Did we mean to break the global financial system? This has become a pressing question as our understanding of the causes of the cost-of-living crisis has got darker with each passing week of this parched summer.
For a time, it was hoped the problem was Covid: that too many people were in the wrong jobs, or goods in the wrong places, when the economy reopened after the pandemic. Then came the war in Ukraine, and the problem became energy prices. Central banks continued to act as if it would all be over by Christmas. As soon as wage settlements came into contact with the underlying weakness of economic growth, inflation would be over. Interest rates would never need to rise by more than a couple of percent, and normalcy would return.
Over the summer, and more intensively since Nancy Pelosi’s visit to Taiwan, a much more troubling explanation of inflation has emerged. It was first raised by a Credit Suisse analyst, Zoltan Pozsar, in March this year when he suggested in a paper that a new global monetary system – which he calls Bretton Woods III – is coming into play. If he is right, the economic model that has created all our wealth for the past 50 years is being torn up.
The original Bretton Woods system was the postwar economic settlement developed in part by John Maynard Keynes in which major currencies were pegged to the US dollar, which was convertible to gold at a fixed price. It had broken down by 1973 and countries including the UK were forced to abandon the peg. After that came what is known informally as Bretton Woods II; most major currencies moved to floating exchange rates, but the dollar remained the world’s reserve currency.
The effect of this system, which has persisted up to the present day, was to divide the world into producer nations, such as Russia and China, and consumer nations, such as Britain and the US. The producers produced trade surpluses that they held in US dollars (and proxy currencies such as the pound and the euro). These surpluses were then used by the consumer nations to fund large government deficits and to keep prices and interest rates low. Low interest rates in turn accelerated the financialisation of consumer economies. They enabled the banking sector to leverage up the value of every asset they held many times over, creating a firehose of free capital to spray at every imaginable investment opportunity. This money-go-round made America and Europe rich. It also created extraordinary economic growth in China, and enabled Russian oligarchs to buy mansions in the UK and yachts in St Tropez. Everyone was a winner, except of course Chinese migrant workers, Russian peasants and the “left behind” communities in Europe and North America that saw little or no benefit from the financial boom.
In February of this year, when Russia went into Ukraine, Western policymakers decided the best response was to shut off part of this system. They excluded Russia – the world’s biggest supplier of commodities – from the dollar-based global economy. The hope was to bring the enemy to its knees. Instead, the move has had the reverse effect. It sparked a crisis in the global commodities markets that has made Russia richer than ever. The rouble is now trading at 25 per cent above where it was before the war, and the value of everything that Russia mines, drills for or grows has risen astronomically in value. It is, Poszar argues, the beginning of a new economic age: Bretton Woods III.
The first steps towards this system have already been taken by Russia. Its government is trying to engineer a new financial system for an Asian trading bloc, including China, that would end the hegemony of the dollar. This context is what makes Pelosi’s visit to Taiwan so politically sensitive. This is not the moment for pushing China and Russia into a common front against the West.
We may choose to think that the Chinese president Xi Jinping will have understood the response to the invasion of Ukraine as a warning not to invade Taiwan. More probably he will have interpreted the response as a warning that 30 years of pursuing an export-led growth strategy have put China’s neck in an American noose. As long as China trades in dollars and keeps its trade surplus in US Treasury bonds, it is in no position to assert its sovereignty over America. Specifically, Xi will be asking himself whether this is the moment to switch from this export-led model towards developing a more autarkic economy. This would involve repatriating its trade surplus to allow Chinese workers to enjoy the full fruits of their labour, and reorienting its industry to meet the resultant boom in consumer demand. With the problems in China’s property market fomenting discontent, 2022 looks like a good moment to begin the transition.
Such a change would bring an end to the global money-go-round. The trade imbalances that have enabled the West to live beyond its means these past 30 years would start to even out. As they do so, galloping inflation in the West would be the inevitable consequence. This would not be the mild kind of inflation that can be cured by interest rate rises alone. It would be the most bitter kind of inflation, driven by the determination of consumers in the West to hold on to the most basic comforts of life. The response to such inflation does not end with 5 per cent interest rates or even 15 per cent interest rates. It ends with Molotov cocktails, the scattering of crowds from the charge of police horses, and helicopters departing from the roofs of smoking public buildings.
Did we, the West, mean to break the financial system that brought us so much comfort? Probably not, but it is a symptom of our foreign policy myopia. Politicians in the UK and US treat foreign policy as if it were a consequence-free pitch for domestic votes. Socking it to Johnny Foreigner is popular on the right for nationalist reasons and on the left for ethical reasons. Both are commendable sentiments, but they miss the bigger picture. Our lives in Britain are connected to everyone else’s in a much more intimate way than most politicians would care to accept. Whether you work in the Knowsley council social services department or on the trading floor of an American bank in Canary Wharf, your salary is subsidised by migrant workers in Guandong, your grocery shopping is cheaper because of freezing Norilsk miners, and your mortgage is paid in part by the oligarch in their St George’s Hill mansion.
The long-term solution lies in renewable energy, which will put an end to fossil fuels, the biggest source of global trade imbalances; in the digital economy, which will reduce the world’s dependence of large pools of underpaid labour; and most important of all, in a new political settlement that reflects the fact that an equitable distribution of wealth is an essential component of a healthy global economy. The question is, will we need to see helicopters land on the roof of a burning Downing Street before this is reached?
[See also: How inflation is worse for women]