In 2006 I wrote with Brad Setser a piece entitled: "How Much is Latin America Part of Bretton Woods II?". I will try to summarize the key features of that piece and I will also try to update the key conclusions of that piece.
The original Bretton Woods (1945-1971) system was a formal agreement led by the ‘center’ (United States) towards the ‘periphery’ (Europe and Japan). The IMF was then created to evaluate the periphery countries and eventually authorize devaluations. The periphery countries had their currencies formally pegged to the US dollar and the dollar reported its value in terms of gold. The system was designed to prevent ‘beggar thy neighborhood’ trade based on competitive devaluation such as those that afflicted the international economy during the Great Depression era. The dollar became the reference currency for Europe and Japan and formal provisions were created such that countries with structural trade deficits could devalue their currencies.
In 2001, the US dollar weakened against the Euro. As a way to preserve their high level of exports to the United States a group Asian countries and oil producing countries pegged their currencies to the dollar. In the same period, United States has posted high fiscal and current account deficits. In turn, the periphery peg has avoided a further depreciation of the US dollar and hence prevented the negative impacts that a depreciation of the dollar might have had in terms of inflation and interest rates. In turn, it is interesting to observe that the periphery nations (Asian and oil producing countries) have been financing the United States through their purchases of international reserves and US treasury securities. The movement is now led from the ‘periphery’ countries (Asia and oil countries) to the ‘center’ (United States). Such an arrangement was coined ‘Bretton Woods II’(BWII) and is used to explain the ongoing ‘stability’ and economic growth among the G7 countries, despite the high US current account deficit and fiscal deficit. Though some scholars argue that the system is not stable and hence its end may come unexpectedly spreading out a hard landing in the U.S. and Asia, others believe the BWII may last for a decade.
In brief BWII is an international monetary system where the periphery countries finances the center, and in turn, helps to keep low interest rates in the center. The United States is the center country and periphery is composed by Asian countries (notably China) and oil export countries.
The key features of this system are:
1. Heavy intervention on foreign exchange markets by the Asian and oil countries to avoid an appreciation of their currency against the US dollar;
2. In Asian countries, reserve accumulation is a by product of export-led growth strategy, which is needed to absorb the abundant labor force in traditional sectors, mostly in agriculture. Such strategy facilitates export growth by preventing or slowing currency appreciation.
3. A significant share of reserve accumulation by BWII countries has being invested in USD and (or) US securities. In turn, such mechanism has been financing the US trade deficit, preventing an increase in US interest rates and postponing (or avoiding) a further weakening in the US dollar.
4. Periphery countries have often large current account surplus.
5. Reserve accumulation in the periphery countries exceeds what is needed for precautionary reasons mostly because the ratio reserves to GDP is higher than needed to prevent a sudden stop episode.