The Information Highway Out Of Bretton Woods

Dean LeBaron
February 26, 1995

Only fate could have determined that the G-7 would sponsor two seemingly-unrelated conferences on the weekend of February 25-26, 1995. In Halifax, Nova Scotia, representatives of finance ministers discussed, with added urgency, preparation for new institutional measures to update the 1944 Bretton Woods Accord. In Brussels, an unusual blend of Eurocrats and technology leaders discussed the implications of the information superhighway.
Halifax dealt with international arrangements for currency alignment and development- finance in the modern economic world under conditions unimaginable only a decade ago. The agenda for this conference had a series of failures before it, the finance ministers having been powerless to stop currency crashes in Britain, Italy, and, the most serious recent case, Mexico. Brussels dealt with the opposite issue—whether to establish institutions to manage the success of global, instantaneous, cost-less, and volume-insensitive information transfer.
On the surface it seems only a coincidence that these two meetings were simultaneous. Except for CNN, I doubt if the participants of one knew what the others were doing. But they related in a miraculously simple way and offered the solution being sought in Halifax.

Bretton Woods recently celebrated its 50th anniversary. Amid statesmanlike speeches by world leaders in 1944, calls for study and moderate reform were sounded. The original Accord, modified in several ways as recently as nine years ago, converted the gold standard to a dollar standard, and governments were encouraged to maintain, wherever possible, fixed rates (lately, "fixed" implied a +/- 2.5% range) around the stated peg, the dollar. More importantly, governments and their central banks pledged a coordinated action to defend weakening currencies through information exchange and support mechanisms . . . they were not to be destructively competitive but cooperatively collaborative. And, finally, two huge and powerful institutions were created, the World Bank and the International Monetary Fund, with the ability to accept government deposits and issue drawing rights (SDR) according to a set of rules. Gradually these institutions, especially the World Bank and its subsidiary, International Finance Corporation, assumed the major role in channeling development capital to emerging economies.

In the two generations since the original agreement, unplanned factors have become mighty forces.
First, foreign currency alignments no longer follow trade but lead it. Purchasing power parity can be way out of line with exchange rates for long periods of time. Exact figures are impossible to determine, but it is estimated by some that 98% of currency flows are speculative, unrelated to trade settlements. Currency levels bear some relation to underlying economic policies but far more to the perceptions of traders of those policies . . . and even to the perceptions of traders about the perceptions held by other traders. Trillions of dollars trade each day on the 24-hour, instantaneous, global-currency lottery. If earlier it was possible to "red-dog" a large stock on a single day, now an entire economy may take only a week. No institution or collection of institutions can stop it with tens of billion-dollar bailouts. Central-bank intervention is rather like sending a kiddy car onto a no-speed-limit autobahn . . . dangerous even if the kiddy car is driven by an adult.
Second, markets for foreign exchange are accessible for high levels of borrowing. Through the use of derivatives, leverage of a hundred times base capital is available. Thus the amounts at risk are huge and grow as the velocity of trading increases.
Third, the entire system is almost instantaneous. There is no time for quiet, reserved, confidential deliberations by central bankers. Waiting to act may be weaker than consciously doing nothing, but the luxury of observing markets slowly adjusting to new equilibria is inconsistent with the evidence of non-linear, non-equilibrium, almost chaotic processes. No procedures have been devised to deal with the speed and magnitude of the outcomes. The closest parallel might be computer programs at the US Department of Defense that analyze and prepare responses to nuclear threats. But even there, if the math worked, the armaments of defense are inadequate to the onslaught of traders with the smell of currency blood in their computer models.
Finally, currency trading has become a major profit center for large international banks. The tyranny of performance measurement of individual traders—the asymmetric payoff where they win big bonuses if they win by taking risks, and only lose their job if they lose money—presents an important element of incentive to play the game high.

It is not in the lexicon of free markets to erect trading barriers. To the contrary, G-7 nations have espoused free trade and full convertibility to all (while the U.S. tempers the advice by calling for "managed trade"). The siren song was that the sober, dedicated-to-stability central bankers would take care of the system. All the developing economies had to do was pursue sound policies. Some would occasionally question whether the United States met the standards for borrowing from the World Bank, but the necessities of the day caused such embarrassing questions to fade.
There is much about foreign exchange trading that we do not know. No tick-by-tick database exists (the closest is the arduously compiled ten-year database of Olsen & Associates in Zurich). There are no volume figures, only reports of interest rate quotes which combine real interest rates, expectations of inflation or deflation, and any separate currency expectations. This is a fast, continuous market about which we only have anecdotal information. And we can’t stop it. Nor should we.
Foreign exchange markets lack only one thing, and it is the only thing which is large enough and fast enough to correct imbalances. Information. And now we come back to the two meetings of the weekend.
The only institution that should be established is a common information gateway through which all currency transactions must pass. Trade information is recorded, protected for security of the parties, and disseminated to the world, continuously. Markets could then respond in whatever way they wished to the observed currency flow. Market analyses would flourish, with the usual mixture of insights and junk. All market participants would have equal access to factual information on trading flows, regardless of size. Governments would be relieved of the responsibility of maintaining a fixed exchange rate because there would no longer be a "dollar" standard. It is worth recalling the dramatic decline of the dollar against the mark and the yen . . . undesirable behavior for a reserve currency. There would be no reserve currency. Everything would float because it does anyway. To pretend there is a fixed mechanism is a fiction of markets long past. The gateway capture is comparatively simple to a world that devised the Internet without really planning to do so. Markets would be stabilized by market participants, properly informed.

And what of the international institutions founded fifty years ago? I am reminded of an old story about central bankers in the gold standard days. It was decided to put the world’s reserves of gold on an isolated island with one central banker to represent each country who would move the gold on the island from one country bin to another according to cabled instructions. The bankers, the world’s gold reserves and a one-year supply of champagne were sent to the island and left to await a resupply of champagne in a year. Cables went daily to the island instructing the bankers to realign the gold according to the settlement requirements. Everything was fine and stable on the world economies for the first year and the new system was heralded a success. However, the first resupply mission which arrived at the island with the champagne found the bankers dead of a tropical disease, and it was estimated they died shortly after arrival. News that the gold had not been moved for a year brought the world’s economies to their knees. Chaos.
The moral? In a free market, disclosure or "sunshine" is the prescription. The next G-7 meeting on Bretton Woods reform should combine with the G-7 meeting on information technology. Something might happen.

- Dean LeBaron