The Ricochet of An Unstable Currency System
In the midst of crisis it is often valuable to step back a bit and try and understand the historical context of what is happening. Such insight can prove invaluable in being able to foresee where things may be going on a longer-term basis and to provide clues to the meaning and possible implications of unfolding events. As economist John Kenneth Galbraith once observed, “…the enemy of the conventional wisdom is not ideas but the march of events.” If we can put the pieces of the puzzle of history and the march of new events together to see the underlying picture, we will understand better what is happening and what is likely to evolve – and that can pay dividends in our investment approach.
From our perspective the largest underlying reason (although there are many) for the present global economic crisis is that the world has suffered from a flawed global currency system since WWI. Let’s look at why and how this has helped produce our current predicament.
As John F. Kennedy once observed, “The great enemy of truth is often not the lie – deliberate, contrived and dishonest – but the myth – persistent, persuasive, and unrealistic.” The world seems to be repeatedly grappling with the myth that a paper currency can be effectively managed in a way that doesn’t create massive distortions and instabilities over time. Let’s look at how this myth has manifested itself in the path, what it creates that is dysfunctional, and how that is affecting the current crisis.
We often find it useful to use a free-market base and then to analyze distortions to it in order to understand what real problems are. In a free-market international gold standard, such as that assumed by David Ricardo in his theory of comparative advantage, trade eventually balances at a sustainable level between trading partners to their mutual advantage. We have discussed this before, but it is important to understand the mechanism by which this operates. If country A (let’s call them Germany for argument's sake) runs a trade surplus with country B (let’s call them Greece) under a free-market, Greece imports goods but must export gold to pay for them. In the process Greece’s money supply (gold) goes down, and so do its prices, while Germany’s money supply (gold supply) goes up, and that pushes its prices up. As Greece’s prices drop and Germany’s prices rise, eventually a sustainable balance is reached where prices are low enough in Greece that it doesn’t have to consistently export gold, while prices in Germany rise enough that it doesn’t consistently export more gold-value of goods than it is getting from Greece. Eventually the balance between gold and goods is reached and a sustainable level of production and import/export is reached between the two nations, such that both benefit and both focus on producing those goods in which they have the strongest comparative advantage (or at least the lowest comparative disadvantage). One of the many problems with fiat or partially fiat currencies, is that they do not balance trade as Ricardo originally postulated, because a gold standard is not (or not fully) operating to do so.
Another distortion that paper currencies or partial paper currencies tend to foster that is a distortion to a free-market base, is a substantial increase in debt, fractionalization, and leverage within the system. A 100% gold coin or 100% convertible gold standard of Ricardo’s free market system does not allow excessive debt levels to be created on a systemic basis. Every ounce of gold borrowed must exist, and must be loaned by its original owner. Temporary down-payment leverage such as a futures contract or option can exist, but it would have to be managed by an exchange with a clear set of rules that would equalize it in a viable economic way by expiration. This means banks can not fractionalize their deposits to loan out more than they actually have or invest more than they have. A bank in a free-market gold standard is more of a match-maker of investments with investors and lenders with borrowers, than it is a free-wheeling high risk gambler. Nor can governments spend more than they can borrow or tax – and any increase in their spending as a percentage of GDP is at once clearly discernible to the populace and must meet their agreement to be prolonged. If the government wants to spend a million ounces of gold, it must get it first, either through borrowing or through tax revenues. Deficit spending is a construct of a fiat currency, not a free-market gold standard. And in fact it is the desire of governments around the world to spend more than they take in, and of bankers to leverage their operations, that is the primary reason the gold standard was abandoned.
In the Civil War the US went off the gold standard to finance the war. But since the rest of the world stayed on an international gold standard for the most part, the US was able to get back on at a depreciated rate, once the war and massive spending requirement had ended. World War I however was different. It was the first time nearly every country on earth wanted to spend more than it took in and the entire world went off of the gold standard. As the Swiss historian Ferdinand Lips observed in his brilliant book, Gold Wars, had a major power or several stayed on the discipline of gold, WWI could not have lasted much longer than around six months before resources would have been exhausted and peaceful and less costly means of settling disagreements would have had to have been found. Instead, in a race to outspend their opponents, each country left the gold standard and spent much more than was ever dreamed possible at the time.
The original intention of the major powers was to return to a gold standard after the Great War had ended. But, the system created after WWI was not a return to a 100% convertible gold standard, and the instabilities of that system are being repeated again and again by the world since. As Galbraith observed, “…little is ever really new in the world of finance. The public has a euphoric desire to forget…”
In 1922 the Genoa Conference established a partial fiat, partial gold-linked system (called the Gold Exchange System) rather than a return to a 100% gold standard following WWI. The major powers agreed not to redeem paper currency for gold and to build reserves instead, allowing more currency than gold to be printed, and leverage to grow in the system as a result. The fiat currency allowed trade to grow with paper-currency acceptance that did not balance trade and so trade imbalances, fractionalization, and debt accumulation could grow in ways that would have been impossible in a 100% convertible gold standard free-market currency system. In our example above, for instance, if Germany had a trade surplus with Greece, it would simply accumulate Greek paper currency. German prices would not be forced, up, and Greek prices would not be forced down because the Greek’s could print more domestic currency to offset the money that went abroad, knowing that the German’s would not redeem.
Trade therefore would not balance, as it would in a free-market. Instead trade imbalances would grow to the point that instabilities and distortions were created. Trade expanded, but far faster than ever before and to levels that were unsustainable. This allowed credit to grow substantially as well. Many Keynesians and historians falsely refer to the Gold Exchange system as a gold standard. But it was not 100% convertible, so it allowed credit to grow beyond what would have been possible in a gold coin or 100% convertible free-market system, and it did not balance trade as a free market would, allowing unsustainable imbalances in trade to simply grow to the point that something had to give.
Massive leverage and credit expansion fed the 1920’s bubbles. The US debt/GDP ratio rose to over 250%, something inconceivable in a 100% convertible gold standard system. But as the unsustainable bubbles caused by excessive leverage in the banking system and trading system unraveled, debt deflation inevitably followed. In the 1930’s, debt deflations eventually forced first the UK (1931), then the US (1933), and eventually even holdout France (1936) into devaluations versus gold as excess money printing of the 1920’s had to be reflected in reality. Each country that devalued eventually saw some up-turn in economic activity in rotation. Some analysts today are comparing the use of QE in modern times to the competitive devaluations of the 1930’s. Japan started QE before this crisis, but since this crisis, the US has led the way as the first major country to buy assets and bonds to try and step deflationary forces in November, 2008. The recovery of 2009-10 followed. So did the devaluation of the dollar by over 12%. The BoE followed the Fed’s lead in March 2009, and the pound fell by about 10% thereafter.
Now even the ECB is making moves towards real QE, although it is hedging with sterilization talk and keeping amounts and real actions close to the vest. The ECB is still nervous about QE but has shifted from never considering to implementing it in a weekend, so the distance toward all-out QE policy seems small in comparison. An increase in the balance sheet of the Fed and ECB would speak louder than words, and so far $18B of intervention has been announced. If the ECB follows through with real QE, we may get more of a devaluation of the Euro, abeit with sharp and frequent intervention interruptions. The decline will either continue until key structural changes are made or the EUR becomes undervalued enough to pull in investment flows despite its structural problems.
Regardless of when the ECB makes this shift, it is likely to have to come, and it will insure that global monetary spigots remain on high for longer than would have otherwise been the case. Cuts in spending and increases in austerity measures in Europe will put the onus on central banks to keep liquidity taps on. New US swap lines may even lead to more QE in the US, and will at least mean increased dollar liquidity until the swaps mature in the years ahead.
Ferdinand Lips, the great Swiss banker and historian, argued in Gold Wars that WWI would not have been possible without the global exit from the gold standard that allowed it to become a major conflict. Barry Eichengreen in Golden Fetters argues that after WWI governments failed to re-instate a 100% convertible gold standard because they saw themselves as social re-organizers who refused to submit to the discipline of separation of money and state that the original Constitution tried to create. Global governments did not return to a real gold standard after WWI and the result was the partial fiat, partial gold linked "gold exchange standard" created at the Genoa Conference in 1922, which ultimately led to huge increases in credit and trade that was not balanced and the debt/GDP run-up that ended in the Great Depression after the bubbles of the late 1920's.
Arguably, the economic dislocation and fallout of that poor decision not to return to the discipline of gold ended up producing WWII (German hyper-inflation would not have been possible in a gold-standard). After WWII, once again governments failed to return to the discipline of Gold, setting up the Bretton Woods system, which simply replaced the Pound with the dollar as a reserve currency, and was again a partial fiat (limited link to gold) system that allowed excessive leverage to proliferate and did not balance trade. That system produced unsustainable credit and imbalanced trade such that it fell apart in 1971 when Nixon suspended all links to gold (essentially another devaluation of sorts for the reserve currency itself).
The fiat currency floating exchange system since 1971 has produced even more massive credit and trade imbalances than ever before, such that the US debt/GDP ratio rose to over 350%, even beyond the crisis levels of the 1930's. Our current crisis since 2000 is the result. It is amazing in some respects that the same unstable system created in 1922 has been recreated now more than three times with the same result of instabilities and imbalances leading to failure of that system. Yet governments are so loath to give back the power of the printing press, that they keep repeating the same mistake again and again, and the costs grow more and more severe.
However the current monetary regime isn’t even partially linked to gold, so currencies don’t devalue against gold anymore officially, they devalue covertly against each other via policy changes. In addition, since gold is not even an informal anchor, it does not limit the degree of debt and credit excess in the system as it did in the past. It is important for investors to understand that in the modern totally fiat currency system, the only limit on government spending and excess credit creation is the markets themselves, specifically the global government bond and currency markets.
Today it is markets that are left to try and force discipline and reality on government spending gone insane absent the limits of gold. Global bond and currency markets are the last limit and link to market reality left. Now if governments want to spend beyond the levels markets will allow, governments must try and suspend markets themselves, rather than the link to gold. German Chancellor Angela Merkel has stated that, “in some ways, it’s a battle of the politicians against the markets” that the EU is currently engaged in. She is right. And Merkel is trying to convince the EU and G20 to “tighten political control over financial markets” as part of her proposed solution to periphery Europe’s over indebtedness problem. Increasingly, what we as investors must now watch out for is that the solution governments try to enact is to undermine and destroy the markets just as they did the gold standard, because that is what is limiting them this time.
Remember that the markets these elitists are trying to destroy are simply the free interaction of buyers and sellers and the extension of property rights. Whether governments will be able to undermine market limitations upon them, or whether markets finally reign in government excessive spending, social-engineering, credit, and un-balanced trade, may become one of the central questions of this crisis. What limited freedom is left for mankind may stand in the balance. And whether hyper-inflation, deflation, or both become the end-game of this prolonged global currency system crisis we are in, may be determined by the answer.
Will Europe Address the Real Problems?
Above we discuss the instabilities of the global currency systems created since 1914 in repeated rounds of attempts and failure. In this context then, let’s look at the eurozone and try to understand what is triggering the current crisis in this region. Bernard Connolly’s book “Thee Rotten Heart of Europe – The Dirty War for Europe’s Money” is a good expose of the story of how the Euro was setup, as well as many of its inherent flaws and political manipulations. Yet like so many books that delve into historical details of a period, it does not provide a full context. Our analysis is that the EMU is an even more flawed version of the same type of fiat currency system that the world political elites have been trying to implement since 1922, that has failed in every attempt, yet with its own unique accelerators to the flaws of such a system.
Soros and others have long suggested that monetary union without fiscal union is bound to fail systemically during deep down-turns. However it is the distortions of a single paper currency system that are leading to the sovereign debt problems that are bringing such deficiencies to the fore for the Euro presently. We’ve looked at some of the persistent flaws of fiat or partial fiat currencies in our On The Horizon Column versus the free-market 100% convertible gold standard example. First they don’t balance trade, but tend to build sustained trade imbalances that eventually become unsustainable. Second they lead to excessive leverage, debt, and credit generation. We’ll add a third problem that a fiat currency central bank system overly favors banks and requires them to have an undue economic priority in the overall system. In the eurozone these flaws manifest themselves in ways that are worth exploring a bit to understand what is really going on.
Instead of balancing trade between member countries, the EUR allowed imbalances to grow because of artificial borrowing ease and inexpensiveness along with the same flaws of any paper currency system we’ve already explored. Now these imbalances have reached a point where the cheap and easy lending is over. Meanwhile, the cost of labor per unit of output -- the wages required to produce a widget -- rose a mere 5.8% in Germany in the 2000-09 period, while equivalent labor costs in Ireland, Greece, Spain and Italy rose by 30%+. While Germany's exports rose an astonishing 65% from 2000 to 2008, its domestic demand flatlined near zero
The "consumer" countries, on the other hand, run large current-account (trade) deficits and large government deficits. Spain, with about half the population of Germany, has a $69 billion annual trade deficit and a staggering $151 billion budget deficit. The reason periphery debts have risen to unsustainable levels so swiftly is mainly two-fold: first the eurozone allowed artificially low interest rates to periphery countries who could borrow at German rates when they could never do this on their own, and second the eurozone increased trade imbalances to favor the more competitive exporters like Germany and The Netherlands. Lower growth periphery countries, like Greece and Portugal, used artificially low interest rates to borrow so they could fund not only their chronic fiscal deficits, but also their growing massive trade deficits. Since trade was never balanced, and since Germany’s unit labor costs continued to gain on these countries without adjustment, trade deficits grew and debts have grown to unsustainable levels. In higher growth periphery countries like Ireland and Spain, artificially low interest rates led to massive property bubbles that arguably outpace that of the US bubble on a per capita basis. These countries therefore face substantial deflationary deleveraging problems now.
Either Germany and its export-surplus neighbors continue bailing out the eurozone's importer/debtor consumer nations, or eventually the weaker nations will default or slide into insolvency. This is a similar conundrum that China/US will eventually have to grapple with because fiat currencies don’t balance trade. Greece is the poster-child of this problem. It will have a 149% government debt/GDP ratio at the end of the current aid package according to optimistic EU/IMF estimates. That means it will need to grow 1.5 times faster than the interest rate it can borrow at to be able to make progress on cutting its debt levels.
All the newest package does is to relieve the liquidity crisis for Greece therefore, while making its overall debt levels even more impossible to pay. The Rogoff & Reinhart (This Time It’s Different) historical solutions we’ve talked about before suggest that Greece needs a massive currency devaluation on the order of 30%+, in addition to restructuring of its debt to write-down the level of a sizeable amount, along with huge spending cuts and cuts in the role and size of government and socialist policies, while the tax system needs to provide incentives and advantages to business formation and capital investment. Real wages need to come down about 35% for Greece to compete with its biggest competitor, Germany.
The ECB and EU seem to believe that if they let the Euro fall in an orderly fashion this will solve periphery real wage and competitiveness problems. It is true that a lower Euro will help. But since the vast majority of Greece’s trade deficit is with Germany, what Greece and other periphery countries really need is a devaluation versus Germany, not versus others. A Euro decline simply benefits Germany, but doesn’t really address the competitiveness problem versus countries that are also in the eurozone, which is where most of the problem lies. The same problem exists for Spain, Portugal, Italy, and to a smaller extent, Ireland.
The new IMF/EU/ECB plan still does not address most of the problems that have created the crisis therefore. Since periphery Europe cannot devalue versus its primary trading partners with which they have trade deficits, real wages will need to come down from internal deflation. But a drop in nominal wages will mean that private-sector debt will increasingly come under fire and there is a danger of a negative feedback loop of deleveraging developing that could lead to a worsening economic contraction that would not help these countries pay their debts. Spending cuts are good, but they won’t solve the problem alone.
Greece and Portugal, and probably Spain also need debt restructuring that is not being considered. The best solution for them would be to exit the Euro, devalue their independent currencies, restructure their debts to more sustainable levels, and implement massive spending cuts combined with large but not as large tax cuts for businesses and capital formation. The current plan covers little of what is truly needed and ignores the key question of debt sustainability for periphery countries that have already arguably reached debt levels that are simply unsustainable absent restructuring or default. This is why default risk continues high and markets continue to riot.
In historic examples of success in tackling this mammoth task, significant devaluations, privatizations, debt restructuring, spending cuts that decreased the role and weight of government, and incentives to business and capital formation were important components. The only true answer is reform. As the markets recognize this they will continue to riot over time until and unless massive reforms are made.
In the end, we should all hope that the “evil speculators” weigh on the euro and attack it with a vengeance for it is not until a restructuring of the EMU or its demise that we can be certain that the underlying instabilities are contained. Alain Madelin (a former French Minister of Finance) recently said on French radio: “politicians are saying that markets are acting irresponsibly but instead what is happening is that markets are starting to ensure that politicians act responsibly!”
Another component of the problems of a fiat currency central banking system is that it tends to favor banks over others economically. We’ve seen this in spades with banks being bailed out with public funds since the current crisis started, while most of the rest of the economy must simply make due on its own. Another element of the latest EU plan involves a European version of TARP that buys EU debt from EU banks and intervenes in markets. Since the EMU started, banks and insurance companies all over Europe have been lured into believing that Greek (or any periphery European country) sovereign bond risk was equivalent to German sovereign bond risk. As a result, EU banks have highly leveraged positions in dubious quality periphery EU debt – and in private-sector debt from these countries too. Thus, as a result of the distortions of the eurozone, European financials are in a pickle. The ECB has therefore started a “Le Tarp” to buy some of these questionable debts from EU banks to help bail them out with public funds.
You have to understand the critical feedback loop of governments and banks to understand current bailouts. Governments bailout banks who in turn use bailout funds to buy more bonds allowing governments to keep running up the tab. If either one has problems, so does the other. This is the construct of the fractional reserve fiat currency system as we enter the end-game period. People are starting to understand that they can’t believe in the wizard behind the curtain of every bailout when repeated bailouts fail to fully resolve underlying problems such that new bailouts are continually needed somewhere else. Since each bailout is really just a short-term confidence scam to hold up the house of cards of an over-leveraged system, disbelief could mean real trouble.
Thus, little countries like Greece, represent big threats to the global economic system if sovereign concerns grow to bigger countries as they eventually will. Whether the European TARP is effective at kicking the can down the road a bit or not may depend upon whether sovereign concerns or interbank lending concerns spillover to larger sovereigns now or later. Europe got a TARP when what it really needed is a growth pact that dismantles overly large government. Growth and solvency issues till not attacked by new plan.
Some analysts note that the second wave of the Bear Market of 1929-1932 started when European banks began to fail, and took off when the Smoot-Hawley Tariff was passed in June 1930. 1929-1942 was not just one crisis but a series of crises that reverberated around the globe as Liaquat Ahamed noted in his book (Lords of Finance: 1929, the Great Depression, and the Bankers Who Broke The World ) :
…part of the reason for the extent of the world economic collapse of 1929 to 1933 was that it was not just one crisis but a sequence of crises, ricocheting from one side of the Atlantic to the other.
The response of developed governments to the Great Recession was to take on tons of public debt to try and paper over the problems. Greece’s situation is like a small flashlight cutting through some of the fog caused by the government’s efforts to mask real problems, and it is unmasking these problems and creating seeds of doubt about all sovereign debt levels. Private (mostly bank) debt has been swallowed by public obligations, and now we get to experience the many jitters associated with sovereign debt concerns. This is the beginning of the end of the easy borrowing party for governments, and as we’ve been highlighting, most of the developed governments will face similar issues later this decade. One of the biggest side-effects of the Greek debt crisis may be a tremendous ripple effect on fiscal matters.
This is the reason that contagion that really gets out of hand could reach much further toward US, Japan, and other developed country debt as well. This is a major problem that could snowball into a major catastrophe if it is let get out of control therefore. We have to continue to watch Greek, Portuguese, and Spanish bonds, and EU banks for contagion implications.
London- based Jenkins, Evolution’s head of credit strategy, said in a recent Bloomberg article:
The capital markets could soon be in the midst of the largest financial crisis of the last 100 years…with government debt itself perceived to be the problem, the potential for political and economic change is much greater.
Now it is important to note that global central banks seem to be getting together to try and coordinate efforts as this crisis has grown. It is quite probable that the SNB (Swiss National Bank) intervened in the EURCHF last week, and thereby supported the Euro. ECB QE efforts could grow and intervention and support mechanisms could become more coordinated again as happened in 2008 and 2009. Therefore, the current bout of the on-going global crisis that really relates to the faulty currency system and the debts that have evolved from its distortions and false incentives, could end up leading to a period of respite similar to the episode from March 2009 through early 2010.
The problem is that the underlying reason for these series of crises is much deeper than the solutions being thrown at it. While it is very likely that the entire systemic problem will come to a head in an even more major crisis than we have yet experienced later this decade, we cannot know for sure if we are in the next leg of it or not, although the odds of this are starting to grow.
Markets are also at a critical point, and it is here where we must get our clues as to whether we are at a point when another wave of crisis is leading to a return of deflationary forces that can derail the recovery. So far our models continue to suggest that this is merely a correction and that the recovery will not be derailed – but failed debt auctions, contagion moving to Japan, the UK, or US in sovereign debt concerns, or continued declines in markets below key support, could tip the balance toward the recovery being more fully derailed and a new leg down of the secular bear market that really started in 2000, as we’ve long suggested.
A breakdown in global stocks clearly below their February lows, in base metals below their Feb lows and continued breakdowns in other markets will be important indicators that things are getting out of control and the degree of interventions will likely get larger. The government has virtually nationalized the mortgage market with over 96% of all mortgages in the first quarter either coming from or being guaranteed by the Feds via FNM, FRE, and FHA.
Also watch inter-bank lending. The recent rise in LIBOR/OIS is reacting to counterparty risk rearing its ugly head once again, and in much more extreme quantities, this is what led to the seizure of the financial system in 2008. If inter-bank lending starts to show sharper and more consistent deterioration, market damage and panic could even increase.
Watch out for poor auction results of EU bonds (or sovereign bonds in the UK, Japan, and the US) ahead as another crisis trigger. When the inevitable debt auction failure does arrive, the ECB cannot monetize the debt by buying it at auction. Meanwhile other heavily indebted sovereign borrowers are wondering if they are next to face market rioting. The next three years many governments must rollover more than 50% of their GDP in debts.
We will have to wait for a valid Follow-Through Day up (high volume and breadth day when the major averages rise 1% or more coming after the fourth day up from a low day) for a signal that the market is reacting more positively to new policy action. Until then we’ll play defensive, seek to understand what is happening and what the risks are, and watch things very carefully.
Disclosure: Short SCGLY, Long Gold