What is Next for our Economy and Currency?

Reading Barrons today, I came across a good piece by editor Thomas Dolan. It reflects on where we are as a nation and world in respect to our economic system(s). It questions what will be the new-world order for exchange. I will paraphrase and add my own comments:

""The worst financial crisis since the Great Depression is claiming another casualty: American-style capitalism." The French president, Nicolas Sarkozy, has announced, with neither a trace of an accent nor a trace of sarcasm, that "Laissez-faire is finished."" And that is good, isn't it? Laissez-faire as a recipy for economic disaster. Humans are driven by greed and fear. Left alone in a capitalist economic system, people will try to maximize their own personal gain at the expense of their fellow man, the definition of greed. SOME regulation is required to keep man from hurting himself in his primative drive for economic gain.

As Dolan quotes and interprets, correctly in my opinion: "In one of the more lucid passages of Das Kapital, Karl Marx said, "In every stockjobbing swindle everyone knows that some time or other the crash must come, but every one hopes that it may fall on the head of his neighbor, after he himself has caught the shower of gold and placed it in safety. 'Après moi le déluge!' is the watchword of every capitalist and of every capitalist nation.""

America is painted by some as the land of greed, and in fact, many in this land act greedily and without regard for their fellow man, as will most people given the opportunity and means, and with NO limits or regulation. It did not help that after World War 2, America's was the only significant economy left standing in the world. Because America had the only functioning industrial complex, by lieu of geographic isolation and friendly status with the border nations of Mexico and Canada, when world finance leaders met in New Hampshire in 1944 to repair the world financial system, the decision was made to index all other currencies to the US Dollar, and the dollar to gold in what was called "Bretton Woods".

http://en.wikipedia.org/wiki/Bretton_Woods_system

As Thomas Dolan continues: "(The agreements reached at "Bretton Woods" were) dictated by the United States. It reflected the astounding dominance of America in the world economy (near the end of) World War II. The U.S. accounted for 40% of global economic output and had at least 80% of the gold reserves. Only the dollar was credible enough to be pegged to gold; other currencies could be pegged to the dollar. Thus, the U.S. became the world's creator and judge of money."

"The U.S. eventually abused its power to create the world's money, flooding the globe with unwanted dollars in such profusion (during the Johnson Presidency years of "guns and butter" during Vietnam and civil unrest), that it couldn't redeem them for gold (when foreign Central Banks so tried in 1971). In 1971 (the US governmnet) admitted that, went off the gold standard and left the world and itself with no restraints on the creation of money and credit."

I don't think it is possible to go back on the gold standard, nor is it wise. Gold and other forms of hard asset economic regulation do not reflect the ability of mankind to grow its economic value. Humans are creative and productive. We can make more with less as we apply intellect to practical problems of life. A currency fixed to a finite amount of gold does not reflect this fundamental truth. This is why gold as financial proxy does not now and never has worked.

What is needed is a GLOBAL method to measure in real time, human productivity and growth, and index the sum of tradable financial instruments to the sum of all productive capacity. This will allow economic growth without artificial restraint, but will also allow expansion without risk of inflation and currency devaluation. Accompanying this new form of financial index should be investing and banking regulations that are tight enough to ensure transparency of all financial structures and transactions, along with limits to leverage; but still loose enough so as to not choke off risk taking that leads to economic expansion and opportunities for everyone.

How can this be done across all economies around the planet? Greater minds than mine will need to figure this out. But it is worthy for global leaders to try to find a way. Do we need a Bretton Woods 3?

Could the Commodity Boom be Nearing an End?

I found a provactive post on the Barrons Online site this week. It was authored by Randall Forsyth, one of Barrons' editors. The idea proposed is that commodities will decline as a result of a backlash or reaction against recent trade deficits in the USA. I accept this argument over the intermediate term. I still think Commodities are in a long term bull market, but it won't surprise me if they take a couple years off while the world economy adjusts to their higher prices.

A strong argument can be made that American trade deficits will continue shrinking due both to a weakening global economy, already under way, and a domestic political reaction reinforced by election pledges of the two Presidential candidates. Specifically, protectionist actions as pledged by Obama, an increase in taxes on the wealthy and corporate windfall taxes against several multi-national companies will all accelerate a shrinking of the American trade deficit. At the same time, to counter inflation imported from America, foreign treasuries will dump their dollars and tighten their own lending standards to reduce liquidity. The net effect is to create a dollar deflation, rather than inflation. It will also raise our own Treasury interest rates as there will be less foreign demand for dollars. This reduces economic stimulus domestically.

As trade deficits decline and move toward a surplus, the dollar naturally strengthens. A stronger dollar is inherently bad for commodities priced in dollars. But what would be bad for commodities would ultimately be good for domestic financial based industries like Banking and Technology. We may be at a crossroads, so consider this possibility while planning your investment strategy for the next six to 24 months.

THURSDAY, AUGUST 21, 2008
UP AND DOWN WALL STREET DAILY

Is the Global Liquidity Tide Turning?
By RANDALL W. FORSYTH

MY INVITATION TO HOB-NOB with the world's monetary muckety-mucks in Jackson Hole this weekend got lost in the mail, yet again. Amidst the Grand Tetons of Wyoming, the Federal Reserve hosts its end-of-summer junket for the movers and shakers and hangers-on to discuss the key monetary matters of the day.

Too bad they are little more than corks tossed on violent seas of global forces totally beyond their control.

The inflationary surge now hitting the U.S. is being felt in spades overseas. Countries that have linked their currencies to the dollar, either explicitly or de facto, are feeling the price effects of the greenback's slide in the past seven years. But as the credit crisis pushes the U.S. economy into recession, the process that pushed prices up abroad could go into rewind.

In a world that's become so interconnected, it seems almost superfluous that what happens in America doesn't stay in America. But it goes beyond the old saw that when the U.S. sneezes, the rest of the world catches cold. The U.S. economy, while the largest in the world, no longer is as dominant. So, the process takes some explanation, so bear with me.

To varying extents, countries in Asia and elsewhere in the world for the past decade or so have tried to keep their currencies' exchange rates relatively stable with the dollar. The U.S., after all, was their best export customer and they all wanted to keep it that way. The key example has been China, which had held the renminbi's exchange rate versus the dollar in a tight band.

With China's burgeoning trade surplus with the U.S., Chinese exporters would accumulate a surfeit of greenbacks. Under freely floating exchange rates, the dollar would decline and the renminbi would rise.

To prevent that, China's central bank would buy up the surplus dollars to keep its currency within a tight band. In the process, the central bank sells renminbi, thereby increasing their supply. The process is the same as Money and Banking 101 textbooks, where the Fed buys Treasury bills, increasing banks' reserves and thereby the money supply.

Other Asian countries, not wanting to lose export competitiveness to China, similarly buy dollars to keep their currencies capped. In the process, they also expand their domestic money supplies.

Of course, these central banks don't keep greenbacks in their vaults but invest the dollars in interest-bearing assets, such as Treasury securities, agency securities such as those from Fannie Mae and Freddie Mac, and U.S. mortgage-backed securities. Private institutions such as banks and insurance companies got funkier and bought higher-yielding mortgage paper rated triple-A but backed by subprime loans.

Economists dubbed this ad-hoc arrangement as Bretton Woods II after the quasi-fixed exchange-rate system lasting from the end of World War II until the early 1970s. Under Bretton Woods I, currencies would be exchanged for dollars at a fixed rate. The dollar, in turn, would be redeemable in gold at $35 an ounce to foreign monetary authorities (U.S. citizens couldn't turn in their greenbacks for gold.)

When the U.S. external deficit grew and foreign central banks found themselves with more dollars than they wanted, they sought to exchange them for gold. On Aug. 15, 1971, President Nixon ended that pledge to redeem dollars for gold, and a year and a half later, the present system of floating exchange rates came into being.

Under Bretton Woods II, foreigners would hold dollars out of their self interest, not because of any U.S. pledge behind its currency. Be that as it may, for years it has been a wonderful system rivaling perpetual motion. The more Americans spent in excess of their income, the more the rest of the world lent to them. That resulted in the famous "conundrum" described by former Fed Chairman Alan Greenspan—that longer-term interest rates remained relatively low even as the U.S. central bank hiked short-term rates.

To be precise, the U.S. current account provided a river of dollar liquidity to the rest of the world. Some of it was offset—sterilized in monetary parlance—by foreign central banks by raising interest rates, increasing bank reserve requirements or selling bonds. For the most part, however, the process inflated the credit bubble.

Like its predecessor, Bretton Woods II became an engine of inflation. Buying up the excess dollars forced banks to expand their money supplies, sending inflation skyward. Some countries that had tied their currencies to the dollar, such as Kuwait, abandoned that peg to fight inflation and no longer import the effects of America's profligacy.

The debasement of the dollar was most evident in the price of gold, which climbed from around $300 an ounce at the turn of the century to a peak of $1,000 last spring. As with the breakdown of Bretton Woods I, this fall in the dollar is being manifested in a surge in oil and other commodities. Foreign economies, which are more dependent on tradeable goods, are feeling this upsurge in prices most acutely.

But is this engine of inflation, the credit bubble that resulted in the massive U.S. external deficit, about to go into reverse?

At this point, it is speculative to conclude that. But alert investors should consider that possibility.

Indeed, Barron's Roundtable member Marc Faber suggests this could happen in his latest missive to subscribers to his Gloom Boom & Doom Report.

A declining U.S. current account deficit could lead to a tightening of global liquidity as foreign central banks accumulate less dollar reserves, which are recycled into the global capital markets. The U.S. current account gap has shrunk from a peak over 6% of gross domestic product to under 5% as weakening consumer demand has cut imports while exports remain relatively robust as growth continues in emerging economies and the dollar is cheap.

As the growth of foreign monetary dollar reserves slows, the dollar is boosted and gold and commodities are hurt, Faber points out. Further, he writes:

"I have a friend who is an outstanding economist who thinks that the Asian current account surpluses will shrink in 2009 by about 50% from their peak in 2007. In this scenario, globally liquidity would become extremely tight and would have a devastating impact on asset markets including real estate, commodities, non-AAA bonds and equities. Such a decline in the Asian current account surpluses would cut the U.S. current account deficit by half and lead to a very strong U.S. dollar."

Let's recap. The credit crunch that has resulted in the U.S. recession (that's yet to be officially recognized) is being transmitted abroad by the reduction of the U.S. current account deficit and the quasi-fixed exchange-rate currency system.

Indeed, if Asian currencies begin to come under downward pressure, either in an international flight to quality or as a consequence of a declining trade surpluses, their central banks could use their cache of foreign exchange—mainly dollars—to stabilize their exchange rates. That would turn them into sellers of dollar assets or at least less vigorous buyers.

The inflationary tide in global liquidity could be turning as a result. The sharp break in gold suggests that could be happening, and that's being transmitted through the commodities markets. The dollar has stopped going down, and even has flattened out against the renminbi. The bear market in risk assets, such as stocks and particularly the Chinese market, also is symptomatic of a liquidity squeeze. As for the U.S. housing market, it is at the nexus, resulting in wealth losses for borrowers and a reduction in lenders' ability and willingness to extend credit.

That's something that the crowd in Jackson Hole can scarcely control. So they might as well enjoy themselves on their junket.

Bretton Woods 2: Wither American currency?

I had to share this article with you. It is a reminder that relative global interest rates and their effects on currency exchange rates are what really matter in investing. All the rest is just noise.

China and the ROW have been financing America for a long time, at least since 9/11, by buying up our Treasuries in exchange for the dollars they get from exporting to our consumers. This has allowed our interest rates to remain artificially low and has encouraged consumption and spending, including the housing bubble. It has kept our financial markets (and financial stocks like banks and brokers) strong and supported full employment (by financing production of consumer products and services).

So what happens when this trend reverses? Interest rates go up, financial assets including housing prices go down and inflation erupts. Eventually, unemployment increases and we get a recession. Through all of this, the only safe place to be, relatively, is in hard assets like oil and gold. The real value of hard assets remains constant through time, which means they increase in value relative to a declining currency like the dollar. Here is the article by economist Randall Forsyth in today's Barrons:


Bretton Woods II: About to Follow the Original?
IS BRETTON WOODS II heading for the same fate as its predecessor?

Bretton Woods is shorthand for the postwar international monetary system, named for the New Hampshire resort town where its blueprints were laid out by the Allies in the latter days of World War II. The rules called for currencies' exchange rates to be fixed against the dollar, whose value in gold was set at $35 an ounce.

In reality, however, foreign central banks would buy dollars to keep their currencies from rising in violation of the Bretton Woods rules. That would require the central banks to expand the supply of deutschemarks, yen or francs, to purchase the excess dollars, which was inflationary. Finally, when they started demanding gold for their dollars, then-President Richard Nixon closed the gold window on Aug. 15, 1971. About a year and a half later, the dollar would float along with the currencies of the other major industrialized nations.

The improvised, more-or-less floating exchange-rate system has prevailed since 1973, about as long as the designated-hitter rule in baseball, and equally unsatisfactory to purists.

Bretton Woods II arose not from some formal treaty but as an ad hoc response to the Asian financial crisis that began 10 years ago next month. Then, the currencies of most of East Asia were informally pegged to the dollar. The Thai baht came under attack, and the pegs of much of the rest of the region's currencies were threatened in turn.

The domino theory, so feared in the Vietnam era, came to fruition in the financial markets as hot money fled the region even faster than it entered. The culmination came a year later, following the Russian ruble collapse, which triggered the Long-Term Capital Management near-meltdown.

That's prologue to the present situation. In contrast to a decade ago, emerging economies around the globe, from Asia to Latin America to Europe, generally run substantial trade surpluses and are accumulating vast foreign-exchange reserves. The main reason: to forestall a rise in their own currency's exchange rate, which would harm their economies' export competitiveness.

As under the original Bretton Woods system, the signal aspect of Bretton Woods II is the willingness on the part of foreigners to hold U.S. dollars. In the current regime, that's meant recycling their mounting surpluses mainly into U.S. Treasury and agency securities, providing cheap financing for the budget deficit, American homeowners and the capital markets.

But, as in the early 1970s, the rest of the world is balking at continuing to accumulate dollars at the same pace as before. Bridgewater Associates' Bob Prince and Jason Rotenberg write in the money manager's Daily Observations letter that private-sector accumulation of dollars abroad overseas has been essentially nil.

Central banks have been forced to step into the breach, buying the dollars needed to fund the U.S. current-account deficit, which is equal to about 7% of gross domestic product. In other words, America spends $1.07 for every dollar it earns. Foreign central banks lend us the difference, a form of vendor financing for all those goods produced abroad, especially oil.

In the process, China has accumulated $1.2 trillion of foreign-exchange reserves. Rather than keep piling up Treasuries ad infinitum, China will invest $3 billion of that in Blackstone, which sounds like a lot but equals 0.25% of its reserves.

Less well-publicized is that central banks are just saying "No" to piling up greenbacks. Not selling, mind you, as the disaster-movie scenario envisions; just accumulating at a slower rate.

There are signs that's beginning to happen, as the Bridgewater duo detail. In just the latest, this week Syria became the second Middle Eastern nation to abandon its currency's peg to the dollar, which followed a similar move by Kuwait last month. Meanwhile, a parade of countries has directed an increasing portion of their reserves away from dollars and euros. Among them, the United Arab Emirates, Switzerland, plus America's good friends, Venezuela and Russia. And China announced this week said it, too, will increase the euro's share of its currency cache -- not reducing dollars, but not adding to them as much.

Syria? United Arab Emirates? When the dollar was being attacked in the early 'Seventies, the dollar was losing value against the Italian lira, long considered a joke among currencies. Informed of this, Nixon was famously captured on the Watergate tapes as saying, "I don't give a f--- about the lira." Later, the dollar would plunge, sending the price of everything, notably oil, soaring. (Question: which was more traumatic back then, Watergate or gas lines and soaring unemployment?)

Conversely, in recent years, if there's ever been a free lunch, the dollar has come closest for America. Because the rest of the world wants greenbacks for transactions or as a store of wealth, the U.S. can print dollars to cover the gap between what the nation spends and what it earns.

But as foreign central banks have become less ardent accumulators of dollars of late, U.S. Treasury security yields have been marching higher. Sure, the bond market has gotten over the notion that the Federal Reserve will cut rates any time soon. More particularly, as bonds have retreated, the dollar's recent recovery has stalled. Could there be a connection?

Bretton Woods II essentially translates into foreigners' absorbing a nearly infinite supply of dollars, which they recycle into the credit markets, funding everything from subprime mortgages to private-equity LBOs to the budget deficit.

They'll do that as long as it serves their purpose, mainly to keep their currencies in check to keep their exports strong. Once it no longer suits them, they'll withdraw from Bretton Woods II just as they did with the original. And U.S. bonds and stocks won't like it.