from noland this week
prudentbear.com
Pertinent Insights from Milton Gilbert:
Over the past few weeks we have witnessed the dollar/yen decline from 112 to trade below 104, a four year low. This despite the Japanese authorities having purchased dollars in the range of $265 billion over the past seven months, an unprecedented 85% annualized expansion of foreign currency reserve positions. Yet the dollar/yen has declined significantly from 117, the level it traded when this massive intervention began back in September. For good reason, the Japanese must now appreciate that their massive interventions are much more effectual in inflating and destabilizing commodity and myriad global markets than they are in supporting our faltering currency. The Japanese dollar support mechanism is now in jeopardy, with unknown consequences.
For some time, U.S. (and global) interest rate markets have been supported by indefinite 1% short-term U.S. interest rates. Recent giddy talk had the Fed on hold through 2005 or even past the end of Greenspan’s term in 2006. The market was today forced to abruptly reassess the situation. Fear will now seemingly take a more prominent role in market psychology, replacing the endlessly profitable greed and complacency. Rosy notions of the Fed permanently held in check by the jobless recovery must give way to disconcerting thoughts of how our extraordinary Credit market (unprecedented leverage and derivative activity) will react to inevitably rising rates. The interest-rate speculators’ support mechanism could now be in jeopardy, with unknown consequences.
We live in an age of extraordinary monetary disorder that somehow still passes for a sound and vibrant global financial system. Over decades the system has evolved from one of a managed “fixed” monetary regime to an indomitable system of “floating” currencies and global Wildcat Finance. This unstable system has been tested over the years. It has as many times persevered, but seemingly only postponing the inevitable day of reckoning through only more dangerous Credit inflation and financial excess. It is my view that this anomalous system is about to be tested once again.
The Great Credit Bubble has imparted massive imbalances at home and abroad. To sustain the Bubble requires enormous and unrelenting Credit excess that now inundates the world with dollar balances. Speculative flows have been unleashed on non-dollar assets of all stripes. Domestic and international asset Bubbles have reached the point of being unmanageable. Economies are structurally maladjusted and vulnerable. Individual financial systems are acutely fragile. The greatest imbalances emanate from U.S. Credit excess, with attendant liquidity effects having now afflicted financial systems and economies globally. Accordingly, our authorities absolutely refuse to initiate policies to rectify domestic excesses and unprecedented current account deficits. They have lost credibility and the dollar is suspect. Yet Credit inflation remains the order of the day. Meanwhile, gross excess runs uncontrolled and on a crash course, reminiscent of dysfunctional processes that led to the breakdown of the Bretton Woods monetary regime in the early seventies. I’ve gone searching for relevant historical insight.
Milton Gilbert was Economic Advisor to the Bank of International Settlements from 1960 to 1975. He wrote his Ph.D. thesis at the University of Pennsylvania on the “breakdown in exchange parities in the 1930s.” He died in 1979 as he neared completion of his brilliant work, “Quest for World Monetary Order – The Gold-Dollar System and its Aftermath.” From the books cover: “ ‘…they came to treat me not only as wrong, but as a kind of half-traitor…because I argued that we didn’t have to sit on our hands, and lose billions of dollars every year…’ So remarked Milton Gilbert as he reflected on his unsuccessful efforts to convince the U.S. to act prudently to maintain the status of the dollar and to correct the balance of payments deficit… Conceived by a man with remarkable foresight, this vision of the international monetary system and the roots of its present instability deserves your attention.”
Dr. Gilbert had truly wonderful knowledge and insight to the workings of international monetary regimes. He also comprehended clearly the heightened vulnerability of the Bretton Woods system wrought by escalating U.S. trade deficits. Gilbert was often critical of U.S. profligacy and lack of discipline, and was controversial for his belief that occasions may warrant the necessity for tight credit, and trade and capital controls.
Gilbert’s book is not easily located, so I have taken liberty to extract extensively. While written about a quarter-century ago, his analysis is exceptionally pertinent in today’s environment of escalating global monetary instability. I hope you appreciate his deep knowledge and insight, as well as his intellectual integrity, as much as I do. The more things change the more they stay the same.
From “Quest for World Monetary Order:”
“The official preference for fixed exchange rates was not arbitrary, but was grounded in the experience of the monetary breakdown in the 1930s. To abandon gold convertibility of the currency and to allow the exchange rate to float were taken as evidence of monetary mismanagement and a failure of discipline. While floating could clear the foreign-exchange market, various cases of floating during the 1930’s, as in Britain, Australia, and Sweden, had shown that market forces would not necessarily produce a stable rate or one that could be considered satisfactory from the standpoint of trade. Floating often encouraged speculation and induced a flight of domestic savings abroad, depressing the exchange rate unnecessarily and worsening the terms of trade. For these reasons, fixed exchange rates that would be altered only by international agreement seemed an essential foundation for international monetary cooperation and liberal trading practices. Apart from lending stability to foreign trade and the balance of payments, fixed exchange rates were considered essential to imposing discipline on domestic monetary affairs with respect to both the government budget and monetary policy. Too much creation of money in the domestic economy would soon show up in a payments deficit, which would help to enforce corrective action.” Page 23
“Under the fixed-rate system, the priority in national policies had to be shifted at times from measures prompting domestic expansion to those aimed at controlling inflation and the external balance.” Page 207
“The political obstacles that stood in the way of firm decision-making could in many cases be overcome only when the catalyst of a crisis atmosphere brought the matter to a head. Beforehand, spurious analyses of the situation, optimistic forecasts, fanciful theories of the adjustment process, and announcements of dubious policy measures were seldom lacking…” Page 15
“Because the authorities did not or could not deal forcefully with the balance-of-payments problems as they arose, the monetary system came apart.” Page 4
“While not the exclusive concern of the United States, the problems of the international monetary system could not be solved without the United States. These problems had to do with the growth and composition of official reserves of convertible securities and gold held by central banks… There was much futile wrangling about whether the key issue was the adjustment process or the adequacy of international liquidity (official reserves). In fact, both were involved, since a reasonably prompt adjustment was essential if excessive reserve growth was to be avoided.” Page 5
“To some extent, the emergence of payments deficits and surpluses could set up forces that constituted an automatic mechanism of adjustment because money supplies and relative income levels between countries would be affected. International competition was also an active force. Many instances of payment balances shifting back and forth of their own accord were evidence of an automatic adjustment process at work. Automatic processes could not, however, be relied upon when an imbalance became sizable, particularly if the cause of disequilibrium were persistent.” Page 15
“…the economic sense of the matter was easy enough to understand. The Fund (IMF) was intended to favor economic expansion and high employment. But if a country’s cost and price levels became uncompetitive, exports would be too low and imports too high to allow a balanced position in external payments at a full-employment level of economic activity – even though productive resources might not be under excessive demand pressure at the time and the situation not be inflationary.” Page 20
“The difference between non-fundamental and fundamental disequilibrium was sometimes only a matter of degree…if the authorities procrastinated and the disparity between different countries’ price and cost levels became too large, this slow-acting corrective could not be expected to work. Disequilibrium then became fundamental…” Page 21
“The real obstacles to the adjustment process were political.” Page 22
“From the White House Tapes, President Nixon is known to have said: ‘I don’t give a [expletive deleted] about the lira.’ Presumably, he did give a [expletive deleted] about the dollar. Nevertheless, he and John Connally, his…secretary of the treasury, took the decision to declare the dollar inconvertible and disrupt the international monetary system. Nixon and Connally came into the game only toward its end. The three preceding administrations had followed the same course, by deciding what U.S. policy on the dollar should be and doggedly sticking to that policy in the face of an ever-mounting crisis… The crux of the matter was the absolute refusal to initiate an adjustment process in a situation of transparent fundamental disequilibrium.” Page 27
“…Some central banks felt it appropriate to convert at least part of their countries’ surpluses into gold in order that the United States should be subjected to balance-of-payments discipline. Discipline was imposed on other countries by the loss of any reserves, foreign exchange or gold, and even by increases of official foreign liabilities. But for the United States, loss of gold was the only effective discipline.” Page 32
“prompt action…” “was the only practical way of avoiding cumulative disorder.” Page 78
“Quite a few felt that the U.S. lack of discipline and the growth of dollar reserves were the basic threats to the stability of the system.” Page 173
”This, then, was the weird position into which the United States had drifted. The gold par value of the dollar had priority, and the adjustment process was to be left to revaluation by other countries… The extent to which top U.S. officials saw the implication of their policy position was a mystery… Treasury Secretary Fowler’s uncertain grasp of the subject was all too evident at the G-10 meeting in Bonn in November 1968. With his policy briefing book open, he pressed the German authorities to revalue the D-Mark, although they had previously announced a decision not to do so. (German economic minister) Schiller, scarcely hiding his annoyance, asked Fowler why it was so necessary for the D-Mark to be revalued. The secretary responded that revaluation was needed because the larger German surpluses on the balance of payments showed the D-Mark to be in fundamental disequilibrium. With an evident air of trumping this ace, Schiller demanded: Then how about the U.S. deficits? Do they not show that the dollar is in fundamental disequilibrium?” Page 148
“Clearly, the only practicable alternative to a major rise in the price of gold was a floating dollar brought on under crisis conditions. This would be bound to produce a flight from the dollar, with unforeseeable repercussions. It was certainly not a conservative course to let this happen, particularly, as the credibility of the U.S. authorities was being undermined by their evident reluctance to initiate an adjustment process… If ever there had been any possibility that the White House would face up constructively to the adjustment process, the opportunity was now passed over. Later events showed that in domestic affairs President Nixon was already concentrating on the next election.” Page 150
“A new feature of the situation was that the rate of wage-price inflation quickened as the recession deepened… And while the budget shifted to deficit and monetary policy was greatly eased, these impulses aimed at reversing the decline in economic activity were swallowed up in rising prices.” Page 152
“The crash program was announced by the president on August 15 (1971), following a weekend meeting of the administration’s economic team at Camp David. On the domestic side, the program was intended to check the inflationary psychology and give an expansionary impulse to the economy… On the external side, the main action was the suspension of the convertibility of the dollar… It has been alleged that the United States allowed, or even encouraged, the crisis of the dollar by a policy of ‘benign neglect’ toward its fate. The phrase had come from a private study group headed by Gottfried Haberler…” Page 154/155
“As the G-10 ministers and governors were scheduled to meet in London in mid-September (1971) to exchange views on how to resolve the crisis, a preparatory meeting of the deputies was held in Paris early in the month. Because the crisis centered on the dollar, Paul Volcker, the U.S. deputy, led off by stating the American position. Washington had ruled out the idea of itself taking any adjustment initiative, so Volcker analyzed the change required in the U.S. balance-of-payments position without proposing fresh U.S. measures to being it about.” Page 158
“The state of confidence was evident from the fact that the market price of gold started to rise at once, reaching $48 in February 1972 and $60 in May. Another sign was the spurt of almost 10 percent in January in the indexes of world-market commodity prices…For 1972, the trade deficit totaled $6.4 billion, as against $2.3 billon the year before and a surplus of $2.6 billion in 1970. This sharp deterioration of the trade balance occurred despite a $5.6 billion or 14 percent increase in exports… A major factor here was the rise in the dollar price of imports due to the devaluation and to the general advance in primary commodity prices… In fact, the current-account deficit for 1972 turned out to be $10 billion; this was an $8 billion change, but the sign was a minus instead of a plus... After consulting with its Group of Ten partners, the U.S. authorities announced a new devaluation of the dollar by 10 percent on February 13 (1973).” Page 165
“Not only had the fixed par-value system broken down, but the way in which the authorities had fumbled matters left the market with an indelible impression that they did not have the will to control events. More speculators became prepared to back their own judgments on exchange rates against the official propaganda line.” Page 168
“The most damaging impact of the exchange-market turmoil was the strong impetus it gave to inflation and inflation psychology. This effect was not an inherent consequence of floating but occurred for two reasons: the particular circumstances of the early 1970s and the fact that the dollar was the key currency in the breakdown… As regarding the specific role of the dollar, large increase in some countries’ money stocks arose out of the flight from the dollar in 1971-72. Thus, the international economy was in a situation of boom and inflation pressure.” Page 194
“The monetary breakdown in 1973 gave a further strong impetus to the inflationary forces; many traders and investors felt that the world economy had become unhinged and that many currencies were unsafe assets to hold. A buying wave for hedging and speculative purposes resulted in a violent upsurge of commodity prices; The Economist’s and Reuter’s indexes, neither of which included gold or oil, almost doubled over the twelve months of 1973. In their post-mortem analysis, “The 1972-1975 Commodity Boom,” Richard Cooper and Robert Lawrence concluded that the demand-supply situation could explain only part of this upsurge and that exchange-rate uncertainties accounted for much of the exceptional prices rise… It was in these conditions of soaring commodity prices that the OPEC cartel announced the sharp rise in the price of oil at the end of 1973.” Page 194
“…the situation was aggravated by the fact that the United States gave up all efforts toward a balance-of-payments program… The Treasury apparently continued to believe that the market would find its own floor for the dollar and that a further dose of depreciation would start a process of substantial balance-of-payments adjustment. Such optimism was misplaced. It ignored not only the obstacles to trade adjustment mentioned above [U.S. trade partners burdened with higher oil and commodities prices], but also the fact that the decline of the dollar intensified the inflationary psychology inside the United States. The 1978 report of the Council of Economic Advisors noted that the effect of depreciation of the dollar on the cost-of-living index, through the rise of import prices, was fairly moderate. But it overlooked the impact on the price of import-competing U.S. products, and also took no account of the effects of the flight from money into real assets, like housing, or of the widespread fear that the drop in the dollar was a reflection of inflation.” Page 206
And snippets from his “Summary and Conclusion” chapter:
“Various rationales were developed to shift responsibility for the failure and to explain it away.” Page 215
“the dollar deficit could not have been eliminated simply by exchange-rate adjustments.” Page 217
“The U.S. position crystallized as a result of short-term reactions to specific political situations, both domestic and international.” Page 217
“…the authorities were to blame for delaying action until capital flight had been needlessly provoked. In the critical case of the dollar, the American authorities themselves had known for several years that a fundamental disequilibrium exited. Yet they failed to take corrective action as month after month and year after year passed, and the time drew nearer when a flight from the dollar would force their hands under crisis conditions.” Page 220
“The vast dollar outflow from the United States in 1970-73 boosted the money supply in many countries and was a significant stimulus to inflation and inflationary psychology…The low state of confidence was reflected in the gold market and in the extreme flare-up of commodity prices in 1973. Worse still, the boom in commodity prices provided the backdrop for the OPEC decision to boost oil prices fourfold at the end of 1973.” Page 220
“While the expectations of the U.S. authorities were obscure, they seemed until late 1979 to be relying on a convergence of growth rates in the main industrial countries and the lagged effect of depreciation in order to bring about sufficient adjustment. Effective policy measures are obviously measures that work in the situation being confronted. Moderate steps can be effective when they are taken promptly, whereas indecision and delay in the face of accelerating disequilibrium will, in the end, demand much more potent and painful measures. All too often official procrastination caused by the political timetable or by fears of an adverse political reaction has resulted in accelerated inflation and external deficits.” Page 226
“The usual instruments called upon to support exchange stability after depreciation of the currency are restrictive monetary and fiscal policy, with the intention of moderating economic activity so as to reduce inflation, improve the balance of payments, and restore confidence.” Page 226
“…cases and times arise when the free play of market forces is subject to obstacles, as it has been with respect to trade, or when a market does not supply its own brakes against excess, as has occurred in the exchange market.” Page 226
“hesitating to take effective action cannot be accounted for strictly by unfailing faith in market freedom.” Page227
“…the 1970s would not have thrown up the same problems if effective adjustment had been achieved in the 1960s and if the huge increases in the world money supply that originated in the flight from the dollar had not been let loose.” Page 219
“The problem for monetary authorities in the 1980s and beyond will be how to maintain exchange stability in a fundamentally unstable environment. This task is not one that they can ignore in the hope that markets will resolve for them.” Page 236
If Dr. Gilbert were alive today, he would surely be appalled by current policy. He would argue adamantly against chairman Greenspan’s view of benign U.S. imbalances rectified over years by the wonders of flexible prices and market forces. Instead, he would profess that only by restraining Credit would the U.S. begin the arduous adjustment process necessary to attenuate its massive external deficit and myriad imbalances. He would speak in terms of the “cumulative monetary disorder” wrought by the enormous and endemic U.S. current account deficits. And, importantly, I believe his analysis would point directly to today’s fundamental disequilibrium in market and monetary processes – let’s call it “free-market disequilibrium.”
While we refer to the current system as one of floating currencies, I don’t think it’s this simple. We have “floating” currencies supported by massive central bank dollar purchases/interventions. Moreover, derivative hedging also plays a major supporting role. Despite the dollar’s weakness over the past 18 months, there has been no need to sell U.S. financial assets. Instead, a phone call to one’s favorite derivative desk to acquire a dollar hedge easily suffices. No dumping of Treasuries (higher interest rates) and other U.S. securities (lower stock prices) necessary with today’s “monetary regime.” Leave the difficult work of managing the massive and ballooning “supply” of dollar risk to the murky world of derivative traders and global central bankers. And, yes, contemporary finance appears darn right miraculous – abrogating those old supply and demand imbalances and dislocations that bring booms to their knees.
But there’s a malignancy: today’s currency “regime” does not impart any disciplining mechanism on the undisciplined and out-of-control U.S financial sector. Credit inflation runs unchecked, speculation unchecked, financial leveraging unchecked. Current account deficits mushroom and interest rates hover at historic lows. Credit excess begets only greater Credit excess. Escalating Asset Bubbles, structural economic distortions, and financial fragility create vulnerability only more intimidating to timid central bankers.
I believe one could build a reasonable case that the current “floating” currency system with massive central bank intervention and derivative hedging programs really is not floating at all. It is more like “fixed” with very, very wide bands. That is, currencies can move around significantly without causing much in the way of financial stress or disruption – without necessitating “adjustment.” Indeed, the system has all appearances of the mythical free-floating free-market system imbued with market discipline and self-adjustment. Yet it is absolutely nothing of the sort. Instead, it is a dysfunctional system completely incapable of self-regulation; excess begets only greater excess until crisis eventually interrupts the process.
Come the day that the marketplace questions the ongoing viability of either of its supporting mechanisms – massive central bank dollar interventions or the ballooning derivative hedging scheme – the stability of the system is in immediate jeopardy. Today’s camouflaged “fixed” global currency system could lurch toward a true floating dollar, entailing disruption unlike anything experienced since the early seventies. What is it that the metals are trying to tell us, anyway? |
