The Upcoming G-20 Meeting (Bretton Woods II)

Let me start off by saying that the following article is both speculation on my part and addresses other speculation that I have seen circulating online. Bretton Woods II is a term being used by the media to address the calls by international leaders to revisit the Bretton Woods System. This has led to speculation, in my opinion incorrect speculation, that world leaders want to return to a Bretton Woods System in its classical architecture.

The Problems We Are Facing

The original Bretton Woods laid the groundwork for institutions such as the World Bank and the IMF. Now the feeling is that these institutions are not doing a good job in terms of forecasting risk and should be more active in terms of managing global imbalances. 

At the heart of this discussion is the conflict over global regulatory competition that has dominated the financial markets since the move off of the gold standard. Countries seeking to make themselves more competitive have sought policies to devalue their currencies and the buildup of foreign exchange reserves has allowed countries to intervene in their markets. Central to this discussion is likely an attack on China which has amassed FX reserves while keeping its exchange rate artificially low. This has allowed it an advantage in terms of pricing power that has turned the country into a manufacturing behemoth. China's willingness (or lack thereof) to join the international community will have massive implications on the outcome of the meeting.

We have also seen massive currency fluctuations that threaten economic stability. Although I am in the business of speculating on currencies, I recognize how destructive the fluctuations are on companies and economies.

Firstly, managing exchange rates introduces an expense that takes away from a company's core business. An ideal system would have companies focus on producing as many products of the best quality at the best price possible. Exchange rates detract from that goal and shift resources from R&D to management.

Secondly, changes in exchange rates change the competitive edge of a company. Let's say a company has a superior manufacturing process that affords it a 5% edge. If the local currency moves 5% against it, its global edge is reduced to zero and a less efficient company can compete because the value of their currency is weaker.

So the obvious answer is to hedge currency fluctuations but this is not without its risks. There is, of course, the issue of cost but there is a far larger risk that has played out in recent months. Most foreign companies were hedging USD exposure and the world was largely short dollars.

The run up we have seen in the dollar has caused massive losses on hedges world wide, particularly in South America. It now appears that there was a very asymmetrical risk to these hedges as the run up in the dollar has been associated with weakening global fundamentals and lower prices. Either these businesses would continue doing business as normal with no negative dollar effects, or they were destined to take massive losses due to bad hedges at a time when demand for their products is slowing and prices are dropping. Hindsight is 20/20 but the situation that these companies find themselves in today is very serious and the risks were clearly unevenly distributed.

FX Reserve Imbalances

Taking a look at a list of FX Reserves, it's clear to see who the winners are - Asian countries. I have been struggling to think about how this imbalance may play out as the game appears to be unstably one sided. Essentially what we are seeing is ballooning FX reserves backed by U.S. treasuries and the only way I can possibly see this imbalance being fixed is through the crash of treasury values. The reason that I say this is that there is a clear solution to other imbalances such as reserves built up by oil exporters who use their oil income as revenue (Iran, Venezuela, etc). Their reserve balances will shrink due to a lower oil price, and will likely reverse when the world ultimately moves off oil.

The U.S. deficit should be one of the topics discussed at the G-20 meeting and the idea of how other countries are funding U.S. consumption should be addressed. How to resolve the issue is something that I won't even try to tackle, but the long term implications of this problem may be put it on the sidelines for now. It is likely that what they call long term reforms will actually be shorter term confidence boosters for the global economy.

Currency Implications

It is argued that a lot of these problems can be fixed by returning to the gold standard and the words 'Bretton Woods' have definitely increased speculation. I believe that the conference will focus on how the international community can better work together and I wouldn't be surprised if they issue some sort of measure intended to reduce currency volatility. However that will fall short of a gold standard for many reasons:

1. At present, countries are looking for a way to expand credit, not limit it. A move to a gold standard at current times would likely prolong the period of lower output and higher unemployment.
2. Inflation, or currency debasement, is not the issue at hand. The discussion will focus on how to get credit to the private market and how to restore confidence so that institutions continue to lend.
3. Bernanke is considered by many to be an expert on the depression. His studies have led him to believe that countries that remained on the gold standard during the Great Depression took far longer to recover. His remarks from a 2004 speech support the idea that he is against the gold standard.

What I will be watching for is exactly the opposite of a return to the gold standard. What we may see is the groundwork for a system of credit expansion that would be super inflationary once credit starts flowing. The reason that I say this is that government actions usually have unintended consequences. The current fight is one of getting credit to the market and avoiding global deflation. The problem is obvious - how do you get credit to the market, avoid inflation AND re-instill confidence in both banks and sovereign nations (and in turn their currencies)? New tools will be emphasized as interest rate cuts are not addressing the root problem. It should be recognized that low nominal rates, even 0% is not inflationary in a deflationary environment as has been seen in Japan over the past 20 years.

Summary

Calling this summit a G-20 summit is more appropriate than Bretton Woods II. The central focus will likely be China's weak currency, ballooning reserves and aggressive export led growth policies. As pointed out in the WSJ, China will want significant concessions if it decides to play along and Europe would have to concede some of its power to China in the role of international financial relations. How this plays out is anyone's guess, but returning to fixed exchange rates or a gold standard is a very unlikely result.

See Also: Financial Times

Disclosure: Author is invested in TBT, far OTM gold calls and Yen

 

Comments

[Pipo:]

Excellent article Adam. Jim Rogers also sees high inflation ahead.

Money printing always leads to inflation and in Japan the rates went to zero but the money supply contracted. There is a very good book about that issue: The Princes of Yen.

Visit a Jim Rogers blog at:

jimrogers-investments....

2008 Nov 04 06:49 AM

[Frogman:]

This recent bear market will be short lived...especially for those who fail to study economic collapses.....Double Down TBT!

2008 Nov 04 04:52 PM

[Kunst:]

"Essentially what we are seeing is ballooning FX reserves backed by U.S. treasuries and the only way I can possibly see this imbalance being fixed is through the crash of treasury values."

That would be the traditional solution. Too many treasuries, down go their values, up go interest rates. If we were talking about debts that had to be paid back in equivalent value, that would be the inevitable result.

Instead, what if the US just creates more dollars, like trillions of them, to buy existing treasuries and/or avoid having to sell more? What can our creditors do about it? Nothing. They can't demand higher interest rates in exchange for financing our budget deficits because we can be our own best customer.

The result, of course, is de facto default, devaluation of the dollar, and substantial inflation of asset values, prices, and undoubtedly to a lesser degree, incomes. This "solves" the housing problem. House prices increase, incomes increase, homeowners go from negative equity to positive, mortgage payments become a smaller percent of income, everything is wonderful. Of course, if you are a lender or depend on any kind of fixed income, you are screwed. The price of "real" stuff -- like oil -- skyrockets, the US standard of living drops, but that's all stuff that has to happen anyway.

Tell me Bernanke and company wouldn't do this. The alternative is a trillion dollars per year bill just for INTEREST on the national debt. Imagine the consequences of that.

2008 Nov 04 10:36 PM

[Adam Katz:]

Kunst,

Although I don't disagree entirely, I think that trade is somewhat premature unless something drastic happens November 15th.

Firstly, Nouriel Roubini addresses this issue and makes a good argument that the printing presses won't be turned on right now:
www.plusev.ca/nouriel-.../

Secondly, if you look at debt as a percentage of GDP, the U.S is, by leaps and bounds, not the worst balance sheet out there. Now that may change if GDP decreases dramatically (obviously debt has already increased). So yes, a depression type environment of a contraction in GDP in excess of 10% may cause a bad stagflation situation. That's why they're attacking the growth problem now and that will probably be the focus for the foreseeable future. That is inflationary but not imminently. First you fix the problem of falling prices, then in doing so, inflation is expected. But as Roubini says unexpected inflation is the real concern and right now everyone expects inflation in the medium to longer term so it may in fact be smoothed in (priced in) through this deflationary period.

en.wikipedia.org/wiki/...

2008 Nov 05 12:10 PM