The Bretton Woods II arrangement is informal and presumed to exist, whereas under the original Bretton Woods arrangement, currencies were actually formally fixed and linked directly to gold. It also included the formation of the IMF and World Bank, as well as many other formal grand arrangements.

The U.S. has a huge savings shortfall and tremendous capital needs, and therefore a need to import capital. So the U.S. allows this arrangement to exist despite the fact that it creates adverse economic externalities. The Chinese are presumed to agree to this arrangement because they presumably need to produce products for export to the U.S., in particular, and to create jobs for their people who are migrating from the farm to industry. Japan has a need to export products to avoid a very severe recession and given the demographically mature population in Japan, there is a need for that population to accumulate assets that they can presumably rely upon in retirement.

Because of that set of circumstances, the presumption is that the arrangement is symbiotic and mutually beneficial for everybody.

The higher debt levels constrain Federal Reserve policy because the higher rates go, the greater the likelihood that something breaks as a result of increased financing costs. It also means that the higher rates go, the greater the impact on the federal deficit. Eventually we may need to borrow to finance the coupon payments on Treasury securities.

In addition, there is this huge disparity in wages between workers in China and workers in the U.S. that obviously gives the Chinese economy a tremendous relative production advantage. It also means that there is a tremendous incentive for U.S. companies to outsource production to China, or outsource labour to India and other lower-wage-per-value-added countries.

That’s important because it has an impact on the job market in the U.S., where any given amount of fiscal or monetary stimulus results in less job formation than previously, which ultimately leads to some form of social unrest. It also means that there is a good amount of capital flight from the U.S. because you can regard this outsourcing, especially in the form of direct investment in plant and equipment in other countries, as capital flight. Capital flight is symptomatic of debtor nations, whereas foreign investment occurs in countries enjoying trade surpluses.

It really comes down to a distribution issue. Shareholders benefit, at least in the short run, from the low cost of labour in other countries and the whole globalization process, the availability of low cost, quality goods benefits the U.S. consumers, but U.S. workers lose in this arrangement. And in the long run, it probably isn’t a very good arrangement for shareholders because there is very little to ensure that the capital invested abroad can be recovered and that it won’t in fact be nationalized, or otherwise confiscated, one day. There is a substantial difference between having capital and plant and equipment in your home country and domiciling assets in another country where you have much less control and where the laws and rules could change substantially overnight.

The loss of jobs and the outsourcing also mean that the U.S. is de-industrializing. To the extent that we de-industrialize, then obviously the industrial base gets smaller. As our debts get larger and larger, the need to dedicate resources toward repayment of that debt becomes greater. It also becomes more difficult because the industrial base, which can be relied upon to produce goods to sell abroad, is diminished.

The natural adjustment process is an exchange rate adjustment. The exchange rate adjustment cannot occur in a BWII fixed rate regime. The de-industrialization eventually nullifies the efficacy of the exchange rate adjustment solution. It becomes ineffective because we do not have the resources that provide for the production that can be priced competitively in a new relative exchange rate regime. In essence, de-industrialization nullifies the currency adjustment solution because the elasticity of production with respect to the exchange rate has declined.

In my view, which is perhaps a little bit extreme, this set of imbalances leads to very nasty things like wars—political, economic and military. That has certainly been the case historically and it’s hard to see why it would be very different this time around.

The other interesting point is that at the time of the Bretton Woods negotiations, post-World War II, by 1945 U.S. industrial production was more than double what it was in 1939. The U.S. produced one half of the world’s coal, two-thirds of the world’s oil, more than a half of the world’s electricity, and controlled 80% of the world’s gold reserves (excluding the Soviet Union), and of course at the time was the only country that had an atomic bomb.

So you can see that the original conditions in Bretton Woods I were much different than the prevailing state of the world today, and the purpose of Bretton Woods was to rebuild Europe, to rebuild the global economy and rebuild Japan post-war. The notion was that you could have greater stability in the global economy if exchange rates were relatively constant, and in this case, fixed to gold within a very narrow band. In that sense, the exchange rate risk would be taken out of global transactions. Bretton Woods I was the result of a huge geopolitical clash. Bretton Woods II is a convenient mechanism but one that provides for a clash of geopolitical objectives.

In fact, the Bretton Woods regime did not work well at the outset. The U.S. needed to recycle its trade surplus into other countries to finance industrial development but had difficulty doing so. Under Bretton Woods, the International Monetary Fund and the World Bank were created and authorized to lend to countries. Japan and Europe had very little industry from which to build cash flow.

The system did not work very well and it became apparent, at least to some people, that a greater export of capital from the U.S. to the European countries was necessary to facilitate investment and the re-establishment of industry. So the Marshall Plan was established, wherein actual grants, as opposed to loans, were made to provide capital to European countries. The Organization for Economic Coordination and Development (OECD) was subsequently established to supervise and monitor the allocation of the Marshall Plan grants. It was the combination of fixed exchange rates, the IMF, the World Bank and the Marshall Plan that together seemed to be a reasonably successful economic architecture. But again, it was successful because the goal was to rebuild and restabilize the global economy.

In the case of Bretton Woods II, we have a plan that is, first, not a formal plan. There is always the day-to-day potential for change, for someone to say "we’re not playing this game any more, we’re going to do something different." This obviously means that there is less stability to the system. But it also seems to me that it’s a plan or an arrangement that leads to greater instability in the global economy and actually increases the existing imbalances, as opposed to trying to stabilize the imbalances with a tendency toward rebalancing.

So, Bretton Woods I was a fixed exchange rate regime that provided stability to rebuild Europe and Japan following World War II. The global creditor nation, the U.S. provided capital to the globe to finance investment. In the case of Bretton Woods II, the biggest global consumers, the U.S. citizenry, are provided with goods and financing for the purchase of goods from foreigners who are producing the goods and who are, as a result, accumulating massive amounts of reserves.

So in BWII, there is a transfer of wealth from the debtors to the creditors and that wealth transfer is constantly increasing. The longer this system continues the greater the imbalance between the foreign creditors and the U.S. debtor. Future generations of Americans will labour to service and retire the present generation’s obligations.

The bottom line is that Bretton Woods II will result in a more imbalanced global economy. It’s a system that is destabilizing rather than stabilizing and that is a very, very important difference.

The recycling of money is in essence providing externalities in the form of a higher U.S. dollar than should otherwise be the case, lower U.S. interest rates than would otherwise be the case, much tighter credit spreads because foreign investors are such huge buyers of U.S. corporate bonds, and lower mortgage rates because they are also investing in U.S. mortgage-backed securities. And they obviously own a lot of Treasury and agency securities. So the U.S. has much lower interest rates generally. This process has led to artificially low interest rates, low inflation rates, and an overvalued currency, and it probably manifests itself in the domestic economy in much higher housing prices, so perhaps a housing bubble as well.

The system that is advertised as Bretton Woods II, a semi-fixed exchange rate stable system, by virtue of the system itself, creates greater imbalances and a much more speculative environment. That takes us to the commodity complex. The natural equilibrating mechanism for trade balance is exchange rate adjustment and under BWI, the transfer of gold from one country to another settled trade imbalances. Gold was the stable value global asset.

If you think the dollar is at some point vulnerable to a decline in purchasing power then you obviously want to purchase hard assets now because those hard assets will retain their value in global terms if they are globally traded assets like gold, diamonds, or oil, among many other commodities. This is particularly true if the yield on dollar denominated bonds is very low.

But just as importantly, if you think that this imbalance leads to the potential for more military action, then there would be a natural tendency, it would seem to me, for leaders of foreign countries to begin stockpiling assets that they might deem valuable in time of war. Just as the U.S., during an election year, refused to open the strategic oil reserve, then you would think there would be copycat countries that, if they had not already, would establish strategic oil reserves and fill them. In that event, you get precautionary demand for oil so that the oil comes out of the ground and goes right back in to the ground. The demand for oil looks very high and prices go up based upon not only commercial demand, but also actual precautionary demand and the speculative demand derived from this BWII system.

The BWII system results in speculation and instability. Importantly, the growth rates of "emerging" economies, like China, are quite high in a BWII system as are the infrastructure requirements. The transformation of growth to newly industrialized areas results in additional demand for commodities that are inputs to the infrastructure development, resulting in a structural demand for particular commodities.

By regulatory solutions, I’m referring to multi-country, negotiated terms of trade. For example, trade quotas, which are voluntarily managed as opposed to forced solutions like tariffs. For example, if the U.S. put tariffs on every product imported from Asia, that policy would have a particular set of investment implications. Radical exchange rate realignments would be another alternative solution with its unique market impact. A market-forced solution might take the form of a foreign boycott of additional U.S. dollar denominated assets.

Depending upon the form of the solution to resolve the imbalance—if in fact we agree that the imbalances require resolution and are resolved in our secular timeframe—then the implications will be quite significant and quite different in the marketplace with respect to interest rates, yield curve shapes, currency values and credit spreads. The importance of the recycling of dollars is huge in the bond market and really affects everything that we do in our portfolios. In some cases, those solutions will tend to be very reflationary and in others, the deflationary tendency will be quite real. Regional growth rates and inflation rates are significantly impacted by the present regime. A change in regime, away from BWII, will exert substantial real economic affects.