A Big Mess is Brewing

China and the US have entered an unholy alliance: China finances the US war in Iraq and in compensation the US keeps its markets open to Chinese consumer goods. Marcello De Cecco, an expert in the international monetary system, calls this Bretton Woods Two. Another way of describing it is that the US is forcing foreign central banks to finance the US trade deficit in order to keep their exchange rates from appreciating and their export-based economies from collapsing.

De Cecco, who is a professor at the University of Pisa, advisor to the Italian government, newspaper columnist and author of Money and Empire, gave a lecture this week at Waterloo's Center for International Governance Innovation (CIGI).

De Cecco argues that the current situation has some parallels to the years leading up to the First World War. Then, the pound sterling was the international currency, backed by gold, but the UK was in decline. The two emerging superpowers were the US and Germany, neither of which had ambitions to replace the pound with their own currency. It was France who challenged the pound as world monetary standard, and France that also threw instability into the system, sometimes deliberately (in 1907-14 there were several episodes where France removed money from German markets for political reasons, forcing Germany to hoard gold). The dollar became the world currency after WWII.

Now, it is the US that seems to be in decline. China is the emerging superpower, but again it is not interested in replacing the dollar as the world currency. In fact, China is behaving very responsibly, doing its best to keep the current system working. The euro is the challenger to the dollar. Half of all world assets are held in private hands in Europe, and European investors may dump the dollar if the dollar starts to decline - as may Americans and everyone else, including even China. Of the many sources of instability in the current system (not the least being the behavior of the US government), Russia, a country that is on the decline and bitter about it, may prove to be a problem.

Professor De Cecco called his talk "From the Dollar Standard to a Multiple Currency Standard: Current Developments in the Light of Pre-1914 Experience" and summarized it as: "The world in which we live today is in many ways similar to, and in other ways different from, the one which existed in the two decades before 1914. New world powers are in the making now, as they were then. Power politics seems to have superseded the politics of alliances based on ethics and values. Is the multiple currency world towards which we seem to be going bound to prove as dynamically disastrous as the one which came to an end in 1914?"

De Cecco ended his talk with the ominous statement, "A big mess is brewing."

Related post:
The Unsustainable World Economy

Update: Gwynne Dyer

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