Today, we have an international monetary system that does not have a name. Just because something does not have a name does not mean that it does not exist, yet the lack of a name has obscured the profound impact that this system has had on distorting credit, money, asset prices, and the economy. Paul Volcker, who spent many years at the U.S. Treasury coping with the breakdown of the Bretton Woods system, referred to our current international monetary system as the “non-system.” It is a non-system to the extent that its terms and conditions were never agreed upon by all the parties involved, but instead it was born from choices made by a few, most notably China, that the other parties accepted and adjusted to. The extremes of interest rates, debt levels, asset price valuation, and investment in tangible assets in the United States are just part of that global adjustment to the new international monetary system that grew from China’s unilateral decision to manage its exchange rate beginning in 1994 [....]
Have we finally reached the stage at which the international monetary system, anchored upon China’s managed exchange rate regime, no longer works for China? In September 2024, China announced a package of reflationary measures which may well prove to be incompatible with the continuation of the managed exchange rate regime. Measures focused on bank recapitalization to facilitate bank credit creation and more money creation are not what one would expect from a central bank seeking also to target the exchange rate. The PBOC has also begun to increase its holdings of local currency Chinese government bonds. This is not the action of a central bank whose balance sheet expansion and contraction will be driven primarily by its buying and selling of foreign-currency-denominated government debt securities in an exchange rate management system [....] when the realization of the incompatibility of the two monetary targets dawns, the market will come to accept that China has moved to a flexible exchange rate and that the non-system is dead.
Monetary systems fail fairly regularly. Our current system was born out of ad hoc monetary arrangements, such as the Plaza and Louvre Accords, patched together following the death of the Bretton Woods agreement in 1971–73. Bretton Woods had been around since 1945, replacing a “gold exchange standard” that had collapsed in stages through the 1930s. Before that, there had been the gold standard, which largely ended with the outbreak of World War I.
The end of the non-system should not come as a surprise. But it will for many people because the lack of a name for this system makes it difficult to define as the cause of the gross imbalances in interest rates, asset prices, debt, and investment levels—which we have long recognized but do not attribute to the global monetary system. The failure of the Bretton Woods system was foreseen by many commentators who understood that the continued, excessive deficits that the United States needed to run to supply reserve assets to the system also undermined the credit worthiness of the United States. Eventually, the U.S. deficit was so large, and the drain on its gold reserves so great, that the international monetary system known as Bretton Woods collapsed. China’s inability to run sufficient surpluses since 2014 to generate sufficient broad money growth and prevent the escalation of its already high debt-to-GDP ratio is not widely recognized as a similar problem. Yet China’s move to a flexible exchange rate to avoid a debt deflation and create sufficient growth in broad money to reduce its debt burden will end the non-system as surely as President Nixon’s announcement that the U.S. dollar was no longer linked to gold ended Bretton Woods. Few analysts understand the impact that this move will have on the international monetary system and the long-accumulating distortions to credit, money, asset prices and the global economy.
When China moves to a flexible exchange rate, it is difficult to foresee how just one new international monetary system could replace the non-system. Given current geopolitical tensions, the prospect of China and the United States hashing out a new Bretton Woods–style agreement is highly unlikely. The Bretton Woods system was effectively imposed upon the rest of the world by the United States as global superpower in 1945, but today that superpower cannot impose its will on China, and it may struggle to impose its will even on its partners [....]
Predicting how any new U.S.-centric monetary system will develop is not easy, but such a system must allow for excessively high debts, the legacy of the non-system, to be inflated away [....] and which drives much higher levels of fixed-asset investment, now necessary for national survival. At the core of this new system will be limitations on the free movement of capital and the conscription of local commercial banks and savings institutions to fund this greater investment in fixed assets [....] For most U.S. corporations, particularly those with large market capitalizations deriving from their successful adaptation to the non-system, this is not good news.
