West unlikely to win all it wants in this financial poker game

Published on Wednesday 12 November 2008 22:39

THIS weekend, the leaders of 20 major economies will meet in Washington at the invitation of George Bush, the US president, tasked with finding a way out of the global financial crisis.

This gathering has been compared to the famous – or infamous, depending on your viewpoint – Bretton Woods conference of July 1944. At the latter, the United States and Britain attempted to repair the collapse in the international trading and monetary system caused by the Great Depression.

Gordon Brown in particular has demanded that we "must have a new Bretton Woods – building a new international financial architecture for the years ahead". Don't get your hopes up. The razzmatazz in Washington this coming weekend will not result in any Bretton Woods II, for a variety of reasons.

For a start, Barack Obama, the president-elect, is avoiding Bush's last attempt to create a legacy for himself. So nothing can really be decided until after the inauguration of the new US administration. Second, the original Bretton Woods agreement was imposed by a victorious US on a war-weary world. This time round, the G20 nations are divided both in self-interest and in what to do about the crisis. Herding cats does not come into it.

The French and Germans want to "regulate" international capitalism, meaning they want more clout for EU political institutions in the new global order. This is opposed by Britain and the US. Brown keeps dropping the "regulation" word into his speeches but he has sided with the US for a decade in vetoing any fresh multinational regulation of international capital flows, largely because he wants to protect the economic independence of the City of London. At best, Brown will back some co-ordination of existing national regulatory bodies.

Meanwhile, the Bric countries (Brazil, Russia, India and China) are in no mood to let the West create a new set of semi-colonial institutions designed to stop them running manufacturing trade surpluses at the expense of the West. I was in Brazil last weekend, where the G20 finance ministers were meeting ahead of the Washington summit. The So Paulo newspapers were dominated by calls from Brazil's president, Luiz Incio Lula da Silva, for the G20, which groups both developed and emerging economies, to replace the G7 as the main international body to resolve the international crisis. Lula himself thinks the Washington meeting will accomplish little, as the West is still unwilling to take the blame for what has happened.

The one initiative we might get from the Washington meeting is a "co-ordinated" fiscal stimulus. But this only because many G20 countries have concluded individually that they need to boost flagging consumer spending by cutting taxes and upping spending.

As President Lula has pointed out, we can't actually find a solution to the global crisis till we've reached a consensus on what caused it. In essence, we've had a gigantic credit bubble – funded by Asian trade surpluses – which has just exploded. In the burst credit bubbles of the 1980s and 1990s, global and local financial imbalances soon righted themselves. The danger in this one is that we allowed the initial imbalances to get so big that, instead of the fiscal elastic springing back into shape, it might have snapped.

The best recent example of this happening is Japan in the 1990s. After a 20-year credit bubble, the Japanese economy imploded. What that meant was that the price of real assets – shares and property – fell so low that consumers gave up spending, and firms stopped investing, for a whole decade as they desperately tried to rebuild their wealth. No amount of tax cuts or interest rate cuts could persuade them to change their mind.

Are we in that situation globally today? The Dow Jones share price index is still roughly 100 points above its last low in 2002, which suggests we are not (yet) in a Japanese-style asset deflation. Similarly, UK house prices are down from the peak in the second quarter of 2007, but adjusted for inflation they are still where they were at the start of 2004. Again, so far, that is not in deflationary territory.

On the other hand, there has been an unprecedented withdrawal of funds from the financial markets, as investors run scared and banks are loath to support each other. Nothing comparable has been seen since the Great Depression of 1929. To give you but one recent example: since the middle of September foreign investors have been exiting the UK on an unprecedented scale. Net outflows of foreign investment from UK fixed income instruments (government stocks, corporate bonds, mortgage securities and the like) in just the past eight weeks are equivalent to 75 per cent of the foreign cash that flowed into Britain during the previous four years. (Question: where is the Chancellor going to borrow, if the foreign investors are running scared?)

The original Bretton Woods was about eliminating the competitive currency devaluations that disrupted world trade during the 1930s. Whatever its defects the resulting system of fixed exchange rates helped restore global confidence and jump-start trade. The ensuing prosperity helped eliminate international frictions. Fixed exchange rates disappeared in the 1970s, their job done.

Could a second Bretton Woods do the same thing for international liquidity? One solution – in fact the idea proposed by the British economist John Maynard Keynes at the original Bretton Woods – would be to create a new world currency and pump that into circulation. But I doubt if that is politically acceptable, any more than it was in 1944.

Which suggests the only tenable solution is for individual countries to flood their financial systems with printed cash (technically: governments borrowing from their own central bank). Such a move is equivalent to calling the fire brigade and should not be attempted in ordinary times. But who now thinks the times are ordinary?