When Currencies Collapse: Will We Replay the 1930s or the 1970s?

Barry Eichengreen. Foreign Affairs. Volume 91, Issue 1. January/February 2012.

The international monetary system rests on just two currencies: the dollar and the euro. Together, they account for nearly 90 percent of the foreign exchange reserves held by central banks and governments. They make up nearly 80 percent of the value of Special Drawing Rights, the reserve asset used in transactions between the International Monetary Fund (IMF) and its members. Of all debt securities denominated in a foreign currency, more than three-quarters are in dollars and euros. The two currencies together account for nearly two-thirds of all trading in foreign exchange markets worldwide. They are the essential lubricants of global trade and finance. Were they not widely accepted, the global economy could not sustain current levels of international trade and investment.

That is why the problems now faced by both currencies are so alarming. Today, more than at any time in recent memory, analysts and investors are voicing doubts about the stability of the dollar and the euro and the international monetary system that depends on them. Consider first the dollar. Faith in its reliability was seriously undermined last summer when the debt-ceiling imbroglio in the United States revealed a seemingly unbridgeable gap between the political parties and raised concerns about the capacity of U.S. policymakers to put the country’s financial house in order. Foreign investors, who hold slightly less than half of all marketable U.S. Treasury debt, saw the crisis as proof that members of Congress would rather let the country default on its obligations than compromise on their own partisan objectives. And foreign governments were spooked. As the debate reached a peak, Chinese officials lectured Washington on the need to act responsibly, China’s state-run news agency disparaged the negotiations as a “madcap farce of brinkmanship,” and Russian Prime Minister Vladimir Putin characterized Americans as “living like parasites off the global economy and their monopoly of the dollar.”

Doubts about the euro are even graver. The eurozone is divided into a relatively vigorous northern tier with sound finances and a southern one with crushing debts and nonexistent growth prospects. Europe’s indebtedness is no greater than the United States’, but unlike the United States, Europe has no federal fiscal system to transfer resources from prosperous to troubled regions-and European leaders seem unwilling to create one. At the same time, they are hesitant to write down unsustainable debts for fear of destabilizing the banks that hold them.

The result is that southern Europe has been left to implement brutal fiscal cuts that are pushing its economies deeper into recession, further impairing their capacity to service their debts. Many southern Europeans, suffering severe hardship, have rebelled against their own governments and accused northern Europe of sacrificing their wellbeing. Many northern Europeans, meanwhile, see their southern neighbors as spendthrift, lazy, and corrupt. Those northerners have become increasingly vocal in saying so and have concluded that more rescue operations would amount to pouring money down a rat hole.

All this implies that the euro will at best remain the weak currency of a permanently troubled Europe. At worst, slow growth and tensions in the eurozone could ultimately lead countries to abandon the monetary union. Both scenarios would threaten the international monetary system.

Such systems have collapsed before: first in the 1930s and again in the 1970s. The 1930s collapse played a significant role in spurring a worldwide depression that crippled economic activity and fed political extremism. In contrast, the systemic failure of the 1970s, although potentially just as dangerous, had far less catastrophic effects; the global economy was wounded, but not mortally. It is crucial to understand these two historical precedents in order to gauge what might happen today if there were full-blown crises of confidence in both the dollar and the euro.

The 1930s: A Disastrous Collapse

The international monetary system of the late 1920s and early 1930s resembled the current system in important ways. It, too, was organized around two currencies: the British pound and the U.S. dollar. With the United Kingdom and the United States making sterling and dollars available-and other countries accumulating them- global foreign exchange reserves more than doubled between 1924 and 1930. Trade credit was readily available, allowing deficit countries to finance additional imports. As a result, during the 1920s, global trade rose twice as fast as global output of goods and services. International capital flows similarly expanded more rapidly than global output, peaking in early 1928.

The boom in trade and in the movement of capital created global imbalances similar to those of recent years. Some surplus countries, notably France, accumulated vast quantities of reserves. Others, such as the United States, recycled their surpluses by lending to the deficit countries of central Europe, mainly Germany. But the deficit countries spent the capital they imported on consumption rather than investment. The world saw the rapid expansion of credit and an alarming run-up in asset prices. As the decade drew to a close, doubts grew about the resilience of this precariously balanced system.

Today’s international monetary system has produced similar conditions and concerns. A key difference between the two eras, however, is the role played by gold in the 1930s. At the close of the 1920s, central banks held between 60 and 70 percent of their international reserves in the form of gold. They used that gold, together with foreign exchange reserves, principally bonds issued by the U.S. and British governments and bank deposits in New York and London, as backing for their money supplies. They stood ready, as a matter of legal obligation, to convert their monetary liabilities into gold at a fixed domestic-currency price.

Concerned about the exuberance of financial markets, the U.S. Federal Reserve began raising interest rates in 1928. As a result, capital flows from the United States to the deficit countries fell off. To prevent their exchange rates from weakening, other central banks had to match the Fed basis point for basis point. As those central banks raised interest rates, credit markets tightened and growth slowed, leading to a reduction in U.S. exports. Economic activity in the United States peaked in the summer of 1929, and the autumn was punctuated by a violent stock market crash. By 1930, most of the world was in recession.

Initially, the international monetary system withstood these pressures. In 1931, however, what had been mainly a crisis of output and employment suddenly acquired an alarming financial overlay. In May, there was a run on Austria’s leading bank, the Creditanstalt. If a bank could go down in Vienna, investors concluded, the same could happen in Berlin, given the superficial similarity of the Austrian and German financial systems. As capital fled and foreign credit become unavailable, the German government was forced to respond with exchange controls and an agreement, negotiated with foreign bankers, effectively freezing Germany’s international loans. British banks had extended some of those loans. Uncertain about the condition of the British banking system, investors began shifting money out of London, steadily draining reserves from the Bank of England. After a pair of belated interest-rate hikes failed to lure back this fleeing capital, the imminent exhaustion of its gold reserves forced the Bank of England to abandon the gold standard in mid-September.

This marked the beginning of the international monetary crisis. Before abandoning the gold standard, the Bank of England had reassured foreign central banks and governments of its unwavering support for the prevailing sterling exchange rate. Having been burned once already, those banks were now not shy about liquidating their sterling balances. Although they could no longer convert them into gold at the Bank of England, they could still dispose of them on the foreign exchange market. The subsequent fire sale drove down the sterling exchange rate and magnified the capital losses incurred by holders of sterling. This underscored the risks of holding reserves in foreign currency.

If the United Kingdom could act this way, it was no longer inconceivable that the United States might, too. Thus, in the weeks after the British dropped the gold standard, central banks rushed to redeem their dollars for gold at the Federal Reserve. The resulting gold losses forced the Fed to raise interest rates in October, even though the U.S. economy was already in a deep recession. By so curtailing the provision of credit, the Fed contributed to the wave of U.S. bank failures that hit toward the end of 1931. By the end of that year, central banks had liquidated nearly half of all the foreign exchange reserves they had held a year earlier. The prevailing international monetary system had imploded.

As international liquidity grew scarce, central banks and private investors searched desperately for other assets, that is, alternatives to the dollar and sterling that were liquid and promised to hold their value. They found them in the currencies of countries still on the gold standard: Belgium, France, the Netherlands, and Switzerland. The share of foreign exchange reserves held in those countries’ currencies rose from ten percent of the total in 1931 to 20 percent in 1932 and 30 percent in 1933.

The problem was that these were not large markets. As their larger trading partners adopted a beggar-thy-neighbor strategy of devaluing their own currencies, these smaller countries experienced more and more trouble competing. Countries still on the gold standard saw their exports stagnate and experienced rapidly rising unemployment. By 1933, these states, once seen as bastions of stability, looked increasingly vulnerable. Capital started flowing out, not in, as central banks moved to liquidate their balances in these countries to avoid further losses.

As doubts grew about the stability of the Belgian and French exchange rates, the share of foreign exchange reserves in currencies other than sterling and the dollar fell sharply in 1934, and then dropped again in 1936, when the last countries still on the gold standard abandoned it. As war clouds gathered in Europe, central banks shifted their reserves to safety in New York, prompting a modest recovery in the value of foreign exchange reserves held in dollars. But this movement was small relative to the earlier drop in dollar reserves. It was not enough to reconstitute a working international monetary system.

The resulting vacuum was disastrous. The chaotic liquidation of foreign exchange reserves made credit scarce and put upward pressure on interest rates at the worst possible time, making it hard for firms to finance not only international transactions but domestic investment, as well. Disorderly exchange-rate movements disrupted trade flows, making it harder for countries to export their way out of the Depression. Nations now losing gold and foreign exchange reserves imposed capital controls that hindered foreign investment. It took years, well into the post-World War II period, for international trade and investment to recover to the levels that had prevailed prior to the collapse of the international monetary system. After the loss of confidence in the system’s two key currencies, the inability of other currencies to provide viable alternatives made this international monetary collapse a global catastrophe.

The Postwar System Takes Shape

At the Bretton Woods Conference in 1944, representatives of 45 nations assembled with the goal of establishing a new international monetary system to replace the one that had fallen apart during the prior decade. In fact, the new system resembled the old one in key respects. Under the new system, currency values were still fixed, now against the dollar. Reserves were still held in a combination of gold and foreign exchange. Gold still accounted for the majority of total reserves. The dollar, which represented the majority of foreign exchange reserves, was still convertible into gold at a fixed price, set at $35 an ounce.

There were some important innovations, however. Under the rules designed at Bretton Woods, exchange rates could be adjusted. A multilateral organization, the imf, was established to oversee the system. In contrast to the earlier era, countries now restricted international capital inflows and outflows; only the United States had deep and liquid financial markets open to the rest of the world. And only official foreign holders were allowed to convert the system’s key currency, the dollar, into gold; private holders were not permitted to do so. Lastly, by the time the Bretton Woods system took shape, the British pound was only a pale shadow of its former self. This system became fully operational at the end of 1958, when the principal European countries removed their remaining restrictions on the ability of foreign firms, banks, and governments to freely buy and sell their currencies for traderelated transactions.

But no sooner did the system become operational than observers began to worry about its collapse. As in the 1920s, the source of anxiety was the fixed price of gold. Not only did foreign exchange now account for a larger share of total international reserves than in the 1920s, but those foreign reserves were now backed by only U.S. gold reserves, as opposed to the combined gold holdings of both the United States and the United Kingdom. As the world economy grew, central banks sought to augment their foreign reserves as a buffer against shocks. In practice, that meant accumulating dollars. The gross foreign liabilities of U.S. monetary authorities, U.S. deposit banks, and the federal government first exceeded U.S. monetary gold reserves in 1960, creating the possibility of a run on the country’s reserves. After barely a year, it was already clear that sustaining the system would require international action.

The solution was the London Gold Pool, established in 1961 by Belgium, France, Germany, Italy, the Netherlands, Switzerland, the United Kingdom, and the United States, with the goal of maintaining the link between the official U.S. price of gold and the price at which gold traded on the London market. These countries acted out of fear that were the market price of gold to significantly exceed the official price, the incentive for arbitrage would become irresistible and a run on U.S. gold reserves would ensue. The European countries agreed to provide half of however much gold had to be supplied to the market to prevent the price from rising, thereby sharing the burden with the United States.

But the arrangement soon proved unworkable. European countries found the costs too high, and France pulled out in 1967. The following year, the London price of gold shot up. In effect, there was a run on the pool, and its operations were suspended. The private market price of gold was cut loose. This marked the advent of a two-tier market in which official transactions in gold took place at $35 an ounce and private transactions took place at a higher price determined by supply and demand.

The 1970s: A Benign Collapse

The advent of the two-tier gold market heightened doubts about the stability of the dollar and prompted questions of whether it would be an adequate source for the safe and liquid assets required by an expanding world economy. Policymakers responded by deciding to create a synthetic reserve asset that could substitute for the dollar, or at least supplement it on the margin. But it took more than five years of difficult negotiations at the IMF to reach an agreement to create that asset, known as Special Drawing Rights. The United States, France, and Germany all had serious reservations about SDRs. The Americans worried that SDRs would accelerate the decline of the dollar, and the French objected that SDRs would artificially support the dollar; the Germans feared, as they did in response to almost every economic initiative, that SDRs would result in inflation. Owing to those concerns, only a modest $3 billion worth of SDRs were issued in 1970.

Meanwhile, the imbalance between U.S. foreign dollar liabilities and gold reserves continued to grow. Doubts deepened about the viability of the two-tier gold market and the prevailing dollar exchange rate. Foreign central banks had to intervene, accumulating more dollars to prevent their currencies from rising. They took limited steps to diversify away from dollars, but there were few other currency markets that were sufficiently sizable and open. Moreover, the obvious targets of that diversification process, such as Germany and Switzerland, worried about the consequences for inflation and competitiveness and took steps to limit the banking and investment rights of foreign entities.

The end was a slow-motion train wreck. Switzerland redeemed $50 billion of dollar paper for gold in July 1971. The United Kingdom made a similar demand in August. Two days later, U.S. President Richard Nixon responded by suspending the convertibility of dollars into gold at a fixed price, once and for all. A few months later, governments agreed to revalue other currencies upward by an average of 7.9 percent against the dollar. But with U.S. monetary and fiscal policies still highly expansionary, the underlying problem remained. One after another, other currencies were revalued against the dollar. Finally, in March 1973, all the other advanced-country governments abandoned their efforts to maintain dollar pegs. Foreign exchange markets were closed. When they reopened, currencies were allowed to float, and many floated upward against the dollar. The dollar-based Bretton Woods international monetary system was no more.

But the systemic consequences of this collapse were quite different from in the 1930s. The failure of the interwar system played a significant role in creating the Great Depression. In contrast, the collapse of the Bretton Woods system in the 1970s did relatively little to slow economic growth or undermine overall financial stability. The 1970s collapse contributed to the U.S. recession of 1973-75 but did not lead to anything remotely resembling the economic and financial crisis of the 1930s. U.S. monetary policy was inflationary, but in the absence of high instability, there was no mass flight from the dollar. On the contrary, the share of foreign exchange reserves held in dollars continued to rise. Indeed, throughout the decade, there was no shortage of liquidity to limit the growth of international trade and finance. The Organization of the Petroleum Exporting Countries added to its dollar balances in New York, there being few other available places to park its earnings. U.S. commercial banks used those balances to fund dollar loans to Latin America and Eastern Europe. Global trade grew twice as fast as global output over the course of the 1970s. International capital flows continued to expand among advanced countries and between the advanced and the developing world.

What accounts for the difference in how events unfolded in the 1930s and the 1970s? Part of the explanation is that, notwithstanding U.S. economic problems, there was no catastrophic loss of confidence in the dollar in the 1970s. Concerns about the currency peaked toward the end of the decade, when U.S. inflation soared into the double digits. But investors were reassured when Paul Volcker was appointed U.S. Federal Reserve Board chair in 1979 and wrung that inflation out of the economy by raising interest rates to high levels and sharply restricting the availability of credit.

There was also a lack of alternatives to the dollar. Other countries’ financial markets were small in comparison to those of the United States, and their central banks continued to discourage purchases of their currencies for fear of inflation and reduced international competitiveness. In principle, SDRs might have substituted more extensively for the dollar. Three tranches of SDRs were issued, in 1970, 1971, and 1972. But even at the end of that process, SDRs still accounted for less than ten percent of the world’s stock of non-gold reserve assets.

Although the linchpins of the old system-the fixed dollar price of gold and the fixed price of other currencies in terms of dollars- had been removed, international trade and finance did not collapse because confidence in the dollar remained strong enough for firms, banks, and governments to willingly use the currency to finance their international transactions. In this way, the experience of the 1970s showed that it is possible for prevailing international monetary arrangements to collapse without catastrophic consequences for global trade and finance.

Let’s Be Franc

That confidence is precisely what is threatened today. As anxiety rises about the future of both the dollar and the euro, central banks and investors are confronting unappealing options similar to those faced by their predecessors in the 1930s and the 1970s. Should they flee to gold? Diversify into the currencies of smaller, more stable markets? Create a new synthetic reserve asset?

Gold has its advocates, as it always has. Ron Paul, the libertarian Republican U.S. representative and presidential candidate, advocates a gold-based system, as does Marine Le Pen, the leader of France’s far-right National Front party. And there is some evidence that central banks, concerned about the stability of the euro and the dollar, are diversifying into gold. The central banks of Brazil, Russia, South Korea, and Thailand all significantly increased their gold holdings during the past year. Overall, central banks bought slightly more than 200 tons of gold in the first half of 2011, more than in any year since 1981. But those are drops in a very large reserve bucket. And no one in a position of authority is seriously talking about reinstating the nineteenth-century gold standard. Given gold’s inherent price volatility, the idea that gold-or even claims on a broad-based commodity basket-could provide a basis for international commercial and financial transactions on a twenty-first-century scale is pure fantasy.

Less far-fetched is the notion that central banks might diversify their foreign exchange reserves into secondary international currencies that they believe are more stable, much as they sought to do in the 1930s. A recent survey of central-bank reserve managers conducted by UBS found a near-universal desire to diversify away from dollars and euros. Recent IMF data show that the share of total reserves accounted for by currencies other than the dollar and the euro rose from 11 percent to 13 percent between early 2010 and early 2011.

Still, 13 percent is a small fraction. And as in the 1930s, it is hard to imagine secondary currencies becoming a majority of foreign reserves. The Australian, Canadian, and Swiss bond markets are tiny compared with those of the United States and the eurozone. At current valuations, even Japan’s large market in debt securities is only one-seventh the combined size of the United States’ and the eurozone’s.

Of course, by piling into, say, Swiss francs, investors could drive up the franc’s exchange rate and increase the effective capitalization of the Swiss bond market measured in dollars and euros. So in principle, additional reserve diversification is possible. But large foreign purchases that push up exchange rates would create competitive difficulties for small economies, such as Switzerland, and ultimately lead reserves to flow back out-just as they did in the 1930s.

What is true of foreign reserves is equally true of other uses of currencies. If banks and firms conducted more of their international business in Swiss francs, they would need to hold larger working balances of that currency. Once again, Switzerland would experience uncomfortably large flows of finance into its small economy. These would be private rather than official flows, but the consequences for macroeconomic stability would be exactly the same. In addition, the presence of more foreign bank balances in Switzerland would raise the danger that the country’s banking system would become too big to save, a prospect Swiss officials are already actively seeking to counter by forcing Swiss banks to hold more capital.

Simply put, Switzerland or even a combination of Switzerland and other advanced economies perceived as well managed, such as Australia and Canada cannot provide a stable basis for the international monetary system. Their currencies are unable to do more than modestly supplement the roles of the dollar and the euro. They do not provide a viable alternative.

China to the Rescue?

With many observers expecting China to overtake the United States in aggregate economic size over the next decade, it is logical to ask whether the yuan could provide an alternative to the dollar and the euro. Chinese officials are advancing this idea by promoting the international use of their currency. They have encouraged Chinese exporters and foreign firms exporting to China to price their goods in yuan. The value of cross-border yuan transactions was $78 billion in 2010, the first full year in which they were permitted. By the end of the first quarter of 2011, such transactions were on pace to reach an annual total of $220 billion, or seven percent of China’s total trade significant progress given that the starting point, two years ago, was zero.

Some 70,000 Chinese companies are now taking advantage of the new rules. Chinese officials see allowing their country’s banks and firms to do international business in their country’s own currency as a way of enhancing those companies’ competitive advantage, since it enables them to avoid currency conversion costs and the risk of fluctuating currency values. There is every reason to believe, therefore, that they will support further movement in this direction.

Somewhat more slowly, the Chinese are building an infrastructure to enable the yuan to be used as a vehicle for international investment. The yuan earnings of firms exporting to China can be deposited in Hong Kong, where eight percent of all bank deposits are now accounted for by yuan-denominated accounts. The resulting pool of loanable funds is then tapped by firms such as McDonald’s, which issue yuan denominated bonds as a way of financing their investments on the mainland. This market tripled in size between mid-2010 and mid-2011. In August 2011, Chinese authorities announced a further liberalization of regulations on the use of yuan funds to finance direct foreign investment in China. In addition, the four big Hong Kong banks, along with banks in Macao and a few overseas banks, have been authorized to invest those funds in the bond market in China itself.

The final step will be encouraging central banks to hold reserves in yuan. China is working toward this goal by negotiating bilateral swap agreements, through which the People’s Bank of China provides yuan to foreign central banks in exchange for their local currencies. In August 2010, central banks were permitted to acquire yuan and invest their holdings in Chinese bonds.

Still, it is unclear how quickly the yuan will gain market share in international financial transactions. Although China is a large economy, its financial markets remain underdeveloped. Its bond-market capitalization totals a bit over $3 trillion, barely one-tenth that of the United States. As in Japan, the majority of government and corporate bonds are held to maturity by domestic investors. Market liquidity remains low. Annual turnover, measured by trading volume as a share of the value of outstanding bonds, is a tiny fraction of that in the United States and Europe. In other words, China is still far from having the kind of deep and liquid bond markets open to foreign investors that make the euro and, especially, the dollar attractive as vehicles for international trade and as forms of international reserves.

Chinese officials have set 2020 as the target date by which they aim to have transformed Shanghai into an international financial center. If that means significantly increasing the amount of international financial business conducted in the city, then the goal is achievable. But if it means transforming Shanghai into a first-tier international financial center and enabling the yuan to rival or supplant the dollar and the euro in the financial sphere, then the Chinese will have to eliminate essentially all restrictions on financial inflows and outflows and move to a fully flexible exchange rate. They would have to put Chinese banks on a commercial footing where they feel no pressure to engage in politically motivated lending. The authorities would need to remove all residual doubts about the security of foreign financial investment. Put simply, the Chinese government would be compelled to fundamentally transform not just the country’s development model but its entire approach to foreign relations, an unlikely scenario, at least in the coming decade.

This is not to say that the yuan could not supplement the dollar and the euro as a source of trade finance in coming years. Firms will readily accept the currency of a large importer if it can be used to purchase that country’s exports, and more so when that currency is expected to appreciate over time. China has already made significant progress in this area. But in its quest to make the yuan a vehicle for international investment and an attractive form of foreign reserves, progress will be much slower.

A Global Currency

Central banks and investors are likely to conclude that neither a diversification into smaller currencies nor an embrace of the yuan can substitute for their reliance on the dollar and the euro. Might they instead push to create a new global reserve unit, as their predecessors did in establishing SDRs in the late 1960s and early 1970s? In 2009, the governor of the People’s Bank of China, Zhou Xiaochuan, argued for replacing the dollar with SDRs as the world’s primary international and reserve currency. A United Nations commission on reforming the international monetary and financial systems chaired by the Nobel Prize-winning economist Joseph Stiglitz similarly argued in 2009 for an expanded role for an international reserve unit, such as SDRs. In response to the U.S. debt-ceiling wrangle last summer, China’s official news agency suggested that “a new, stable, and secure global reserve currency may also be an option to avert catastrophe caused by any single country.”

This is not the first time that a synthetic unit, like SDRs, has been proposed as the basis for the international monetary system. The idea goes back to the Bretton Woods negotiations in 1944, when John Maynard Keynes argued for something along those lines. SDRs have existed for more than four decades, and yet they still account for barely three percent of international reserves. A fundamental reason is the difficulty of agreeing on how SDRs should be allocated. Should they be given to countries according to their weight in the world economy, in which case the majority would go to the rich countries? Or should they be allocated according to need, in which case many or all would presumably go to poor countries? What is the best way to measure weight in the world economy-or, for that matter, need? The difficulty of reaching agreement on these questions now, as in the 1970s, is the reason why the stock of SDRs remains small. It is why it will be hard to expand that stock sufficiently to replace the use of national currencies as international reserves.

It is even more far-fetched to imagine that SDRs could replace the dollar and the euro in their other international roles. For firms to accept payment for exports in SDRs, it would be necessary to create exchanges on which firms could convert SDR claims into local currencies or for commercial banks to provide such services. For each party that disposed of an SDR claim, someone else would have to be willing to hold it. Someone would have to create liquid markets in SDR forwards or futures, on which firms and investors could hedge against the risk of changes in the value of local currencies against SDRs. Banks would have to be willing to borrow and lend internationally in SDRs. Corporations issuing international bonds in SDRs would have to find willing buyers, but institutional investors, such as pension funds and insurance companies, would be unlikely to purchase SDR-denominated bonds whose value against local currencies might drop, since their contractual liabilities are denominated in those local currencies.

Redux: 1930s or 1970s?

By process of elimination, the world is left with the dollar and the euro as the only instruments capable of supporting current levels of international transactions. If doubts about the stability of these currencies deepen further and central banks curtail their holdings of them, those central banks will have less capacity to intervene in financial markets and buffer the effects of volatile capital flows on their economies. In response, governments are likely to limit those flows via capital controls, as they did following the liquidation of foreign exchange reserves in the 1930s. Trade credit would become more costly, since commercial banks would demand additional compensation for holding dollar and euro investments. This situation would resemble the wake of the failure of Lehman Brothers in late 2008 and early 2009, when dollar credits became scarce and international trade declined precipitously. But what was then a temporary problem would instead be a permanent condition.

How serious would the impact on international trade and investment be? The answer depends on how severely confidence in the dollar and the euro eroded, and how reluctant those engaged in international trade and financial transactions became to accept dollars and euros. The experience of the 1930s suggests that in the worst case, international trade and financial flows would be severely depressed. The economic and financial globalization that has lent important impetus to economic growth in recent decades, especially in emerging markets, would be threatened. Alternatively, if the current economic and financial problems in the United States and Europe translate into nothing more than a few points of additional inflation and some depreciation of the dollar and the euro against other currencies, then the consequences will likely be similar to the relatively benign outcome of the collapse of the Bretton Woods system in the 1970s.

It is clear that the dollar will have to decline further in the medium term to restrain the growth of the U.S. current account deficit. To prevent that decline from precipitating a crisis of confidence, U.S. policymakers will have to put the federal government’s finances on a sustainable footing. But critically, that fiscal consolidation must be done in a way that does not gut the federal government’s support for basic research, education, infrastructure, and other programs on which the economy’s growth depends. A country that does not grow its economy cannot continue to grow its financial markets-and cannot provide adequate international liquidity to the global economy.

Whereas the United States must preserve financial stability, Europe must restore it-an even more daunting task. Doing so will require European policymakers to acknowledge that not just Greece’s debt but those across much of southern Europe are unsustainable. It will require them to proceed with restructurings to remove the lingering uncertainty that is demoralizing global markets. Countries in crisis will have no choice but to proceed down the road of fiscal austerity. Banks will have to be forced to raise their capital-to-asset ratios well above the current target of nine percent, so that they can absorb losses on their holdings of government bonds-a step that will almost certainly require the injection of public funds. All this will be expensive, and the costs will have to be borne disproportionately by Europe’s wealthy countries, such as Germany, which are the only ones with the necessary resources.

Reaching political agreement on these decisions will be difficult, to put it mildly. Countries with budgetary room for maneuver, such as Germany, will have to show far more willingness to use it. The European Central Bank must become more supportive of economic growth and less single-mindedly fixated on price stability. Southern European governments have already committed to putting pro-growth structural reforms in place, but even if those are implemented, it will take time for them to have any tangible effect. If Europe fails to grow, it will not be able to dig its way out of its debt hole and restore the confidence necessary for the euro to remain a significant source of international liquidity.

Which scenario will we see-that of the 1930s or that of the 1970s? The answer turns on the actions of policymakers in the United States and the eurozone. The fate of the global economy hangs in the balance.