their home markets, but rather by inter-

national financial intermediaries toward

the rich “center.” So, Chinese and Asians

should put their savings in international

banks and these funds will return to Asia

in the form of Foreign Direct Investment.

The problem with FDI, however, is that

one can only support gross international

capital flows of today’s magnitudes with

“collateral” of one form or another. The

authors liken the process to an implicit

economic contract between the U.S. (“the

center”) on the one hand and the “pe-

riphery” East Asian nations on the other,

who collectively agree to a standard total

return equity swap. In such “contracts”, the

less creditworthy party to the contract is

required to post “collateral” for actual and

potential mark to market losses.

The U.S. current account deficit therefore

purportedly represents not a form of

“Its champions argue that the U.S. current account deficit can increase without limit.”

– 1� –

potential financial fragility, but a sup-

porting mechanism to a swap contract. It

reflects international collateral, which in

turn supports two-way trade in financial

assets that liberate capital formation in

poor countries from inefficient domestic

financial markets. Contrary to the

widely held assumption of development

economics that capital must flow from

rich countries to poor ones, therefore,

the theorists behind BWII suggest that

net capital inflows to rich countries,

such as the U.S., are essential for global

economic development, as such inflows

represent the “collateral,” the absence of

which would derail international financial

intermediation. In this framework, the U.S.

is no longer a renegade debtor nation, but

almost akin to a central clearing house,

which represents the best depository and

manager of collateral.

How strong are those arguments of the

Bretton Woods II proponents? Whilst

it may be proper to distinguish, (as

Dooley Folkert-Landau and Garber all do),

between the profit maximizing behavior

of private sector agents and the actions

of central bankers—which are largely

driven by broader social and economic

considerations, particularly the prevention

of disorderly market conditions (ironically

the prevention of which themselves are

creating the foundation for future financial

instability)—the private speculator/official

sector distinction drawn neither eliminates

the remorseless arithmetic of compound-

ing interest rates implied by the onset of

debt trap dynamics, nor the additional

costs posed to homeland security, given

that the transfer of wealth implied by

America’s current account deficit indirectly

finances foreign terrorist organizations

and terror sponsoring states at the margin.

By extension, BWII understates risk. Intui-

tively, an environment in which war and

terrorism proliferate ought to increase the

risk of investment, not decrease it. By the

same token, a regime based on structural

current account deficits in the U.S. and

structural current account surpluses in

Asia, (in which the Asian current account

surpluses are recycled to provide cheap

financing for the U.S. current account

deficits), presupposes a relatively free

flow of capital at both ends. However, the

reality is the opposite: capital cannot freely

flow into and out of China and even if it

could, property laws do not seem to be

sufficiently well developed, consequently

rendering the risk of expropriation by the

government quite high. Finally, the U.S.

twin deficits, longstanding pension indus-

try problems and the contagion emanating

from the sub-prime mortgage crisis, all

pose future policy risk uncertainty for

capital being recycled back into the U.S.

The BWII analysis also ignores the risks

posed by mounting trade protectionism in

response to these growing imbalances. To

the extent that protectionism succeeds in

reducing the imbalances in U.S. trade, also

reduces the increase in dollar savings held

in the hands of foreigners. Assuming no

change in their portfolio preferences away

from U.S. assets (a not entirely realistic

– 1� –

assumption, as there may well be some

form of retaliation which reduces the

proclivity to hold dollars), there is in fact

less foreign savings available then for them

to disperse additional external financing

requirements at the margin and risk

premiums revert to “normal” levels.

Protectionism is also a very blunt policy

tool, which cannot be directed specifically

against one particular offending trading

partner. Although the rules of the WTO

allow for the imposition of a general tariff

to correct grave financial imbalances, these

must be “non-discriminatory,” which

means they cannot be applied specifically

against China, East Asia or Japan or any of

the other specifically “renegade” nations.

It means non-offending parties get caught

in the crossfire as well, as was the case,

for example, when President George W.

Bush, introduced a temporary levy on steel

imports, penalizing its closest ally in the

war on terror, Great Britain, in the process

(a country, which by and large has played

by rules of free trade).

Additionally, in the absence of self-disci-

pline on the part of one or two “renegades,”

others are almost certain to emerge, many

of whom may (such as certain Gulf States

or Russia) have less of a vested interest in

the maintenance of American financial

stability, along with the realization that the

provision of capital to a country engaged

in war enables that country to invest in

more military equipment—equipment that

can ultimately be used against the country

providing the finance for guns AND butter

in the first place.

And finally we find the notion of the U.S.

as “central clearing house/depository”

to be questionable. The “international

collateral” construct appears to be another

instance of rationalizing circumstances ex

post facto, rather than seeing it for what it

truly is. On the face of it, it seems hard to

believe that the world’s largest savings

bloc represents the contracting party

forced to post “collateral” in order to

attract FDI. In fact, one of the major

rationales behind the long mooted Asian

Monetary Fund is the recognition that

in spite of the significant contraction in

bond yields since the late 1990s, western

investors continue to extract huge risk

premiums from the East Asians as a quid

pro quo for the provision of their capital.

This is manifestly perverse, especially

when one considers that the ultimate

source of much of that liquidity is Asia.

Without their capital the fragility of the

U.S. financing position would be seen in

all of its precarious glory, and the resultant

risk premiums would rise considerably. All

of the nations of Asia continue to run large

current account surpluses, the proceeds of

which are funneled back into the U.S. bond

market, where the savers obtain a yield

of approximately 5 percent, in a country

which is now the world’s largest debtor

nation, suffering the twin diseases of a

declining currency and higher inflation

(both of which are eroding the real value

of the Asian creditors’ respective invest-

ments). The logic is akin to Warren Buffett

being forced to pay a premium to invest

into a failing company.

“In the absence of self-discipline on the part of one or two ‘renegades,’ others are almost certain to emerge.”

– 1� –

The argument also posits the curious

notion of America as a neutral “central

depository,” acting within the constraints

of a rules-based multilateralist system.

Suffice it to say, this does not jibe with

the reality of today’s U.S., increasingly

prone to military unilateralism. In fact,

historically, the Americans have tended to

view multilateral institutions or systems

as having little relevance to them on the

spurious grounds that such “rules” only

apply to other nations, seeking to emulate

the American system, the ideals of which

supposedly constituted the basis for such

rules and institutions in the first place.

And the U.S. has certainly not been

averse to jettisoning any kind of multi-

lateral arrangements when it suits them.

During the 1930s, for example, President

Franklin Delano Roosevelt, via his 1933

Executive Order, declared it illegal to

own circulating gold coins, gold bullion,

and gold certificates, thereby repudiating

the government’s obligation to repay the

country’s bondholders in “gold coin of

the present standard of value.” The act of

confiscating gold itself was a violation of

private property rights and was illegal.

But the taboo was broken. As economist

Eric Englund has noted, “By not pay-

ing bondholders in gold coin, the U.S.

government technically defaulted on its

Treasury bond obligations.” (“Should the

U.S. Government’s Sovereign Credit Rating be

Downgraded to Junk? http://www.lewrockwell.

com/englund/englund18.html)

Some forty years later under President

Richard Nixon, the U.S. government again

defaulted on its obligations. According to

the late economist, Murray Rothbard, not

only did the U.S. renege on its financial

obligations, but also the Nixon administra-

tion in effect repudiated the entire Bretton

Woods monetary system, which had

governed the global economy throughout

the entire post-war period:

“For two decades, the system seemed to work

well, as the U.S. issued more and more dollars,

and they were then used by foreign central

banks as a base for their own inflation. In short,

for years the U.S. was able to ‘export inflation’

to foreign countries without suffering the rav-

ages itself. Eventually, however, the ever-more

inflated dollar became depreciated on the gold

market, and the lure of high priced gold they

could obtain from the U.S. at the bargain $35

per ounce led European central banks to cash

in dollars for gold. The house of cards collapsed

when President Nixon, in an ignominious

declaration of bankruptcy, slammed shut the

gold window and went off the last remnants

of the gold standard in August 1971.” (“Mak-

ing Economic Sense,” Ludwig von Mises

Institute, 1995)

In fact, it is hard to think of any real world

examples that would correspond to the

collateral thesis. NYU Professor Nouriel

Roubini notes that in 2002 Argentina took

policy decisions that effectively amounted

to some implicit partial expropriation of

foreign FDI (confiscation of bank assets,

freezing of utility tariffs, etc. that led to

severe capital losses on FDI investments).

Though Argentina was also sitting on a

pile of foreign exchange reserves in 2001

– 1� –

(which, pace the BWII thesis, should have

been the collateral for this expropriation

risk), yet those reserves were neither at-

tached, nor seized by the U.S. government

or any foreign creditors of Argentina in

spite of the so-called “FDI expropriation.”

Likewise in the context of Asia, Roubini

notes the extreme unlikelihood of a

country such as Japan attempting to seize

China’s collateral in the U.S. in the event

that the latter expropriated Japanese assets

in China. Far from upholding the stability

of the international financial system, the

U.S. deficit as “collateral” would seem to

be an open invitation toward heighten-

ing conflict if it were truly operative. A

military response would almost certainly

follow were collateral to be repeatedly

seized as a consequence of an implicit

economic contract failing to be honored.

Put simply, reserve accumulation is a

function of pursuing renegade economics.

Asian central banks need to accumulate

reserves to prevent the appreciation

of their currencies from occurring,

thereby perpetuating their current account

surpluses; until now, the U.S. has willingly

acceded to this arrangement because it has

enabled the country to pursue a guns and

butter foreign policy, and provided cheap

capital that has kept the dollar’s decline

orderly and helped sustain economic

growth and low interest rates in spite of

mounting external imbalances that might

have otherwise justified significantly

higher rates.

The Need for a Change in the Status QuoThe lessons for present day policy mak-

ers are stark. A perpetuation of existing

exchange rate policies, based on flawed

economic analysis, is creating broadly

similar conditions to those that prevailed

before the Great Depression. History

suggests great economic hardship will

follow and that it will be proportionately

borne greatest by the debtor nations.

Today’s largest debtor nation is the U.S.,

which is showing itself increasingly prone

to using military options to enforce its

objectives, given the precarious state of

its national finances and corresponding

loss of economic leverage (particularly in

evidence in relation to America’s fruitless

efforts to get China to revalue its currency

substantially). But creditor nations, such

as China, remain dependent on America’s

aggregate demand. So even though the

U.S. might experience more economic

hardship, China, Japan and East Asia will

suffer as well in the absence of a change in

the status quo.

Thus far, the continuation of China’s

stubborn reluctance to countenance a

significant revaluation, ongoing low

Japanese interest rates, and a perpetuation

of America funding its wars on the cheap

has essentially given warped signals to

the international marketplace and vastly

expanded the use of the yen “carry trade.”

In the yen carry trade, “investors” borrow

at essentially zero and reinvest elsewhere

in high yield instruments, relying on and

“Until now, the U.S. has willingly acceded to this arrangement because it has enabled the country to pursue a guns and butter foreign policy.”

– 1� –

protected by the belief that none of the

three foregoing countries will materially

change policy. The ultimate effect of this

carry trade, then, is to increase debt in the

U.S., increase the value of the U.S. dollar,

reduce risk premiums and result in an

artificial misallocation of capital in all

three countries.

At this juncture, therefore, there would

appear to be a coincidence of interests

between the surplus renegade nations

and the debtor renegade nations to begin

to move toward some sort of respective

currency adjustments so as to preclude the

dire outcomes that are likely to flow from a

perpetuation of the status quo. The initia-

tive for reform, as Dialynas and Parikh

note, would appear to lie with China, not

the U.S., given that a dollar devaluation

in the absence of a yuan revaluation will

simply perpetuate China’s cost advantage

it has over the United States and the rest of

the non-fixed world, especially Europe, as

a manufacturing center. When the dollar

weakens against the euro or the British

pound, the yuan weakens by roughly the

same proportion. More significantly, by

largely retaining this peg (despite peri-

odic marginal, step-by-step revaluations),

China forces other Asian exporters to

manage their respective currencies closely

against the U.S. dollar, thereby exacerbat-

ing and expanding current imbalances. So

it is China that must take the first step. As

Dialynas and Parikh argue:

“One way to discipline a ‘renegade nation,’ es-

pecially one such as China with a high savings

rate and undervalued currency, is by revaluing

the currency. Undervalued currencies are

expected to appreciate over time. Maximum

value is achieved by hoarding a currency, which

is expected to appreciate. Hoarding results in a

high savings rate.”

The corollary also applies in relation to

large debtor nations with overvalued

currencies, such as the U.S.: “It makes

little sense to hold a currency that is likely

to depreciate,” which in turn induces

over-consumption relative to national

savings, given the expectation that today’s

dollars are likely to have considerably less

purchasing power tomorrow.

A significant revaluation of the Chinese

yuan relative to the dollar would appear

to have the merit of restoring economic

balance by altering the goods exchange

rate, as well as relative savings rates and

consequently the flow of capital. So why

has this not occurred?

As noted earlier, Beijing’s monetary

authorities continue to argue that if the

currency were to be revalued too strongly,

it could very well cause problems in the

banking system and undermine China’s

“step by step” reform process. Cleaning up

the banking system and floating their lead-

ing financial institutions via IPOs remain

the top priority of policy makers in China.

In this respect, a revaluation will surely

not help the cause from their perspective.

First, the banks have been recapitalized in

recent years with U.S. dollar-denominated

bonds. Second, many of the big Chinese

banks have been providing currency-hedg-

– 1� –

ing services for their big state-owned-

enterprise clients without laying off the

exchange-rate risk.

Furthermore, much of the country’s

growth is export oriented, despite the po-

tential opportunities afforded by China’s

enormous domestic market; partly as a

consequence of this export orientation, it is

unbalanced toward the outward looking

coastal regions and away from the very

backward interior. China wants growth,

but it wants more of that growth in the

interior, without shutting off its export

engine and thereby engendering

a coastal revolution (as occurred in the

19th century).

The reality is that these excuses are

lame and reflect policy preferences, not

economic necessity. Why should a policy

that encourages domestic consumption

necessarily disadvantage the coastal

regions? Would they also not benefit from

policies designed to boost consumption?

Perhaps Beijing’s policy makers still harbor

irrational fears about a breakdown in

centralized authority in the event that this

dramatic policy measure was taken. But

this fear is more a product of the Commu-

nist Party’s lack of democratic legitimacy,

rather than sound economics. A proper

functioning political system would ensure

a fairer distribution of resources, but this

is not Beijing’s concern. The reality is

that it is placing the ruling party’s own

political dominance above the interests of

the global economy, in effect seeking to

improve China’s living standards at the

expense of everybody else. If this is not

renegade economics, it is hard to know

what is.

China’s exports are growing by 30 percent

a year, imports by only 20 percent. And

the latter figure largely reflects imports

for infrastructure needs, which go on to

support those same export industries.

There is very little in the way of consumer

goods imports. Nothing short of a mas-

sive revaluation would restore China’s

trade account to equilibrium and thereby

silence the Western protectionists. China’s

incrementalist currency appreciation

strategy has clearly proved wanting and

ultimately destructive for global trade.

To keep the renminbi rate well below its

natural equilibrium rate, the authorities

continue to buy increasing amounts of dol-

lars. Yes, an increment of these purchases

is sterilized with offsetting monetary

operations; but the ballooning growth in

Chinese money and credit, and increasing

inflationary pressures is clearly testament

to how much go unsterlized. Since a small

change in China’s exchange rate has done

little to affect China’s balance-of-payments

disequilibrium, the only reasonable

conclusion is that the initial revaluation

will set up strong expectations of future

revaluations. This will induce even

larger capital inflows to China, as market

participants anticipate the profits from

further revaluations and encourage very

high savings within China.

(This is a mirror image of the problems

faced by the Asians in 1997, who sought

“China’s incrementalist currency appreciation strategy has clearly proved wanting and ultimately destructive for global trade.”

– 1� –

rigidly to maintain their dollar pegs in

the face of deteriorating current account

deficits. When downward pressures on

a currency occur in foreign exchange

markets, if the exchange rate is allowed to

adjust freely, an initial depreciation tends

to lessen pressures for more depreciation.

The rewards for speculating in the market

(by betting on a future depreciation)

diminish. With an exchange rate rigidly

pegged to the dollar, however, government

attempts to maintain the rate often raise

the expectations of traders that the cur-

rency is headed for a fall. This places even

more downward pressure on the currency

as traders rush to sell it in anticipation that

they will be able to buy it later at a lower

price. If the governments involved do not

have sufficient foreign exchange reserves

to stave off the speculators and others

in the market, they eventually have to

concede failure and allow the currency to

depreciate. When that process begins, the

fall in the currency may be quite dramatic

and may overshoot the equilibrium rate.)

True an abrupt shift in its exchange

policy will not be cost free for China. If for

example Beijing were to refix its exchange

rate at double the current rate, then the rate

of savings in China would drop abruptly

and meaningfully. The Chinese currency

would then, by construction be overvalued

by some 15 percent on a PPP basis and the

impact of the overvaluation would lead to

a reduction in production, which would

lead to perceptions of further overvalu-

ation. Capital could flee the country

quickly and debt would likely grow, as

preferences shifted toward borrowing in

an overvalued currency on the belief that

repayment would eventually occur in the

currency at a lower value.

On the other hand, Beijing’s monetary

and financial authorities could mitigate

the resultant risks by tightening existing

capital controls simultaneous with the

revaluation and thereby “trap” the stock

of capital, thus avoiding the extremes

generally associated with capital flight and

dissaving. What is clear is that whatever

the short term costs of significant revalu-

ation, the costs of perpetuating the status

quo are likely to be far more severe in the

medium and longer terms.

U.S. as Renegade; the Militarization of Energy PolicyThe same applies for the U.S., which must

surely begin to assume its own interna-

tional monetary obligations if it is to de-

mand the same of its Asian creditors. The

U.S. has been perfectly happy to accede to

the current state of affairs in spite of the

immense economic damage it has inflicted

on its domestic manufacturing sector

(and the concomitant evisceration of its

middle class) because it has provided the

country with a cheap form of war finance,

a particularly important consideration as it

has gradually militarized its energy policy.

If one includes America’s array of privately

outsourced services along with a profes-

sional permanent military, the costs run

around three-quarters of a trillion dollars

a year. Chinese, Japanese and other central

– �0 –

banks of East Asia via Bretton Woods II

indirectly finance this cost. Since these

countries also indirectly compete with

the U.S. for the same energy resources,

we have a paradoxical situation in which

they are in effect “feeding the hand that

bites it.” This is inherently unstable as

the foreigner eventually realizes that the

provision of capital to a country engaged

in war enables that country to invest more

in military equipment—equipment that

can ultimately be used against them. In

such circumstances, America’s external

creditors will decide that they would

rather invest the accumulated current

account proceeds in their own military

jets and equipment for themselves. That

is to say, they would prefer to own the jet

rather than finance it for the U.S. Then the

“magic” of Bretton Woods II disappears.

Since the end of the Cold War, the United

States has abandoned the principle of

building up a defense force for the

purposes of addressing the security tasks

immediately at hand, and instead has

embarked on a policy of maintaining

military capabilities far in excess of those

of any would-be adversary or combination

of adversaries. Von Clausewitz once said,

“War is diplomacy by other means.” Under

recent U.S. administrations, however, war

has become an extension, not of diplomacy,

but of energy policy.

While the Pentagon readily acknowledges

it can do little to promote trade or enhance

financial stability, it increasingly asserts

that it can play a key role in protecting

resource supplies. Resources are tangible

assets that can be exposed to risk by

political turmoil and conflict abroad—and

so, it is increasingly argued, they require

physical protection, which in turn is used

to justify the extraordinary sums now

lavished on the Pentagon.

To add to the problem, we are on the

verge of a collision between rising energy

demand and depleting energy supplies,

and a historic migration of the center of

gravity of planetary energy output from

the developed to developing world, with

the higher attendant political risk that

accompanies this move. But America is

paying little heed as to how it acquires this

energy; it too embraces a form of renegade

economics and is in part able to do so

because Bretton Woods II provides noth-

ing in the way of an external constraint of

its debt-bingeing financing requirements.

Quite the contrary: it subsidizes it.

Debt Trap Dynamics: Is the U.S. Immune?Does the “currency” of global military

might make the U.S. immune to debt trap

dynamics? Optimists have rejected the

risk, arguing that the U.S. current account

deficit is somehow a sign of economic

vitality. Typical are the remarks of former

Dallas Fed President, Robert McTeer,

who suggested: “We live in a country

that capital is trying to get into. Would

you rather live in a country that capital is

trying to get out of?”

That clever formulation grossly under-

states the problem. It is necessary to

“The foreigner eventually realizes that the provision of capital to a country engaged in war enables that country to invest more in military equipment—equip-ment that can ultimately be used against them.”

– �1 –

examine the underlying nature of the

capital flows flooding into the country.

Foreign Direct Investment (FDI) is a very

different proposition from speculative

capital flows. In an environment of heavily

leveraged turbo-charged credit, hot money

inflows, however desperate to get into a

country today, could become tomorrow’s

precipitating conditions for a currency

crisis in the event that such capital begins

to cut and run en masse a la Korea or

Thailand in 1997. In the words of former

Treasury Secretary Lawrence Summers,

“In looking at a large current account deficit

in the classic emerging market context, [it

is important to distinguish] whether that

investment…is taking place in the traded goods

sector, where it is generating the export capac-

ity that can ultimately service debt, or whether

investment is being allocated increasingly to the

non-traded goods sector. Here, too, the record is

clear: an unusual interest rate environment and

heavy foreign competition in manufacturing

has changed the composition of investments

in the United States substantially toward the

non-traded goods sector as manifested particu-

larly in the dramatic increases in the price of

residential real estate in and around most major

American cities.”

What makes the situation worse is that

there are no offsetting national savings

flows being directed to investment in the

traded goods area. American net invest-

ment has declined over the last four or five

years. In fact, according to Summers, virtu-

ally all of the deterioration of the current

account deficit can be attributed to reduced

savings and increased consumption, rather

than to increased investment. Again, this

is a product of the yen carry trade, East

Asian mercantilism, and China’s stubborn

currency policy.

Of course, it could be argued that a

significant dollar depreciation at this stage

in and of itself will solve the problem of

funding the U.S. current account, in effect

by making U.S. dollar-denominated assets

so cheap that they will be snapped up by

eager foreigners. In effect, the U.S. will

be (in the words of former British Prime

Minister, Harold Macmillan) “selling the

family silver” in order to fund its debts.

But using proceeds from the sale of assets

to fund debt repayment flows is a very

dangerous and ultimately self-defeating

game because as the economy sells off its

productive base it correspondingly loses

the ability to fund those deficits. We have

all learned from the game of “Monopoly”

that debt burdens can be relieved from as-

sets sales. But the game also demonstrates

how bankruptcy results when revenues

cease and rent payments continue. The

Federal government can generate revenues

by selling assets, but the very fact of these

sales then reduces the productive base

going forward and the continuation of the

trade deficit implies that continuous sales

are required because productive revenue

cannot be generated in sufficient quantities

required to reverse the debt trap dynamic.

As a result of the historic embrace under

the Rubin Treasury of a strong dollar

policy in order to retain portfolio inflows

– �� –

to fund growing U.S. debts, a good deal of

the productive capacity of the American

economy has already been transferred to

other countries, as any resident of Detroit

can attest. The American automobile

industry, a number of high tech manufac-

turing concerns, capital/durable goods,

and aviation have all succumbed to foreign

competition, hollowed out by the relentless

incursion of cheaper (and often higher

quality) foreign imports. Moreover, the

production facilities established elsewhere

as a consequence of previously misaligned

exchange rates are technologically ad-

vanced, garnering great economies of scale

and making a return to the U.S. even more

cost prohibitive. In a country like China,

where the establishment of public capital

(roads, bridges, waterways, schools, etc.)

has been very significant and continues

on a massive scale, the marginal economic

cost of the establishment of the next factory

is reduced to next to nothing. The corollary

is that closing industrial facilities in the

U.S., and transferring capital resources and

production to foreign (preferably non-

union) sites, has weakened manufacturing

employment prospects in the U.S., creating

many ghost towns and making a major

repair of U.S. industry and infrastructure

problematic to unfeasible.

The Proliferation of Renegade Nations Begets More MilitarizationIn the absence of this sort of self-discipline

among one renegade, others are sure to

emerge, expanding global imbalances of

saving, investment and consumption and

making the problem even more difficult

to solve eventually. As trade flows shift to

other regions (such as, the Middle East oil

producers, the Latin American soybean

and copper producers, the Indian service

providers), multiple participants with

different utility functions and constantly

shifting roles accumulate more U.S. dollar

reserves. One can already see this when

looking at the global stock of foreign

exchange reserves. According to the BIS,

between 2000 and 2005, emerging market

economies accumulated reserves at an

annual rate of $250 billion (or 3.5 percent

of their annual combined GDP). This was

almost five times higher than the level

seen in the early 1990s. The numbers

today are even more staggering: As of

June 30, 2007, China had $1,330 billion in

reserves, Japan $924 billion, Russia $414

billion, South Korea $251 billion, Taiwan

$266 billion, India $229 billion, Brazil $147

billion, Singapore $144 billion, Malaysia

$98 billion, Thailand $73 billion. Compare

this to the U.S. at $67 billion. Additionally,

the foreign exchange reserves of the major

oil-exporting countries have risen by about

$430 billion since the end of 1998, reaching

$519 billion by July 2006. Thus their share

in global foreign exchange has risen from 5

percent at end-1998 to almost 12 percent by

mid-2006 (http://www.ecb.int/pub/pdf/

other/pp75-86_mb200707en.pdf). These

new “renegades,” like China today, are

likely to operate with motives other than

profit maximization, which compounds

the potential for imbalances to deteriorate

further and makes their resolution even

more problematic.

“A good deal of the productive capacity of the American economy has already been transferred to other countries.”

– �� –

Faced with the inability to resolve its

problems economically, the U.S. is likely

to be increasingly tempted to embrace the

military option for the resolution of its debt

crisis. A successful military option enables

the victorious country to reap the spoils

of the loser. Military victories allow for

the confiscation of foreign assets and/or

forgiveness of prior debts. The realization

of the futility of an internally generated

solution leads to hope for and support of

an externally war driven solution.

The war solution, as seductive as it

appears, has tremendous costs, which will

be borne most fully by future generations,

as the current Iraq war demonstrates.

Beyond the tremendous human costs,

the burden associated with a loss in war

renders resolution even more problematic

and severe.

By now, the country’s acute and growing

debt build-up has led to a significant

privatization of military and intelligence

functions, well beyond any form of

congressional oversight and, hence,

impossible to control. It is also incredibly

lucrative for the owners and operators of

so-called private military companies—and

the money to pay for their activities

ultimately comes from taxpayers through

government contracts. Any accounting of

these funds, largely distributed to crony

companies with insider connections, is

chaotic at best. Jeremy Scahill, author of

Blackwater: The Rise of the World’s Most

Powerful Mercenary Army, estimates that

there are 126,000 private military contrac-

tors in Iraq, more than enough to keep the

war going, even if most official U.S. troops

were withdrawn. “From the beginning,”

Scahill writes, “these contractors have been

a major hidden story of the war, almost

uncovered in the mainstream media and

absolutely central to maintaining the U.S.

occupation of Iraq.”

Manufacturing has been outsourced and

dispersed around the globe; likewise today

in defense matters. One can understand

why given the strains on the official

numbers on defense expenditures, which

have soared to the highest levels since

World War II, exceeding the budgets of

the Korean and Vietnam War eras as well

as President Ronald Reagan’s weapons-

buying binge in the 1980s. According to

calculations by the National Priorities

Project, a non-profit research organization

that examines the local impact of federal

spending policies, military spending today

consumes 40 percent of every tax dollar.

The Pentagon always tries to minimize the

size of its budget by representing it as a

declining percentage of the gross national

product. What it never reveals is that

total military spending is actually many

times larger than the official appropria-

tion for the Defense Department, due to

“black budgets,” increased outsourcing

and the fact that many costs associated

for the military are accounted for under

“civilian” applications, such as health care

costs for the soldiers. For fiscal year 2006,

Robert Higgs of the Independent Institute

calculated national security outlays at

– �� –

almost a trillion dollars—$934.9 billion to

be exact—broken down as follows

(in billions of dollars):

Department of Defense $���.�

Department of Energy (atomic weapons) $1�.�

Department of State (foreign military aid) $��.�

Department of Veterans Affairs (treatment of wounded soldiers) $��.�

Department of Homeland Security (actual defense) $��.1

Department of Justice (one third for the FBI) $1.�

Department of the Treasury (military retirements) $��.�

NASA (satellite launches) $�.�

Interest on war debts, 1916-present $�0�.�

Totaled, the sum is larger than the

combined sum spent by all other nations

on military security, as Professor

Chalmers Johnson notes in his recent

book, “Nemesis.”

This spending helps sustain the national

economy and represents, essentially, a major

jobs program. However, it is beginning to

crowd out the civilian economy, causing

stagnation in income levels. It also contrib-

utes to the hemorrhaging of manufacturing

jobs to other countries. On May 1, 2007, the

Center for Economic and Policy Research

released a series of estimates on “the

economic impact of the Iraq war and higher

military spending.” Its figures show, among

other things, that, after an initial demand

stimulus, the effect of a significant rise in

military spending (as we’ve experienced

in recent years) turns negative around the

sixth year. The report concludes: “Most

economic models show that military

spending diverts resources from produc-

tive uses, such as consumption and

investment, and ultimately slows economic

growth and reduces employment.”

Incredible as it may seem, even the analy-

sis by Higgs understates the true costs of

the Iraq war. War is the natural outcome of

the pursuit of renegade economics: a “read

my lips, no new taxes” fiscal policy entails

the ongoing importation of capital. So the

true costs of the country’s increasingly

militarized foreign policy is not simply

the rapidly growing Pentagon budgets, but

also the broader costs associated with the

current account imbalance.

Toward a New Kind of Global RebalancingA sharp change in policy is therefore

required, and it must be done in coordina-

tion with America’s external creditors,

especially China. It may be the case, for

example, that a 100 percent revaluation of

the remninbi is still perceived as insuf-

ficient to attract capital back to the U.S. The

accumulated debt, fiscal and productive

prospects of the U.S. may be such that pro

forma value of the currency is much lower

than the static discount. This would be a

major challenge for Washington if fiscal/

debt burdens were unable to adjust down

quickly. Absent a downsizing in spend-

“War is the natural outcome of the pursuit of renegade economics: a ‘read my lips, no new taxes’ fiscal policy entails the ongoing importation of capital.“

– �� –

ing and debt, large rate increases would

normally be required to retain capital.

But these rate increases in themselves

are self-defeating in that they will lead to

more debt creation and an exacerbation of

debt-trap dynamics.

Consequently, a thoughtfully constructed,

well-coordinated set of fiscal, monetary

and trade policies is required to resolve the

global imbalances whilst keeping global

economic stability. As Dialynas and Parikh

argued in 2006:

“The policies must increase the U.S. savings

rate, reduce the U.S. federal deficit, reduce con-

sumption’s share of GDP in the U.S., improve

the flexibility of the foreign exchange markets,

“tax” foreign producers, and maintain current

levels of U.S. employment. The U.S. Federal

Reserve should implement a zero interest rate

policy (ZIRP) that would curtail growth in the

fiscal and current account deficit by lowering

the financing cost on the existing stock of debt.

Implementation of the ZIRP would require the

Federal Reserve to announce that the policy is

in place until certain measurable improvements

in the U.S. savings rate, fiscal deficit and

current account deficit are achieved. At the

same time, strategically contractionary fiscal

policies must be deployed to offset the monetary

stimulation and the redistribution effects of

ZIRP on U.S. asset prices. In addition to cuts

in government spending, tax increases on gains

associated with financial assets and real estate

will be required. Fiscal policy should be aimed

at deterring investment in non-productive

financial assets and increasing productive

capital spending and domestic employment.

We need more engineers and fewer real

estate agents.

Domestic imbalances are expected to subside

upon the implementation of the ZIRP and stra-

tegic contractionary fiscal policy enactment.

The combination of very low interest rates and

higher taxes on both asset sales and consumer

leverage increases will negatively affect the

domestic rich and help the debt-burdened poor.

The coming hangover in the U.S. housing

market will also be cushioned. The ZIRP will

relieve the inevitable adjustment upward of

mortgage payments on the huge outstanding

stock of adjustable mortgage debt. The fiscal

package would include a tax on real estate that

will prohibit a further escalation in prices and

speculation normally associated with low inter-

est rates. It will also include a tax to mitigate

price gains in equities. As with the increased

tax on equities, the real estate tax provides for

a wealth transfer from those in society that

are asset rich to the federal government. This

one-time domestic tariff on accumulated asset

appreciation is expected to accrue to the U.S.

government, thus allowing the government to

capture the externalities associated with prior

misguided policies.”

As the authors note, fiscal tightening

would be needed to offset the stimulative

monetary effect and redistribution effects

that zero interest rates would have on

U.S. asset prices. Strategic fiscal tighten-

ing would require cuts in government

spending as well as tax increases on gains

associated with financial assets and real

estate. Fiscal policy should be aimed at

deterring investment in non-productive

– �� –

financial assets and increasing productive

capital spending and domestic employ-

ment. Consequently, the fiscal package

would include a tax on real estate that will

prohibit speculation normally associated

with low interest rates. It will also include

a tax to mitigate price gains in equities. As

with the increased tax on equities, the real

estate tax provides for a wealth transfer

from those in society that are asset-rich

to the federal government. This one-time

domestic tariff on accumulated asset

appreciation is expected to accrue to the

U.S. government:

“It is important to note, however, that this

proposed policy is not meant to finance an

expansion of the government. Federal spending

must be cut substantially and, at a minimum,

match the wealth transfer to the government

for the tax on assets. In fact, substantial debt

reduction must occur to ensure an eventually

successful exit from ZIRP. Because the asset

taxes would be imposed upon sale, the wealth

transfer would be gradual, so the spending cuts

should also be gradual. In this way, the ZIRP

and tight fiscal policy would avoid a recession

brought on by the negative multiplier effects

that normally accompany asset deflation in an

over-leveraged economy.

This marrying of fiscal and monetary policies

would necessarily require that the Fed suspend

its independence. The sacrificing of indepen-

dence is well justified given the present U.S.

protectionist sentiment. Current Fed Chairman

Ben Bernanke argued in 2003 that the Bank

of Japan should relinquish its independence

to better enable the coordination of Japanese

monetary and fiscal policies and avoid further

deflation. The ZIRP in Japan required that the

Bank of Japan sacrifice its autonomy. The Bank

of Japan, in announcing the end of ZIRP, is

now retrieving its independence. In the same

vein, the U.S. Fed should welcome the chance

to participate in a coordinated policy to restore

international stability and avert direct tariffs.

The ZIRP would create a ‘synthetic’ trade

tariff to U.S. importers, as the recycling of

trade flows into U.S. bonds would yield zero

percent rather than five percent today. It

would resemble the Rinban operation in Japan,

whereby the Bank of Japan buys bonds, inject-

ing liquidity into the market and controlling the

shape of the Japanese yield curve. (Of course,

the U.S. Fed is fully capable of doing the same

thing.) Thus, instead of the current situation,

in which foreign savings are ‘crowded in’ by

relatively high and rising U.S. interest rates,

the ZIRP would ‘crowd out’ these foreign capi-

tal flows, causing the U.S. currency to decline.

The decline in the U.S. dollar would probably

be gradual and would raise the cost of foreign

goods and reduce U.S. consumption. As noted,

the ZIRP will dramatically reduce the financing

costs of the fiscal deficit, which would, in and

of itself, reduce the fiscal deficit as the interest

contribution of the deficit declines. The ZIRP

in combination with appropriate fiscal policies

should boost domestic investment in produc-

tive assets as producers maneuver to take of

advantage of the policy shift from consump-

tion/import to production/export.

The U.S. ZIRP/fiscal adjustment will require

foreign participants to reassess market strate-

gies and investment decisions. The decline in

“The fiscal package would include a tax on real estate that will prohibit speculation normally associated with low interest rates.”

– �� –

the value of the U.S. dollar will cause a one-time

devaluation of the existing stock of dollar-de-

nominated holdings in foreign portfolios. It is a

one-time tax on foreigners for prior rights to sell

into U.S. markets. Presumably, the combination

of ZIRP and stipulation by the Fed of its con-

tinuation would increase the ‘cost’ to a foreigner

of exporting to the U.S. The complementary

cash flow recycling into U.S. bond markets

would slow if foreign products were redirected

elsewhere on the margin. The U.S. bond market

adjustment to reduced foreign demand would be

trivial because the monetary and fiscal policies

would serve to increase savings, reduce supply

and provide ample liquidity.

The transition could be easily managed. In

sharp contrast, today’s policy makers are in a

‘conundrum’ in attempting to explain the effect

of foreign cash flows on the U.S. economy. We

do know that foreign cash flows: 1) depress

yields, 2) lead to higher asset valuations,

3) increase consumption and GDP, 4) expand

the current account deficit, 5) increase debt,

and 6) increase the fiscal deficit. So, rather than

running today’s reactive policy of inference

yielding, long-term deleterious results,

we recommend a policy that is a results-

determined (domestic growth, reduced fiscal

deficit, reduced current account deficit)

set of policy prescriptions.”

The present U.S. housing crisis may have

been avoided had ZIRP been implemented

when originally proposed in April, 2006. In

addition to the benefits of a ZIRP policy noted

above, a ZIRP policy is required to alleviate the

downward price pressure in the U.S. housing

market today.

Conclusion

In conclusion, it is useful to reiterate Frank

Graham’s call to reconcile three priorities

in international economic policy: “the

liberty of the individual, the sovereignty of

states, and the welfare of the international

community.” The current global monetary

order, burdened by massive imbalances

in savings, consumption and investment

and poorly crafted currency regimes that

perpetuate these imbalances, is moving

the world far away from Graham’s laud-

able objectives, toward an environment of

dangerous financial fragility and height-

ened militarism. Short of the unrealistic

re-emergence of a gold standard, there is

little question that additional fiscal/regula-

tory policies must become tools for today’s

policy makers. Fiscal policy has been

virtually absent from the artillery of U.S.

policy makers for almost a generation.

George H. Bush raised taxes and lost the

1992 election to “it’s the economy, stupid!”

The false legacy of George H. Bush’s

political defeat has inhibited future U.S.

policy makers and significantly contrib-

uted to the present adverse fiscal and

current account deficit positions. Relying

on blunt monetary policy tightening as the

sole counter-balancing tool to a profligate

federal government is akin to playing

baseball without a glove. Similarly, Asia’s

desire to avoid dollar appreciation and

America’s corresponding desire to secure

war financing on the cheap together has

created the kernel of a new Bretton Woods

system of fixed exchange rates. But as we

have sought to illustrate, this regime is in

– �� –

fact less a system, more a rationalization of

a highly unstable, fragile and unsustain-

able set of monetary conventions that are

more likely to break apart than to expand

and consolidate. It has perpetuated further

unsound financial practices, such as the

yen carry trade and highly leveraged

structured product schemes. The resultant

flow and stock imbalances associated with

Bretton Woods II are much larger than the

imbalances created by the initial Bretton

Woods regime and certainly well beyond

anything associated with the historic gold

standard. The scale of these imbalances

and the difficulties sustaining a coopera-

tive equilibrium in a game with strong

incentives for the pursuit of

“renegade economics” make the likelihood

of severe global economic dislocation

highly likely in the absence of change. A

three dimensional solution is required.

China must allow its currency to float

freely; the U.S. must increase tax rates

and lower interest rates; and, Japan must

tighten monetary policy, increase federal

spending and cut taxes.

We hope this paper will serve as a way of

bridging the disequilibrium and restoring

international stability. The re-emergence of

the former Soviet Union states, China and

India as important global participants in

the global economy demands fresh think-

ing and new policies before it is too late.

“China must allow its currency to float freely.”

– �� –

AppendixA Brief Note on The Gold Standard,

Exchange Rates and Trade

This paper examines trade balances and

exchange rates. The authors are of the

opinion that exchange rates are very

important. Exchange rates influence capital

flows, trade and country leverage. The

operable assumption is that exchange rates

are undervalued in trade surplus nations

and overvalued in surplus countries.

Sustained trade surpluses indicate an

undervalued exchange rate and vice versa.

Sustained trade imbalances are not likely

in a globalized, freely floating economy.

Nor are sustained imbalances possible

with a gold standard. A casual observation

of exchange rate changes and economic

outcomes suggests that the emergence of

China, the most populated nation in the

world, at a substantially undervalued man-

aged exchange rate created an enormous

exogenous shock to the global system.

Today, the Western world has accumulated

enormous debts and confronts crisis as a

consequence of misaligned exchange rates.

Investors and speculators consider numer-

ous factors such as: 1) labor costs, 2) tax

system, 3) political system, 4) regulatory re-

gime, 5) environmental standards, 6) social

standards, 7) trade balances, 8) purchasing

power parity, 9) relative interest rates, and

10) military to determine an “equilibrium”

exchange rate. Exchange rate valuations

change as perceptions of these variables

change. The consequence of which is to

create an alignment of exchange rates such

that trade is never greatly out of balance.

The gold standard required the transfer

of gold from a trade deficit country to the

trade surplus country. As such, the gold

standard imposed a strict constraint on

trade imbalances. A country could run

a trade deficit as long as it held a store of

gold to transfer. No gold, no goods. This

system, like a freely floating exchange rate

system, prohibited “renegade economics.”

Note on Yen Carry Trade

The fix of the Chinese currency requires

the Japanese construct policy (tight fiscal,

loose monetary) to retard the appreciation

of the yen leading to the yen carry trade.

The yen carry trade is the origin of the

massive global credit creation. Investors

borrow in yen at an approximate rate of

zero and lend the proceeds of the loan to

high interest rate countries such as the

U.S., Australia, New Zealand, Canada,

Brazil, etc. The borrowing of yen comple-

ments Japanese policy further depressing

the value of the yen driving it further from

its fair value as estimated by purchas-

ing power parity (PPP) and causing an

appreciation in the funded currencies.

Currencies already overvalued on a PPP

basis. The primary risk to the strategy

is an appreciation in the yen (funding

currency). Since Japan is less competitive

than China, the yen must decline gradu-

ally to the yuan. The yuan fix means that

the yen is more fixed. So, by substitution,

the yen carry trade is really the yuan carry

trade and the vast liquidity formation and

low risk premiums associated with the

liquidity can only be corrected by a large

revaluation in the yuan or a freely floating

yuan and/or zero interest rate policies in

the funded countries.

– �0 –

Nominal Exchange Rate Changes (-ve means appreciation)

CNY JPY MXN KRW BRL

1���-1��0 ��.� -��.� ���.� -1�.� N.A.

1��0-1��� ��.� -�0.� ��.� 1�.� N.A.

1���-1��� -�.� ��.1 1��.� �0.� ��.�

1���-�00� -1.� -1�.� 1�.� -��.1 10�.�

We understand that real exchange rates should also be examined. Differences in

country inflation calculations complicate matters. The story remains the same when

real exchange rates are examined.

The Chinese yuan was devalued while the yen and Korean won appreciated during

the late 1980s thru 1997. Subsequently, the won underwent a major devaluation and the

yen remained relatively stable. The Mexican peso experienced a tremendous inflation

as well as a loss of competitiveness resulting in a continuous devaluation.

The Brazilian economy experienced a tremendous competitive strain

forcing the government into massive devaluations.

■

■

■

0

50

100

150

200

250

300

350

400

Jan-85

Jan-87

Jan-89

Jan-91

Jan-93

Jan-95

Jan-97

Jan-99

Jan-01

Jan-03

Jan-05

Jan-07

Jan

1992

= 1

00

MXN CNY KRW JPY

Nominal Exchange Rates – Rebased

Source: Bloomberg

Figure 2

BRL Nominal Exchange Rate vs. the USD

0

100,000

200,000

300,000

400,000

500,000

600,000

700,000

800,000

Jan-92

Jan-93

Jan-94

Jan-95

Jan-96

Jan-97

Jan-98

Jan-99

Jan-00

Jan-01

Jan-02

Jan-03

Jan-04

Jan-05

Jan-06

Jan-07

Jan

1992

= 1

00

Source: Bloomberg

Figure 3

Figure 1

– �1 –

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

Trade Balance/ GDP

-6

-4

-2

0

2

4

6

8

10

12

14

Brazil

% o

f GD

PChinaJapanKoreaMexico

Source: IMF WEO

Figure 4

Real GDP Growth Rates

-10

-5

0

5

10

15

20

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

YoY

% C

hang

e

MexicoKoreaJapanBrazil China USA

Source: IMF WEO

Figure 5

Trade as a function of GDP in China has grown dramatically during the past twenty

years. To engineer export growth, South Korea engineered a very large devaluation

matching the prior Chinese devaluations.

■

A consistently high growth rate in China is partially a result of its export monopoly.

The growth rate of China is very high and as we have observed in the previous chart,

its trade balance as a percent of GDP has also grown rapidly. The growth of both the

numerator and the denominator is strongly indicative of renegade economics.

■

■

– �� –

Brazil China Japan KoreaIndonesia Mexico

Source: IMF WEO, Bloomberg

200

0

400

600

800

1000

1200

1400

U.S

.$ B

illio

nFigure 6

Stock of Reserves

1990199419972007

1985

U.S. Trade Balance (12 Months Up to April 2007)

(1,000)

(900)

(800)

(700)

(600)

(500)

(400)

(300)

(200)

(100)

0

U.S

.$ B

illio

n

Source: IMF Direction of Trade Statistics

Figure 7

KoreaBrazilMexico

ChinaJapanWorld

U.S. Trade Balance (12 Months to April 2007)

Source: IMF Direction of Trade Statistics

Figure 8

BrazilMexicoOther

KoreaChinaJapan

The enormous growth in reserves is a combination of positive trade balances and

capital inflows into what are perceived as undervalued dirty peg currencies.

The unprecedented growth in reserves in China, in conjunction with its very large

exports is evidence of a very undervalued currency. The same is true for Japan.

■

■

The Chinese growth strategy: export consumer goods, import capital goodsand raw

materials. The enormous export of goods destabilized the global economy.

The U.S. growth/war policy relies on capital from abroad and encourages “feel good”

consumption in the U.S.

Much of the “Other” category is due to importation of oil.

■

■

■

– �� –

China Export Performance Post Devaluation

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06

YoY

% C

hang

e

2

0

4

6

8

10

12

14

16

18

Perc

ent o

f U.S

. Im

ports

(%)

China's Share in U.S. Import ValueNominal Growth of China’s Exports to the U.S.China’s Export Volume Growth (World)

Source: IMF Direction of Trade Statistics, WEO

Figure 9

Consistent growth in penetration of Chinese exports into the United States indicative

of grossly inappropriate mix of U.S. policies and Chinese exchange rate.

■

– �� –

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This publication contains the current opinions of the author(s) but not necessarily those of Pacific Investment Management Company LLC. Such opinions are subject to change without notice. This publication has been distributed for educational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission of Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660. ©2007, PIMCO.

1 Bretton Woods II refers to the arrangement under which China, in particular, pursues a development strategy that combines large current account surpluses, direct investment inflows, capital controls, and a more or less fixed exchange rate. Under those circumstances, it has been accumulating huge foreign exchange reserves, most of them held in US Treasuries. Michael Dooley, Peter Garber, and David Folkerts-Landau have advocated that this system is stable and is likely to persist for some time. See “An Essay on the Revived Bretton Woods System,” NBER Working Paper 9971, June 2004. For a discussion of PIMCO 2005 Secular Forum which discussed the BWII arrangement, see Bill Gross, “The Strange Case of the Bare Bottomed King,” </LeftNav/Featured+Market+Commentary/IO/2005/IO+May-June+2005.htm> PIMCO Investment Outlook May/June 2005. For analysis of the dollar and the U.S. current account in recent years, please see the following installments of Paul McCulley’s Fed Focus: “The Morgan le Fay Plan,” November 2002; “Our Currency but Your Problem,” October 2003; “Through Holes in the Floor of Heaven,” December 2003; “Twice Blessed,” March 2004.

2 This paper is a sequel to “A Zero Interest Rate Policy (ZIRP): Remedy to Global Imbalances” by Chris P. Dialynas & Saumil H. Parikh, April 2006. The authors acknowledge the assistance of Saumil Parikh and Katerina Alexandraki. The opinions expressed in this paper are the authors’ and may not reflect the viewpoint of PIMCO.

3 This paper is a sequel to “A Zero Interest Rate Policy (ZIRP): Remedy to Global Imbalances” by Chris P. Dialynas & Saumil H. Parikh, April 2006. The authors acknowledge the assistance of Saumil Parikh and Katerina Alexandraki. The opinions expressed in this paper are the authors’ and may not reflect the viewpoint of PIMCO.

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