Will the Bretton Wood 2 Regime of fixed and/or heavily managed exchange rates in many emerging market economies collapse in the same way as the Bretton Woods 1 regime (the “dollar standard” regime that ruled after 1945 in the global economy) collapsed in the early 1970s? What are the similarities and differences between those two regimes? It is interesting to note that the same factors – U.S twin deficit, U.S. loose monetary policies and fixed pegs to the U.S. in the dollar standard regime of Bretton Woods (1945-1971) - that led to the commodity inflation and goods inflation in the early 1970s and thus to the demise of the Bretton Woods 1 regime (in the 1971-73 period) are also partially the same factors that are leading now to the rise in commodity and goods inflation in emerging markets that are pegging to the U.S. dollar and/or heavily managing their exchange rates.

Thus, like the rise of commodity and goods inflation led to the demise of BW1 the current rise in commodity and goods inflation in emerging market economies may be the trigger that will lead – as argued in my 2005 BW2 paper with Brad Setser and a more recent 2007 paper of mine – to the demise of BW2. It is true that BW2 is still alive as the massive ongoing reserve accumulation by BRICs, GCC and other emerging markets suggests. But the rise in inflation that these exchange rate policies are causing may soon lead to its demise: abandoning pegs and/or letting currencies appreciate at a faster rate will be the necessary step to control inflation in such emerging market economies.

Let us flesh out this comparison between BW1 and BW2 in more detail…