Bretton Woods: The Deal That Was Struck
After WW2, the US was able to set the terms of trade for the whole world, and that’s precisely what it did.
The US was the world power. The rest were exhausted.
The US, located in a temperate climate, protected by two oceans, and unified by the world’s largest network of interconnected waterways, has so many natural advantages that there is no contest. It should always win at everything.
That’s how it felt as the 730 delegates of the world’s 44 allied powers gathered in Bretton Woods in July 1944 to discuss what would happen after the end of the war that was grinding towards its inevitable conclusion.
The US could not deploy troops to the four corners of a planet exhausted by war or station troops in every potential hotspot.
The US would not impose a Pax Americana, with tariffs and royalties on trade flows, extracting rent from the allied powers who owed the US for the liberation of their countries.
The deal was that the US would help everyone rebuild, most conspicuously Germany and Japan, and buy their exports to help them produce their way back to affluence.
This was a very generous act. While the US could not station its ground troops everywhere, it did agree to patrol the oceans as the only country with a remaining large-scale navy to promote free and secure trade.
In return, it demanded the support of its allies to fight the Cold War as it saw fit.
Bretton Woods established several vital institutions, the IMF, the World Bank, and the IBRD. It put the West’s countries on the gold standard, with the USD at the center.
The USD became the US’ primary export in exchange for buying everyone's goods. Thus began the growth of the US’ structural trade deficit.
This was peak US power, with the US at the top of the food chain. It was the first attempt at a global system of trade - the ultimate industrial policy.
Arguably, its power has declined ever since.
Post-Bretton Woods
As the rest of the world rebuilt, the US continued the New Deal set up by FDR to combat the effects of the Great Depression.
This deal morphed from FDR policy into a New Deal political dynasty as Eisenhower, although from the other political party (Republican vs. Democrat), saw no option but to continue the direction of travel started by FDR.
The US could not be seen, as it combated Communist ideology, to be treating its workers worse than the Soviet Union.
Its companies had the wealth. They could afford to treat their workers generously.
As the rest of the world began to rebuild and prosper, benefitting from the security blanket provided by the US Navy, corporate America began to lose a little edge, and its cost structures became more bloated.
The Gold Standard
One of the key agreements reached/imposed by the US as part of the Bretton Woods system was a system of fixed exchange rates underpinned by the USD, which was to be convertible to gold at $35/oz.
This worked fine when the US held 65% of the world’s gold reserves and was the dominant player in world trade.
As Europe and Japan grew, their domestic production and per capita income began to approach that of the US.
The US began to decline in relative geopolitical terms compared with Europe and Japan.
The cost of the Vietnam War and the launch of Lyndon Johnson’s Great Society programs, neither of which he was prepared to pay for by increasing taxation, caused a rise in inflation and a decline in the value of the USD.
Gold outflows from the US accelerated, and eventually, confidence in the USD's convertibility into gold declined to the point that, in 1971, President Nixon removed the US from the gold standard.
The Rise of China
During the 1960s, as nations within the Bretton Woods system prospered, China was concerned about its neighbor to the North, Russia.
The Soviet military was second only to the US, and China was at a strategic disadvantage. It needed to industrialize. That meant acquiring raw materials, technology, markets, and access to those markets through secure sea lanes.
China needed the US to join Bretton Woods. However, some obstacles remained, such as Taiwan occupying seats that otherwise would have belonged to China.
China was one of the largest delegations to Bretton Woods, but the civil war and its outcome separating the PRC and Taiwan in 1949 left Taiwan with the seats at the IMF and World Bank.
Nixon's 1972 trip to China famously boosted China’s increased collaboration with the United States. However, China did not formalize its membership until 1980.
China - The World’s Factory
As the always insightful commentators at Doomberg note, China doesn’t mind getting dirty when it can accumulate geopolitical advantages. Doomberg cites one material in particular, graphite, as an example. Graphite is a critical ingredient in producing batteries for EVs.
Doomberg concludes that if a commodity is deemed critical and producing it is environmentally taxing, China will inevitably dominate it.
The full article suggests a way to address market failures such as this. The US needs to identify a list of critical materials—gallium, germanium, graphite, magnesium, and all manner of rare earth elements are prominent on this list—that are aligned with national security and should be produced onshore or in collaboration with partners.
Once the list is established, steps must be taken legislatively to ease the permitting process for producing these materials. Otherwise, the environmental lobby will obstruct the process for years.
The most conspicuous example of such obstruction is the final approval of the Mountain Valley Pipeline delivering gas from West Virginia to the Southeast:
The project was first approved in 2018 and, despite being 94% completed, was continually delayed, at a cost of millions of dollars, by various environmental groups using the court process.
It became Keystone Pt II, and it finally took an act of Congress—Section 324 of the Fiscal Responsibility Act 2023 (the deal that broke the debt ceiling impasse)—to make it happen and stop further interference from the judicial branch.
This is an excellent example of industrial policy, in this case, allowing the free flow of much-needed fossil fuel by the safest method from a place of abundance to a place of need. The problem addressed by the pipeline is apparent:
There are not enough pathways to transport fuel from its source to the highly population-dense areas where it is needed in the West, the Southeast, and the Northeast.
Industrial Policy
In the land of the free and the home of the brave, industrial policy is supposed to be ‘un-American.’ The US was founded on principles of rebellion against the heavy hand of government.
In the tradition of Austrian political economists such as Hayek and von Mises, these principles champion the role of the individual and businesses as the best allocators of capital and resources.
The federal system is set up to allow multiple experiments to find the best solutions. There is a foundational antipathy to grand design and a structural preference for decentralization.
Industrial policy instead believes in the wisdom of allowing the government to put its thumb on the scale, pick winners, and nudge the economy towards certain desired outcomes.
The New Deal was probably the most significant and conspicuous example of industrial policy the US has ever embarked on. Its legacy costs are still with us.
The New New Deal
As the US has evolved from apex world creditor and guarantor of free trade across the world’s oceans to the world’s biggest importer ($3.4 trillion in 2022) and debtor ($35 trillion and counting), its reputation in its own eyes and those of the rest of the world has shifted.
The rest of the world is not the only one concerned about the US’s ability to continue to perform the role it has carried out since Bretton Woods.
The US is also asking itself questions about the right balance of domestic and foreign policy on an increasingly constrained budget.
The implicit bargain offered by industrial policy is that, in exchange for ceding to the government the architect's role, the resulting structure will be of more significant benefit than if there had been no intervention.
The interstate highway system and a world-class standing army are examples of things only a centralized government could achieve. However, governments tend to experience mission creep and push ever further into the economy.
According to the Congressional Research Service,
“… industrial policy commonly refers to a comprehensive, deliberate, and more or less consistent set of government policies designed to change or maintain a particular pattern of production and trade within an economy. It generally involves policies designed to promote emerging industries or prop up declining ones, as well as the channeling of resources into specific sectors and activities considered important for economic growth. A variety of instruments can be used to implement an industrial policy, including subsidies; tariffs and other trade restrictions; rules; regulations; technical standards; tax incentives; government procurement regimes; and preferential access to credit. In addition to aiming to accelerate economic growth, industrial policies can be designed to safeguard national security, create employment opportunities in specific industries or regions, achieve environmental and social sustainability, or improve the competitiveness and export performance of domestic firms.”
It continues:
“…China’s statist model of economic development, for example, relies on a comprehensive industrial policy that nurtures a wide range of strategic and emerging industries through government measures, including subsidies and protection against import competition. The scope and scale of these market-distorting practices can create an uneven playing field for U.S. firms.”
The US is concerned that its generally open market puts it at a disadvantage compared with nations such as China that aggressively favor their domestic champions and exploit their environment and disadvantaged groups such as Uighurs in flagrant violation of international norms.
There are some contradictions inherent in the way China is perceived. While the leader in the development of nuclear energy (the most abundant and efficient renewable energy resource) and in the production of photovoltaic solar panels, it is also, with India, the world’s leader in developing the thermal coal capacity needed to produce these panels.
Implementing Industrial Policy US-Style
Implementing industrial policy requires supply-side tools, such as government loans and tax incentives to developers and manufacturers, and demand-side tools, such as consumer incentives in the form of credits for the purchase of EVs.
Each tool can distort markets, favor inefficient practices, and lead to the misallocation of capital.
The government’s concern in implementing policy is not maximizing corporate profitability. That is up to the companies themselves.
Unsurprisingly, companies seek to maximize the benefit of the incentives offered. Tax credits are only helpful if the developers and manufacturers have sufficient tax bills to offset the credits they earn.
Since they often don’t, a $20 billion per year market grew among big banks such as JP Morgan, Bank of America, and Wells Fargo to enter into deals with companies designed to monetize the tax credits and depreciation produced by renewable energy projects.
In seeking to ‘democratize’ the use of these credits, the government passed the Inflation Reduction Act (IRA) to allow transfers of tax credits separate from the complex deals in which they were historically monetized.
This is how that part of the IRA works:
The IRA also allowed tax-exempt entities to participate by allowing deemed ‘refunds’ of tax provided the tax-exempts participated in a prescribed way (unfortunately quite complex to implement).
You Have to Love Legislation
When the IRA was written, it contained a wonderfully progressive concept that phased out the $7,500 tax credit available for purchasing an EV based on the taxpayer's income. Sounds fair.
It also contains a provision - a concession to the EV manufacturers - that permits the manufacturer to pass on the total value of the credit through a lease, regardless of the lessee’s income level.
So, for example, having taken the full benefit of the $7,500 tax credit when I bought a Tesla Model Y in 2020, it was clear I would not be entitled to this credit if I traded this model for a new Model Y in 2024.
Instead, I traded the old Model Y and leased a new one. Tesla reduced the capital cost of the vehicle I leased by the total amount of the credit plus $500 from NY State and priced the lease at the reduced price.
The government can virtue-signal its progressive credentials, and the credits continue to flow unabated with the benefit of some financial structuring in the form of a lease. QED.
Is Industrial Policy Working
The U.S. government indicated in April 2024 that it plans to issue grants of more than $6 billion each to Taiwan Semiconductor Manufacturing Company, Samsung, and Micron, following an $8.5 billion grant for Intel announced last month.
TSMC is slated to receive a $6.6 billion grant and $5 billion in loans to help build a third chip factory in Phoenix, Arizona.
A $6.4 billion grant to Samsung will help the South Korean company expand its existing facility in Austin, Texas, and build a network of four smaller fabs in nearby Taylor.
Micron, a U.S. company, is poised to receive $6.1 billion to build new semiconductor plants in New York and Idaho.
Intel’s grant will support factory construction and modernization projects in Arizona, New Mexico, Ohio, and Oregon.
The CHIPS and Science Act, which created a $39 billion fund to support manufacturing incentives, will fund all of the grants. Commerce Secretary Gina Raimondo said that the department plans to distribute all those funds by the end of this year.
It is easy to think of this spending in isolation without realizing where it is funded: tax revenues.
The relative debt to GDP ratios of leading economies paints a sobering picture:
As this debt burden grows, the cost of servicing it begins to crowd out other activities…such as industrial policy:
Takeaways
Bretton Woods marked the start of an era of US economic and geopolitical hegemony.
That era began to end when China was admitted to the WTO in 2001.
COVID-19 highlighted some of the uncomfortable dependencies the US has on trading partners, such as China, with which it is in increasing geopolitical and economic tension.
Industrial policy is a widely used tool that has become increasingly important as a means of combating uncomfortable dependencies.
Through a strong dollar, the US has sufficient economic power to continue funding its industrial policy initiatives for the time being.
The room to move, however, is becoming increasingly constrained.
The complete alignment of current industrial policy embodied in the Inflation Reduction Act tax credit offered to the renewable energy industry creates the opportunity for capital providers to lower their tax bills and perform what the government considers a social good.