Martin Wolf - in his FT column today - discusses my latest paper on Asia financial issues and the instability of the Bretton Woods 2 (BW2) regime of effective currency pegs to the US dollar that is followed China, most of East Asia and many other emerging market economies. The paper is  titled "Asia is Learning the Wrong Lessons from Its 1997-98 Financial Crisis: The Rising Risks of a New and Different Type of Financial Crisis in Asia" (available in full for RGE subscribers).

As the title of the paper suggests I argue that Asia has learned the wrong lessons from its 1997-98 crisis. While 2007 looks in many ways very different from 1997 when East Asian currency and financial markets were collapsing and their economies were entering in a severe recession caused by the currency and financial crisis, not all is clear for East Asia today in spite of high growth and buoyant financial markets.

The paper argues that the current East Asia financial and currency policies represent a return to fixed exchange rates as most - but not all - of the policy makers in the region are aggressively preventing a necessary currency appreciation via massive and growing amounts of forex reserve accumulation. Such reserve accumulation has been at the rate of $450 billion in 2006 alone and now at an even faster rate in 2007. By now the stock of forex reserve in Asia is over $2.5 trillion and rising rapidly.

These policies are however creating -  via partially sterilized intervention - a massive growth of monetary base and of credit in Asia that is feeding a variety of asset and financial bubbles as well as leading to goods inflation in some countries; these bubbles are dangerous and likely to lead to a financial bust over time.

These currency policies - effectively what has been referred to as the Bretton Woods 2 regime of fixed rates in Asia - have also made East Asia more dependent now than ever before on the US business cycle and on growth developments outside of Asia. Thus, China and Asia are now seriously vulnerable to a US hard landing that now looks more likely.

These Asian currency and financial policies have also contributed to global current account imbalances, to excessive global liquidity, to the bubbly conditions in a variety of global - not just  Asian - asset markets and to a serious underpricing of risk in global financial markets.

Thus, Asia is fighting today the last war as vulnerabilities in Asia are very different today from those that led to the 1997-98 crisis. Asia instead is not addressing the financial vulnerabilities created by its currency policies that risk to lead - with or without a US hard landing - to a new and different type of financial crisis in Asia, one triggered by excessive liquidity, excessive credit growth and asset bubbles in many financial markets.

As discussed in my paper, one major manifestation of these asset bubbles is the Chinese stock market today where the bubble craze has led to a P/E ratio of 50. And indeed today even Alan Greenspan today is forecasting a bursting of this Chinese stock market bubble and a dramatic contraction in Chinese stocks.

Since Wolf's column is restricted to FT subscribers I will not fully post it but I will just quote some key passages from it: 

With the important, but geographically limited, exceptions of Argentina and Turkey in 2001, the crises of 1997-98 have so far been the last in the long series of financial crises that afflicted emerging economies in the 1980s and 1990s. Today, the desire of outside investors to put their money in these economies is overwhelming, as is shown in the strength of their financial markets, the low spreads on external borrowing and the size of the private capital inflow: in 2006, for example, net private capital flow to emerging economies was $256bn. The IMF is now almost entirely out of business.

What explains this new stability? As Nouriel Roubini of New York University’s Stern School of Business argues, the Asians did not learn the lessons most western economists thought they should. This is not to deny that there have been substantial structural improvements in Asian economies, notably in the capitalisation and regulation of financial systems. But this is not the heart of the matter. The big event has been elsewhere: the great mistake, Asian policymakers concluded, was not pegged, but overvalued, exchange rates. That error was what had brought the humiliating dictation by IMF officials operating under the thumb of the US Treasury.

“Never again” became the watchword. Never again has been the result. Now the east Asian emerging economies are mostly creditor nations. Moreover, much of their accumulation of external assets is in official hands ...

The scale of the reserve accumulation demonstrates the obvious: these countries have refused to adopt the freely floating exchange rates many outside economists recommended. They have, instead, chosen to keep their exchange rates down. This, in turn, has generated current account surpluses. Sustaining such surpluses requires a stable excess of savings over domestic investment. One instrument they have used has been sterilisation of the monetary consequences of reserve accumulations, to prevent the normal expansion of money and credit, overheating, inflation and so loss of external competitiveness.

If a substantial part of the world economy is generating huge current account surpluses, somebody else has to run offsetting deficits. That conclusion became still more potent when oil prices soared, since this shifted income to countries that painful experience has taught not to spend their additional revenue quickly. In a world of fluctuating currencies, however, accumulating large quantities of net foreign liabilities is easiest for countries able to borrow freely in their own currencies. The reason is simple: only such countries can borrow without risking significant currency mismatches inside their financial systems. It is no accident then that the US has emerged as the world’s chief deficit country – its “borrower of last resort”. It alone is able to be a vast net borrower without risking the health of its financial system.

So is what some economists have called “Bretton Woods Two” – a fixed exchange rate system anchored on the US dollar – both the answer to financial instability in emerging market economies and a basis for sustainable export-led growth?

 Mr Roubini argues that it is not. The policy generates ultimately unsterilisable increases in foreign currency reserves. This causes excess monetary growth, domestic asset price bubbles, overheating, inflation and the loss in competitiveness that governments had tried to prevent by suppressing the rises in nominal exchange rates. It distorts domestic financial systems, by pushing interest rates below equilibrium levels. It generates a waste of resources in accumulation of low-yielding foreign currency assets exposed to the likelihood of huge capital losses. It makes Asian economies excessively dependent on demand from outside the region. It exacerbates US protectionism. Finally, it compels US monetary authorities to sustain easy monetary policy, in order to offset the leakage from domestic demand caused by the huge current account deficits.

 The post-crisis policy system has proved more durable than many (including myself) expected. At its heart, however, is China. Though not affected directly by the crisis, it was one of the countries that learnt its lessons in the Asian way. Today’s result is a dynamic behemoth accumulating foreign currency reserves at a rate of $50bn a month in the first quarter of the year and expected by the IMF to generate a current account surplus of 10 per cent of gross domestic product this year. I do not believe these astonishing trends are desirable or sustainable. Why that is so and what to do about it I intend to discuss next week. 

Wolf's views and insights are always most thoughtful and deep. So we will wait until next week to get his views on what China should do and its role in an orderly rebalancing of global current account imbalances.