Financing gaps, competitiveness, and capabilities: why Bretton Woods needs a radical rethink

8   Financing gaps, competitiveness, and capabilities

Why Bretton Woods needs a radical rethink

Pallavi Roy

The international financial institutions (IFIs) of the Bretton Woods System (BWS), namely the International Monetary Fund (IMF) and the World Bank (the Bank henceforth), were meant to overcome collective action problems among countries and help solve market failures in financing on a global scale (at least outside the “Iron Curtain”). The system worked for a while and contributed to the rapid global growth in the post-World War II period. However, it then unwound spectacularly in 1971 when US President Richard Nixon ended the pegging of the US dollar to gold, spurred on by West German, Swiss, and French redemptions of dollars for gold.

Partly as a consequence, the 1970s and 1980s were decades of global stagnation, high inflation, and high unemployment in the developed economies while many developing economies languished even more. The world economy started looking rosier from the 1990s as capital started flowing to developing economies, and trade expanded under the aegis of the World Trade Organization (WTO). Earlier in the 1980s a few economies like South Korea, Taiwan, Malaysia, and Thailand had “emerged,” and by the end of the 1990s China was emerging as the world’s economic powerhouse and the Indian subcontinent was also displaying steady growth rates of gross domestic product (GDP). China’s manufacturing growth helped boost demand for African and Latin American commodities and its purchases of US Treasury bills financed the growing budget deficits of the United States and helped keep the Yuan low against the dollar. This new system of global payments began to be described by analysts as Bretton Woods 2 (BW2), in which exchange rates were managed by some emerging economies to uphold their export-oriented economies and the dollar was once again the reserve currency of choice, this time informally as opposed to the formal mechanism of the BWS, allowing the United States easily to finance its current account deficit. This system is not without its critics who feel that the US deficit position is unsustainable.1

However, the current international monetary system (IMS) is unsustainable for other reasons, explored in the first section below. The central and most critical issue of international political economy that grows from history, beginning at Bretton Woods in 1944, and explored in this chapter is how the current world economic order can resolve the gap in financing for capability development. The chapter discusses the need to implement new institutions that can design and implement financial instruments that suit the needs of developing economies. It begins by examining why the current system is unsustainable—ironically having failed to address the problem that had led to the collapse of the original BWS. The chapter then explores the origins of the Bretton Woods global payments system, the immediate imperatives behind it, and how far it was able to solve the problem of capability building.

An unsustainable system?

This chapter posits that the real reason for this unsustainability is the failure of BW2 to address the critical problem that also led to the failure of the original BWS—the permanence of payment surpluses and deficits in many countries. The new BW2 system might reflect the continuing dominance of the United States as the global superpower, in military and economic power, but there has been a significant change in power structure with China’s emergence as an economic powerhouse with substantial and persistent dollar surpluses. The financing situation, however, remains unchanged with the United States running a permanent deficit balanced largely by China’s payments surplus. In the case of the original BWS, surpluses and deficits were not meant to be permanent. The IMS was supposed to provide solutions so that deficit countries could move back into surplus, and surplus countries using their reserves were to help countries in deficit. By the late 1960s, however, the United States was in permanent deficit and other countries had to maintain surpluses to balance the world economy, and the unraveling of the original BWS was in part linked to this problem.

As indicated earlier, according to much current discourse the real problem is how to reduce US deficits and how to get China to reduce its surplus. While this adjustment is necessary according to a large body of literature,2 the necessity is not an immediate one given that the United States is not about to lose its reserve currency status very soon. The critical issue is that the global payments system, whether the initial Bretton Woods system or the so-called Bretton Woods 2, has not addressed the most important problem underpinning the payments deficits of developing countries. This problem of financing the development of organizational and technical capabilities in emerging enterprises and sectors is crucial, so that the competitiveness required for addressing trade imbalances can be acquired. This specific problem should not be confused with the broader issue of “capacity development” that can encompass investments in institutions, human capabilities, and so on. While these latter aspects of development are also important, we are concerned with a more specific capability because without its development, developing countries in particular are unable to engage in the global trading system in a sustainable way.

“Capability development” refers to the processes through which firms learn to organize modern production methods in order to achieve international competitiveness. This capability, in turn, requires financing the process of learning. Learning is only successful if the financing comes with credible conditions, and the disciplining mechanisms and the governance agencies that oversee the financing cannot be significantly distorted by rent-seeking interests.3 The development of globally competitive sectors and in particular the development of a broad-based employment-generating manufacturing sector is essential for sustaining development in labor-surplus developing economies. The absence of a global financial architecture that can provide the financing for developing these capabilities has contributed to the instability of the global payments system. A later section outlines the framework of capability development in greater detail.

Persistent deficits constrain the financing abilities of developing countries, and that financing capability is the basis for achieving capital accumulation. Industrial development and, in particular, the development of a broad-based employment-generating manufacturing sector is essential for sustaining development in labor-surplus developing economies that least have access to financing. Hence, any new global system should address this gap in financing, and despite the huge amounts disbursed by both Bretton Woods institutions, the financing provided by the IMF and the Bank has yet to cater to capability development or broad-based manufacturing in developing countries. For too long the Bank moved away from project financing to lending for governance or bureaucratic reform, and the IMF focused on conditional lending that only took into account “macroeconomic stability” (or the balance between inflation and employment and size of the budget deficit). Even though both the Bank and the IMF have recently made changes to their lending policies, they are still far from addressing the pertinent financing needs identified above. The problem is compounded by the fact that the global power balances that led to the creation of the BWS have changed substantially, thereby making it even more difficult for a new financing paradigm to be created. Hence, a radical shift is required in the task of creating a new global financing system that will adequately address the needs of the global South.

Members of the Organisation for Economic Co-operation and Development (OECD) countries, on the one hand, are credible states with large productive tax bases and do not face much difficulty in persuading surplus emerging powers like China to finance their debt. Thus, the United States finds such favor among lenders, helped in no small amount by the fact that it is also the world’s leading economic and military power. Developing countries, on the other hand, have weaker state capacity as they are still negotiating the fraught process of transitioning from pre-capitalist to capitalist economies, and they also often lack credibility as debtors given the vulnerable state of their economies. Their tax base is smaller, and they have lower credibility in attracting the long-term lending that is so necessary for development financing. What is today readily available for OECD countries needs to find its way to Bangladesh or Chad, and BW2 has no tools to achieve these investments on a significant scale. Yet global stability in the longer term is dependent on the sustainable growth of developing economies. If there is a global crisis looming, it is the crisis of underdevelopment brought on by a dearth of financing opportunities in the very countries where potential growth is very high. Instead, the capital that does find its way to developing countries is “hot money” or short-term capital flows that are volatile and dependent on capricious sentiments and the availability of liquid financial instruments.

The critical issue of international political economy that is explored in this chapter is how the current world economic order can solve this gap in financing for capability development. It discusses the need to implement new institutions that can design and implement financial instruments that suit the needs of developing economies. The next section explores the origins of the Bretton Woods global payments system, the immediate imperatives behind it, and how far it was able to solve the problem of capability building.

The beginnings of the IMS

The United Nations Monetary and Finance Conference, held at Bretton Woods in 1944 and more popularly known as the Bretton Woods conference, brought together 730 delegates from 44 governments. They were as disparate as the United States, Liberia, Bolivia, British India, Mexico, the Soviet Union, Iceland, Poland, the United Kingdom, and China among many others. Some were imperial powers, some colonies or in varying degrees co-opted by larger countries, and a few were countries trying to build their polities and economies independent from larger powers. The conference was also convened during World War II and therefore under circumstances that were far from ideal. It became a stage for the changing dynamics of the international political economy, with British imperial power on the wane, American power on the ascendance, and colonies, especially Asian ones, getting restive about their dependent status.

Despite this, what the Bretton Woods conference achieved was a relative harmonization of interests among disparate countries in terms of setting up two seminal institutions that were to help finance and, where necessary, refinance development over both the short term and the long term. The IMF was set up to provide short-term financial assistance for countries that were facing balance-of-payments (BoP) crises. The World Bank, initially called the International Bank for Reconstruction and Development (IBRD), would provide long-term financing. The IMF was the cornerstone of the negotiations, and its chief responsibility was to provide liquidity to countries that needed it.4 This provision was predicated on the understanding that the economic crisis of the interwar years was a result of freely floating exchange rates that held countries hostage to external pressures and limited their role in currency management, much to their detriment. A fixed exchange rate that would still allow countries enough room to intervene in currency markets was therefore necessary, but maintaining or “defending” a fixed rate regime also required adequate liquidity in the form of foreign exchange to deal with short-term imbalances and flexibility within countries to adjust their prices and productivities so that deficits, in particular, were not permanent.

The IMF was envisioned as the institutional answer to help countries gain access to this liquidity. In the case of a large payments deficit, a country could experience a sudden shock to its economy if it has to adjust rapidly. This disequilibrium made access to liquidity important, and this was the role of the IMF. It would be useful to parse the main debates at Bretton Woods and also to explore the oft-ignored agency of developing countries at the conference.

Main debates at war’s end

Not surprisingly, recently discovered transcripts found by an economist in the uncatalogued section of the library at the United States Treasury reveal that the most contentious debates at the conference took place around the IMF and its role.5 Interestingly, not all of the important debates were on the “dollar-sterling” issue that many historians have identified as the overriding concern at the conference.6 While the conflicting British and American positions about the reserve currency and adjustment mechanisms (discussed below) in the world economy certainly took center stage, the transcripts throw light on some other important debates that saw developing countries take on the developed ones and at least in some cases achieve important concessions. Recent work by Eric Heilleiner has also provided robust evidence of the involvement of developing countries in the conference, not just as spectators.7

One of the most critical debates concerned the nature of the IMF’s functions. Was it going to concentrate on economic development of both developed and developing countries—in the sense of focusing on full employment for the former and aiding in the development process for the latter—or would its mandate be the narrower one of smoothing over temporary BoP crises? The debate summed up the widely diverging policy imperatives for developing and developed countries. For the former, economic development and strategies for industrialization and “catching up” were far more important than developed-country imperatives of full employment and social welfare; however, in the end, it was the latter’s interests that dominated, given the balance of power in the world. Hence, at this stage financing for capability development was not even part of the conversation, which in the large part remained restricted to addressing BoP crises. Given the economic context of the interwar period, even this was a significant achievement, but the system still did not go as far as it should and could have gone, because had the United States wished, the developing countries’ agenda could also have emerged as a priority.

The other keenly discussed issue was how the IMF would deal with the “debt legacy.”8 Colonies like Egypt and India were demanding that they be allowed to use the sterling credits that the British had provided in return for goods exported to them by their colonies during World War II; at that point, they were unable to use them because of exchange controls imposed on them by the UK government. This measure would have made the IMF responsible for a direct legacy of the war, a role that the United States, United Kingdom, and France opposed. Among other issues, and one that seems anodyne now—the composition of the current account—also saw divisions drawn between developed and developing countries. The question of quotas and how they were to be paid for was hotly contested and divided the delegates. The reason to highlight these seemingly small victories is that they were conceded at a time when the world was deeply divided but developing countries had little agency. There are lessons for what can be achieved today in light of the changed power structures: the developing world can negotiate harder to design a global financial architecture that is more inclusive and equitable.

At the time, the BWS was defined by the competing recommendations of the British and American delegations about what the international monetary architecture would resemble. This chapter does not examine the intricacies of the differences as there is more than ample literature on the subject.9 The British delegation led by John Maynard Keynes mooted the idea of an International Clearing Union (ICU), which would have the authority to create a new currency (bancor) that would act as a reserve currency. Overdraft facilities to the tune of $26 billion would also be provided to countries with a BoP deficit so that they could borrow without fulfilling strict conditionalities. The system would have worked like a conventional banking system in which surpluses would be lent out to countries with a deficit just like deposits in a bank are lent as loans. His proposal also put forward corrective measures that were to be taken both by creditor and debtor countries when conventionally the burden of adjustment fell on the debtor.

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