Bretton Woods 1 & 2...& 3?
Introduction
Before I get into any discussion about Bretton Woods 3, I think it’s best to outline Bretton Woods 1 & 2 so we can understand Bretton Woods 3 within the context of the previous systems. There were significant forces driving us from Bretton Woods 1 to 2 and many of those same forces are driving us further from 2 to 3. Understanding the full story and evolution of the Bretton Woods systems should help paint a clearer picture when looking to make sense of a possible third iteration.
Bretton Woods 1
Bretton Woods 1 began in 1944 in Bretton Woods, New Hampshire (hence the name) in direct response to the world war coming to a close. As WW2 neared its end and the new world order was looking to establish the first global monetary standard, the allied powers thought it necessary to convene and solidify the new era with a collectively agreed-upon system more conducive to the global and unipolar world they aimed to create. Trust needed to be regained after such a turbulent and inflationary string of years, so the obvious choice to accomplish that goal was to establish a unified gold standard.
However, rather than a traditional gold standard where everybody held gold and issued their currency and exchange rate independently from other nations, this new gold standard would be centered around the emerging superpower of the world, the United States. Countries would be able to redeem their currencies for USD and then USD—and USD alone—could be redeemed for a fixed value of gold at $35 per oz.
Why Center Bretton Woods 1 Around the US?
Aside from the US being the undeniable most powerful nation—which, in a lot of ways, let it do whatever it wanted to do—the United States also had most of the world’s gold. Throughout WW2, the US disproportionately benefited from the massive demand coming from the other allies and simultaneously faced little damage compared to Europe given its distance from the war. This combination of large account surpluses and avoiding rebuilding-induced deficit spending resulted in the US stockpiling the bulk of the world’s gold reserves. So when the world was ready to create a new gold standard, it made sense for the United States (the largest holder of gold and most powerful nation) to back *its* currency with gold and have other nations simply peg their currencies to the dollar.
Because the United States guaranteed a fixed exchange rate between the dollar and gold, everyone felt comfortable holding and conducting trade with a 2nd layer money (in the case of the dollar) and 3rd layer money (in the case of other currencies) under the assumption they were effectively as good as gold. The only issue was that everyone had to trust the United States to maintain that exchange rate or even just maintain convertibility in general and not abuse its privilege, which is exactly what the US would end up doing and what eventually led the world to Bretton Woods 2.
The Failures of Bretton Woods 1
Before I go straight into the start of Bretton Woods 2, let me outline why Bretton Woods 1 actually failed. The story of why Bretton Woods 1 failed is similar, as we’ll see, to why Bretton Woods 2 is failing today. The problem at the heart of these systems that inevitably leads them down a path of self-destruction is fiat and loose fiscal and monetary policy are simply too tempting. As the United States financed more and more spending throughout and leading up to the late 1960s—largely because of the ‘guns and butter’ policy of Lyndon Johnson during the Vietnam war—inflation was increasingly becoming more and more of a problem and jeopardizing the dollar’s peg to gold.
The United States was spending at an alarming rate and some simple back-of-the-envelope math would have told you that its spending wasn’t sustainable with the gold reserves it had. At a certain point, other nations began to worry the United States was spending beyond its gold reserves—which it was—and sought to repatriate its own gold reserves from the United States for fear the window of convertibility was closing. As you can imagine, this only exacerbated the run on the US’s gold reserves and, in 1971, President Nixon decided to suspend the dollar’s convertibility to gold. Had he not done so, the US would have seen all its gold reserves—the money it actually cared about—slowly vanish. The moral of the story then, if I were to summarize it, was the US liked to spend more money than it had, the broader world economy needed dollars for trade and so it was happy to buy the debt the US financed, and eventually, the US was levered to such an extent that it had to break the dollar’s tie to a real asset it couldn’t inflate.
Now, while many like to point to the day convertibility was suspended in 1971 as the official end to Bretton Woods 1, the problems that led to that suspension far preceded it and there’s an argument to be made Bretton Woods 1 effectively ended much sooner. In either case, the break from dollar convertibility to gold and the new floating dollar exchange rate signaled a clear departure from the original Bretton Woods agreement and the start of whatever this new thing was that the United States had created, now referred to as Bretton Woods 2.
Bretton Woods 2
As an important side note, while I and probably every other person you would see or hear talking about this topic will use the term Bretton Woods 2, this was never an officially established or agreed-upon system, meaning the name itself was simply a way to reference the departure from Bretton Woods 1. When the United States chose to change its end of the bargain by no longer upholding the dollar’s exchange rate with gold, the system was coined Bretton Woods 2 in hindsight as it was somewhat of a surprise—depending on whom you’re asking—and forced onto the rest of the world. The new system was obviously something different from Bretton Woods 1, so the name Bretton Woods 2 just stuck, but I digress.
Given the United States was still the dominant world power and everyone was already so comfortable using— conditioned to use even—USD for global trade, the dollar remained at the center of the monetary system much like it was in Bretton Woods 1. The key difference was now the United States wasn’t bound by its gold reserves, which, unsurprisingly, afforded it much more freedom to spend. More specifically, it opened the flood gates for the US to monetize its debt.
With virtually every nation still using and needing USD to facilitate trade, demand for dollars in Bretton Woods 2 held strong and actually increased over time, though that could mostly be contributed to the changes in population and demographics. Nevertheless, no country’s currency could dream of measuring up to the dollar, so nations came to accept the new monetary order and happily held USD as the plurality of their FX reserves. The crucial detail to keep in mind is the United States had to supply all those dollars needed abroad by issuing debt. In other words, other countries funded the United States’ debts just to get their hands on dollars they needed for trade liquidity. So the Bretton Woods 2 system effectively replaced gold as the pristine collateral of the world with USTs (United States treasuries).
Under Bretton Woods 1, every form of money was a derivative of gold and thus nothing was more desirable to hold, especially as collateral, than gold. Under Bretton Woods 2, however, everyone, for practical reasons, needed dollars, and even if you didn’t like dollars, there weren’t any viable alternatives to take its place as the safest and most liquid asset. As long as the US remained top dog, a global monetary system centered around its least terrible version of fiat made sense. But, as alluded to, this dynamic of heavy demand for US debt didn’t help solve the United State’s spending problem, it only encouraged it. And this brings us to the current failures of the Bretton Woods 2 system.
The Failures of Bretton Woods 2
With the United States not only capable of but structurally encouraged to endlessly finance its debt to meet global dollar demand, deficit spending, as we all know, got a little out of hand. Apparently, a system built around credit and debt where there are no real limitations on what the issuer of the global reserve currency can spend isn’t all that sustainable. Color me shocked. Though overspending seems to be the common denominator for why both Bretton Woods 1 and 2 failed and are failing, the difference lies in how both systems were constrained. Bretton Woods 1 was constrained by the availability of a real asset (gold), but Bretton Woods 2 appears to be constrained by some open-ended level of debt. Fiat is often characterized as having no real constraints, but it seems its limitations are simply harder to pin down. Floating exchange rates and ostensibly unfettered spending may have benefits in the short term, but the imbalances that behavior creates eventually have to, well, balance. In some sense, then, Bretton Woods 2 is constrained by leverage.
The problems around debt can only be solved by levering up so many times, and each time you do lever up, the chances and severity of the inevitable break increase. We may not officially be at this tipping point that signals an end to Bretton Woods 2, but these are some of the failures that seem to be pushing us closer to that day. Where we are right now could perhaps be compared to the late 60s when Bretton Woods 1 was dead in all but name, but it’s not obvious what would or could replace the current system, making the comparison to the late 60s and the potential for a Bretton Woods 3 more difficult to accept. The difficulty around believing in a viable replacement for the current system will be clearer when I get into the criticisms of the proposed Bretton Woods 3, but first, what exactly is the proposed Bretton Woods 3 and why do we think it’s a possibility?
Bretton Woods 3
There are a lot of reasons a change in the global monetary system could be upon us, but the main reasons have to do with de-globalization, inflation, and real vs nominal wealth. While concerns around these factors grow and we arrive at the harsh reality of a failing Bretton Woods 2, we are left searching for a better, more practical alternative. Yet, in the face of failing fiat currencies, reliable and liquid stores of wealth not subject to the same inflation or geopolitical headwinds are growing more scarce. Without any viable fiat alternatives to pull us from the darkness, the most popular theory for what asset(s) and collateral will underpin the next system, if we do see a transition, is a commodity-based monetary system. To explain why this belief has grown in popularity, let me explain how it relates to the problems of de-globalization, inflation, and real vs nominal wealth.
Throughout all of Bretton Woods 2, we have seen a consistent upward trend in globalization that has imposed a persistent deflationary force on global markets. However, events as of late have sparked a significant reversal in that trend with many countries looking to duplicate supply chains, diversify out of sanction-sensitive assets (like USD), and contend with other destabilizing and war-related circumstances, including huge increases in military spending. All of these influences that are part of the larger trend away from globalization are incredibly inflationary and put a lot of pressure on economies. As supply chains continue to break down, and further division in geopolitics ensues, trade will falter, commodities will become more scarce, and prices will soar.
Affording real goods in times of growing uncertainty like this will become less of a guarantee—highlighting a luxury the globalized world has unfortunately taken for granted—and that will drive countries to hold what they and everyone else need: commodities. If the world de-globalizes and paper wealth is not the reliable medium of exchange it once was, nations will have to turn to things people and other nations actually need and are willing to trade, which could open the door to a commodities-as-reserves system. When fiat wealth doesn’t buy you what you need, commodities likely will because other countries need them just as much as you do.
Focusing in more on the inflation element of this hypothetical commodity-based system, with USD and other major currencies inflating at fairly historic levels, there is little desire outside of safety and liquidity purposes to hold negative-yielding assets like treasuries (or even worse, regular dollars). Why sell your commodities for dollars or dollar-denominated treasuries when the value of those commodities will go up in dollar terms? You’d be better off holding onto your commodities and only selling them when you absolutely need to some day in the future, at which point their prices would be higher. In other words, holding fiat as FX reserves makes little sense when it is losing value relative to the commodities you sell to get it. With that in mind, so long as commodities continue to be harder to come by and inflation runs hot, commodity holders and producers will gain the most and currency holders and commodity importers will lose the most.
As for the distinction between nominal and real wealth, when countries are cut off from much-needed commodities previously sourced through the global market, no amount of nominal wealth will resolve that. Treasuries don’t magically turn into things like oil and you certainly can’t print commodities. Dollars or some other fiat on your balance sheet may have the appearance of wealth, but real wealth is derived from the physical goods an economy needs to function. Nominal wealth, as in numbers on a screen, is far from the same as a commensurate amount of wealth in barrels of oil. We can and do use oil to make things and run our economies, but fiat wealth is just a means to an end—a way of getting things like oil when there’s a willing seller. So if push comes to shove under wartime pressures, the currency and collateral of choice will be the real wealth in the system: commodities.
Who Benefits From Bretton Woods 3?
The primary benefactors of a Bretton Woods 3 system would, unsurprisingly, be commodity-rich nations. If commodities become the reserve of choice and primary store of value or medium of exchange for global trade, it goes without saying the nations with the most commodities—especially the important ones like oil, natural gas, and food—would have the most wealth and hold the most power. To be more specific, countries like Russia, Saudi Arabia, Australia, Canada, and the United States would all have a lot of power given their outsized stock of commodities within their respective borders. The United States would lose a lot of power from the transition away from USD and US treasuries as the primary reserve asset, but it’s fortunate to be one of the largest commodity exporters in the entire world, so it wouldn’t be a complete reversal of power. That said, the US still has the most to lose, and a commodity-based monetary system bodes very well for the ideologically divergent eastern bloc, namely, Russia and Saudi Arabia. As far as they’re concerned, their commodities, our problems.
Criticisms of Bretton Woods 3
Now, there are a number of criticisms of this hypothetical commodities-as-reserves system that seriously bring into question the possibility of such a system ever existing. For one, there would be an extreme drop in liquidity if reserves consisted predominantly of physical commodities, which is largely due to the logistical nightmare they pose in terms of settlement. Fiat—and eurodollars more specifically—however, are extremely liquid and allow countries to facilitate trade with relative ease. The current system we have now with USD and the eurodollar is mostly digital and thus allows settlement to take place at the stroke of a keyboard, but physical commodities can’t be moved around over the internet. Fiat’s salability across space due to its largely electronic nature is one of the principal reasons we use it today. We live in a digital world and commodities can’t be exchanged through cyberspace, making them far too illiquid to meet the needs of global trade.
Another concern with using commodities as reserves or a medium of exchange is the need for coincidental wants. Fiat and certain hard assets like gold or bitcoin can be stores of value used on later dates to purchase whatever is desired, but a commodity like corn or cobalt is only useful if you need corn or cobalt. If one of those is your primary export, you better hope the nations with the oil, wheat, or whatever else you need to import want those commodities you have to sell. If they don’t, you’ll need to find something they do want, which can make trade much more complicated and inefficient.
And if all that wasn’t enough, the value of reserves in a commodity-based monetary system would also move in the opposite direction as traditional FX reserves, which is the direction you want them to move. Commodity exporters would have to buy most aggressively when commodity prices are high and their surpluses are large, and they would most likely have to monetize their reserves when prices are low and their economies are struggling. In other words, their reserves would be most valuable when they need them least and least valuable when they need them most, which is the opposite of what you want out of your reserves and would only add to the volatility of commodities (reserves).
The value of reserves should either be stable or inversely correlated to the performance of the underlying economy. Commodity prices, however, are positively correlated with economic performance as increased demand drives their prices higher when economies are running hot—meaning prices are high when the economy is using commodities the most and selling them the least, and prices are low when they are using them the least and selling them the most. This is problematic because you want your reserves (your money) to go up in value when your economy is struggling and go down in value when your economy is doing well. The inverse relationship between FX reserves and economic performance helps to balance economies through self-correcting exchange rates, but that mechanism wouldn’t be present in a commodities-as-reserves system.
Conclusion
As you can see, the discussion over a Bretton Woods 3 is much more complicated than it might seem on the surface. Aside from the use of commodities as reserves posing its own unique set of problems, there are still a lot of reasons to hold onto the US dollar. The main reason is there really isn’t a good alternative. Say what you want about the US dollar, but it is the king of fiat. There is no other currency that can match the liquidity and flexibility of the US financial markets, and so there is no lesser evil to replace it. The discussion over a Bretton Woods 3 may be a testament to our desire or need for a new and better functioning monetary system, but that doesn’t mean there *is* a better system currently available. Commodities can and probably will play an important role in the multipolar world ahead, but they simply can’t meet the liquidity and trading needs of the global economy. Perhaps this means we attempt a return to Bretton Woods 1 through a new gold standard, but that, too, has liquidity limitations and there’s no reason to believe it wouldn’t see the same fate as the actual Bretton Woods 1.
In short, I think there are still more questions than answers at this point and we’ll have to see how events continue to develop before either a fix to Bretton Woods 2 or a path to Bretton Woods 3 becomes clear. The only thing I will say with any degree of certainty is there is tension building up in the system, both financial and geopolitical, and the chance of a break or major catalyst sending things flying in one direction or another is growing every day.