In Part I, we began our analysis with a discussion of Mundell’s Impossible Trinity. We also covered the gold standard model and Bretton Woods model. This week, we will examine the Treasury/dollar standard and introduce what could be called Bretton Woods II. Finally, we will conclude with market ramifications.
The Dollar/Treasury Standard
The flaws of the Bretton Woods system led President Nixon to close the gold window in August 1971. In terms of the Impossible Trinity, we had the following:
- Floating exchange rate
- Independent monetary policy
- Open capital account
The third element didn’t occur immediately, but, as the anecdotes in Part I about the advent of currency futures and the Eurodollar market suggest, the owners of capital were agitating for the ability to leave the Bretton Woods straitjacket on foreign investment. In the years following 1971, restrictions on foreign investing steadily declined.
The dollar/Treasury standard effectively replaced gold as a reserve asset. As foreign economies acquired dollars for reserve purposes, they would now hold Treasuries as the primary reserve asset. Although this change, in theory, didn’t eliminate the Triffin Dilemma, in practice, it did. Foreign nations needed a currency to conduct trade and investment and the willingness of the U.S. to act as importer of last resort overcame concerns about America’s creditworthiness. As long as foreign dollar holders remained confident, the U.S. could expand the reserve asset (Treasuries) almost without limit.
The lack of constraint on Treasury supply led to two outcomes. First, foreign nations that wanted to develop economically could use export promotion as a model. In this model, the developing nation restricts consumption through low deposit rates, capital controls and an undervalued exchange rate. These constraints lead to high levels of domestic saving, creating liquidity for investment. What isn’t invested, however, must find a home and that home, based on basic macroeconomics, is either a government fiscal deficit or a trade surplus.