International Perspective, by Marshall Auerback
Endgame for Fiat Currencies?
June 14, 2005
“I actually think that for the first time during this entire rally, you could argue that gold is genuinely benefiting from concerns people have about currencies”. – Kamal Naqvi, precious metals analyst with Barclays Capital.
With attention now suddenly focused exclusively on the flaws of the euro, the dollar has pretty well had a free pass on the global foreign exchange markets. That is, until China had its say. But in a hard-hitting address, the assistant governor of the Bank of China, Ma Delun, lashed out at the United States without identifying it by name, suggesting that US macroeconomic policy, not China’s “artificially undervalued currency”, is in large part to blame for today’s global economic instability. Ma noted: “The dominating reserve currency issuing country has the ability to run a chronic trade deficit with almost negligible cost of issuing money. This fact reveals the privilege and benefits enjoyed by the reserve currency issuing country, rather than an unfavorable trade status as [is] being complained.” The assistant governor added: ‘If the value of the reserve currency is unstable, all the other countries will be in a dilemma -- they will either import inflation and deflation, or bear the cost of exchange rate fluctuation. It is fair to say that since the reserve currency issuing countries have already enjoyed the privilege and benefit of issuing currencies in credit, they should shoulder the related responsibility of maintaining stable exchange rates among themselves.”
One can make the case that however ill-conceived in its execution, the euro’s birth largely has come about in response to the problems outlined by China – namely, the systematic abuse by America’s policy makers of the dollar-dominated global reserve currency system. In fact, in decades past, many economists noted the dangers of embracing a US dollar-based reserve currency system in the absence of any overriding monetary discipline, such as was afforded under a gold standard. Ma’s words were echoed decades before by the great French economists, Jacques Rueff, who described the arrangements of Bretton Woods for the Americans as “the wondrous secret of deficits without tears. They could give without taking, lend without borrowing and buy without paying.” More poetically, Rueff made the point: “If I had an agreement with my tailor, that whatever money I pay him returns to me the very same day as a loan, I would have no objection at all to ordering more suits from him.”
Rueff was right to warn that by 1965 the Bretton Woods system had reached “such a degree of absurdity that no human brain having the power to reason can defend it”. Devoid of any external discipline, the system lent itself to systematic abuse on the part of the reserve currency issuing country. After all, who can long resist the temptation of an unlimited overdraft facility?
There is still some market discipline on the dominant currency, but that discipline has weakened and needs to be reinforced with self-discipline, not a characteristic one readily associates with America’s monetary officials today. By virtue of this “unlimited overdraft facility”, a dominant currency tends to become cumulatively less competitive. A dominant currency is likely to become a weak currency as there will be too much of it — the position of the dollar today (and perhaps the euro as well).
The dominant nation is also likely to accumulate debt, on a horrific scale. This is like the situation that precedes an avalanche. More and more loose snow gathers, until there is a huge overhang. At some point, the so-called “creditors revulsion” comes into play; the appetite for the dominant currency is sated, and people want to sell. This invariably sets the stage for a currency collapse.
That is, of course, unless the alternatives are worse. It is hard to know what to make of the euro today, now facing its first major test of credibility in several years. The Euroland economies today risk finding themselves in a situation where there are apparently no policy tools readily at hand to deal with the problem of declining aggregate demand, a situation which, if perpetuated indefinitely, would ultimately be highly inimical to the long-term success of monetary union and the euro itself. The forex markets are beginning to sense this. Fiscal policy is theoretically constrained by the limitations of the Stability Pact. In practice, it is now constrained by the fact that so many nations are already grossly in violation of its imposed limits, rendering further fiscal stimulus somewhat untenable, both politically and economically. Devaluation is clearly no longer an option in a widespread currency zone, even though it must be acknowledged that the euro’s recent 11 per cent fall against the dollar will undoubtedly help kick-start exports again.
Longer term, however, a smaller core would make the euro a more viable alternative to the dollar, although almost by necessity a smaller core would almost certainly diminish its potential to supplant the greenback as a viable reserve currency alternative.
But what sort of core? An “original six” looks unlikely, in light of the Netherlands’ publicly expressed disinclination to isolate the UK and join a grouping dominated by France and Germany. Given the more economically liberal traditions of the Netherlands, a Franco-German dominated union which tries to put up the ramparts to defend against “Anglo-Saxon liberalism” in the absence of a positive economic alternative vision, is a non-starter. An embrace of this option would simply exacerbate political tensions by converting divergent shocks that could have been readily accommodated by exchange rate changes into divisive political issues. In the words of Milton Friedman, “Political unity can pave the way for monetary unity. Monetary unity imposed under unfavorable conditions will prove a barrier to the achievement of political unity.”
As for sterling, the path of monetary policy and the economy in the United Kingdom provides a preview of events in the United States. The Bank of England steadily tightened monetary policy in 2003 and 2004 to combat a housing bubble. By mid-2004, housing price inflation that had reached nearly 25 percent a year began to fall, dropping almost to zero by the end of the year. A modest rebound in housing prices has since been reversed. The weakness in the housing sector has been translated into sharply weaker retail sales and a slowdown in the U.K. economy against a backdrop of huge credit card debt. Some modest stimulus from government programs was provided during the run-up to the early May election, but now that that support is no longer forthcoming, the outlook for the U.K. economy has deteriorated. Expectations are rising that the Bank of England will need to cut short-term interest rates later this year, which is hardly sterling bullish.
What about the yen as another alternative? For all of the discussions of the disastrous state of America’s fiscal imbalances, they are dwarfed by Japan’s. Of the ¥40 trillion budget deficit, about 8 percent of GDP must be borrowed. Last summer, Japan's Ministry of Finance estimated that a one percentage point rise in interest rates would increase Japan's debt servicing cost by ¥3.3 trillion, about $30 billion over three years and by a larger amount in future years as new borrowing at higher interest rates occurs. As Japan's economy grows and inflation atrophies, its long-run fiscal goal needs to be to stabilize and then reduce its high (140 percent) ratio of government debt to GDP. In the past, I had argued that one possible solution would be to boost inflation above expected levels, effectively establishing a debt confiscating policy to establish self-sustaining recursive dynamics, which would propel the economy into growth mode.
But a recent analysis by Richard Duncan should give pause to all “Japanese inflationists”. In a February 2005 piece for FinanceAsia, Duncan made the startling observation that in 2003 and the first quarter of 2004, monetary authorities in Japan created 35 trillion:
“To put that in perspective, Y35 trillion is approximately 1% of the world’s annual economic output. It is roughly the size of Japan’s annual tax revenue base or nearly as large as the loan of $2500 for every person in Japan and, in fact, would amount to $50 per person if distributed equally among the entire population of the planet. In short, it was money creation on a scale never before attempted during peacetime.”
We confess to have long taken the view that debt deflation dynamics were a major contributing cause of Japan’s long time economic malaise With excess private debt and incipient price deflation, we argued that prevailing extremely low nominal interest rates were ineffective in stimulating demand in the Japanese economy, and contended that wherever debt deflation dynamics had prevailed in the past, such as in the 1930's in the US, a monetary policy that succeeded in increasing the monetary aggregates rapidly enough to raise the general price level was possible. Historically, when this occurred, the subsequent rise in nominal income greatly alleviated debt deflation dynamics and an economic recovery ensued. We argued that given the state of Japan’s economic plight, this stimulus had to be pursued with exceptional vigour.
Unfortunately, in light of Duncan’s analysis, it is very hard to make the case any longer that the Bank of Japan has never pursued this policy with anything like the degree of conviction required. During the 15 month timeframe analysed by Duncan, the MOF has bought more dollars through currency intervention then during the previous 10 years combined. But the surplus liquidity generated did not find its way back into the Japanese economy. Rather, it simply flowed into the US, helping to sustain the latter’s ongoing credit bubble. If “liquidity abhors a vacuum”, then the actions of Japan’s monetary and financial authorities demonstrate conclusively that its first port of call is invariably the place where it is needed the most, which today remains the USA.
We have a unique situation in the global economy today: it is hard to make a compelling case for any of the dominant paper currency alternatives available. Even after the destruction of Bretton Woods, one could find various paper currency repositories of value during the 1980s and 1990s, which provided investors with the prospects of excellent returns.
During the early part of the 1980s, for example, it was easy to make a compelling case for the dollar on the back of President Reagan’s supply side reforms and the corresponding restructuring of corporate America (against a backdrop of heroic leadership from then Federal Reserve Chairman, Paul Volcker).
By the mid-1980s through to the end of the decade, the so-called “triple merits” bull market Japanese assets had begun with a corresponding huge appreciation of the yen against the dollar. What in retrospect set the stage for a massive asset inflation at the time seemed to offer an investors’ nirvana: booming economic growth, rising asset values and correspondingly minimal inflationary pressures. The yen more than doubled against the dollar during that period.
Finally until its abolition in the late 1990s, the D-mark consistently held the trust of the global foreign exchange markets, due to the singularly successful stewardship of the German economy by the Bundesbank. In fact, Germany’s post-war economic order arguably offered the most successful institutional arrangements for the operation of monetary policy for any Western country in the post-W.W.II period. No doubt, most Germans long for the steady predictability afforded by the D-mark.
Where can one find comparable alternatives today? Is gold’s recent strength in the midst of widespread currency turmoil telling us something? Gold’s initial rally during the early part of the 21st century was largely perceived as a product of the prevailing weakness of the dollar in response to America’s massive net external debt and growing current account deficit. More recently, it has rallied strongly in the midst of the euro’s travails. Many have remarked that, if all of the world’s currencies are unattractive, gold might regain some lustre as a reserve currency and concomitant store of value. It helps that nominal interest rates everywhere are negligible, albeit rising. It also helps that, in a world of ubiquitous excessive debt, gold is the one asset that is no one’s liability.
In today’s world, decades of government intervention to prevent financial crises and price deflations have encouraged economic agents to accumulate the highest private debt burdens ever attained. Even without outright price deflation, these debt burdens are now acting to suffocate demand and threaten (at best) stagflation, at worst, outright financial crisis. Gold’s relative strength suggests a new paradigm at work in the financial markets. With its recent return to respectability, one can almost anticipate that management of the gold price will become an even more integral component in the official sector’s expectations management game, particularly with so many fissures now appearing in the paper currency world. But like Banquo’s ghost in Macbeth, gold appears set to make continued unwanted appearances, haunting policy makers as it relentlessly rises against each of today’s fiat currencies.
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