Bretton Woods 3.0

Bretton Woods 2.0”, coined by Folkerts-Landau and Garber in 2003, described a monetary order organised around China recycling its surpluses into US debt, thus acting as both the source of the deterioration of the US current account and the enabler of its sustainability. We think that a “Bretton Woods 3.0” framework has emerged, with two major differences with the Folkerts-Landau/Garber model: first, the key counterpart of the US funding need is a mature economy, Europe. Since 2022, Euro area investors have been the largest foreign holders of US government debt. This should be seen as beneficial to the US: it is safer to rely on savings from a political and military ally to continue running spendthrift fiscal policies than on a geopolitical rival such as China. Second, this does not entail a massive US bilateral current account deficit: the US trade deficit with the Euro area in goods is offset by strong exports of intellectual property. This puts the US in a comfortable position.

Why fix something that is not broken? The new Chair of the US Council of Economic Advisors came up with ideas to force Europeans to increase their exposure to US debt, as a “fee” to benefit from US military support and avoid tariffs. This is “overkill” since Europeans are already spontaneously strongly contributing to the US financial sustainability. In his plans, Europeans would also be requested to appreciate their currency vis-à-vis the dollar under a “Mar A Lago Accord”, which – short of financial wizardry which we think is impractical – contradicts the first objective, while weighing on Europe’s already shaky growth performance. A limit to such US coercive approach is that the Europeans’ alternative strategies – e.g. developing their own defence sovereignty – could become economically attractive if the cost of the transatlantic relationship becomes too high. We find it interesting that Friedrich Merz, CDU-leader and winner of last Sunday’s election, has expressed interest for such strategic overhaul. A coalition with SPD could make it happen, but that non-mainstream parties will have the possibility to block the constitutional reforms needed to increase Germany’s fiscal space will however be an obstacle.