Creating order out of chaos
By Shahid Javed Burki
Monday, 03 Oct, 2011
THE last time the global community attempted to create a new economic order out of total and utter chaos was in 1944 when the likely victors of the Second World War assembled at a resort, Bretton Woods, in New Hampshire in northeast of the United States.
The countries invited to attend the meeting were `likely winners` since the war in East Asia was still not over. Japan surrendered several months later. The Bretton Woods meeting was held largely at the urging of John Maynard Keynes, the British economist, who had studied the economic aftermath of the First World War. He had concluded that the seeds for the Second World War were sown when the victors of the conflict chose to punish and humiliate those who had lost and laid down their arms.
Keynes wrote about the treatment meted out to the vanquished arguing that real peace would only return if the European countries could rebuild their economies and provide hope to all the people in the continent no matter whether they were the winners or the losers.
His advice was not taken and the result, as he had predicted, was another European upheaval. Germany took to the battlefield again in order to avenge the humiliation at Versailles.
The task before the conferees was easy at Bretton Woods. While several countries had helped with the war effort,there was only one clear winner, the United States. And there was also one clear thinker. John Keynes provided the intellectual underpinning of the system of global economic and financial management that was to emerge from these deliberations.
The countries attending the meeting decided to adopt a system of two-tier exchange rate with all currencies linked to the American dollar at a fixed rate and the dollar itself pegged at the rate of $38 per ounce of gold. If countries got into external financial crisis they would be provided funds by the International Monetary Fund, a new institution set up for this purpose.The Fund`s resources would come from the quotas paid to it by the member countries with the United States paying the most. These payments would be used by the Fund to create its own currency, the Special Drawing Rights (SDR).
As the name suggests these constituted the `rights` the member nations could exercise in proportion to the contributions they had made to the Fund`s capital. But the withdrawal will not be automatic. It could be made by the country in distress after it had satisfied the authorities in the Fund that they were making policy adjustments to prevent the recurrence of the crisis.
But the Fund`s mandate was to dealwith emergencies. War-torn Europe needed to be rebuilt as well. For this purpose the Bretton Woods conferees created another institution and called it the International Bank for Reconstruction and Development, the IBRD. The bank was promised a lot of capital but only a part of it was `paid-in`. It could use the rest of the promised money as collateral to raise funds in the capital markets by selling bonds. Later, when a number of former European colonies became independent countries, the IBRD expanded its mandate and changed its name to the World Bank.
What this brief history of the past experience of creating order out of chaos tells us is that it is possible to restructure the global system if there are people who have the intelligence and the foresight to think deep into the future. There are not many at this time who could fit that description. In 2008 when Barack Obama won the election to the US presidency there was an impression that a man of vision had arrived on the scene. His slogan `yes, we can` not only excited the electorate in the United States but reverberated across the globe. Unfortunately, he has fallen short of what was expected of him.
The global economy is now faced with three different sets of crises that need to be dealt with simultaneously since they impact on one another. The first of these, of course, is the crisis in Europe where a bunch of countries on the continent`s periphery have gotten into a cycle which may end in at least one of them most likely Greece defaulting on its foreign obligations.The situation in these countries has earned them their own unflattering acronym the PIIGS for Portugal, Italy, Ireland, Greece and Spain. If a default does occur several large European banks that hold large amounts of PIIGS debt will face possible bankruptcy. This will set up a chain reaction reminiscent of the bankruptcy of Lehman Brothers in the United States that froze for a while all institutional credit. The solution to the European crisis is to create an institutional mechanism that will allow the countries under stress to borrow from an entity backed by the powerful states in the Union. This means institutional support by Germany and to a lesser extent France. Neither especially Germany is prepared to go that route. German Chancellor Angela Merkel is too afraid of the political right in her country to take on extra burden to save the Eurozone from collapsing.
The second crisis is in the United States where a new political movement the Tea Party Movement has created an environment in which policymakers are too scared to tread. The tepid economic recovery in the country that has kept the rate of unemployment very high and for a very long time must not be allowed to persist. It does not call for cutting down government spending as the Tea Partiers want and are likely to get unless someone in the political system is prepared to provide real leadership. What is needed is a significant increase in government expenditure over the short term for as long as economic recovery remains sluggish and the rate of unemployment is unacceptably high. The only person whocould do that is President Obama but he will have to first shed his diffidence and distaste for strong action.
The third problem not quite a crisis at this time but could become one if attention is not given to it is the consequence of the accumulated reserves in the emerging world that are mostly invested in the United States and to a lesser extent in Europe and Japan. These reserves are the result of the East Asians selling more in the global market place than they have been buying for themselves and the oil-exporting countries able to charge a high price for their abundant resource.
About two thirds of the total global savings of some $10 trillion are with these countries. If for whatever reason, confidence in one of the large economic entities in the world the United States and the European Union were to suddenly disappear there will a run on the liquidation of these reserves. This will be the equivalent of the dreaded run on the banks.
What the global economy needs at this time is a mechanism that addresses these problems and finds a comprehensive solution. This is what was done in 1944 by the victors of the Second World War. If there was an expectation that something like Bretton Woods II would come out from the recently concluded annual meetings of the World Bank and the International Monetary Fund that did not happen. The leaders of global finance have gone home after giving long speeches on the threat their respective countries and the world collectively face without promising action.
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