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Mark E. Bachmann, CFA
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I've been happily retired for three years after a 30 year career in business and on Wall Street. I’m an avid student of current events and now devote my time to research, writing and tending my family. I’ve had a life-long fascination with markets and have been a private investor throughout my... More
  • Mr. Putin And The Dollar

    Summary

    • The dollar's reserve currency status has for years disguised its weak fundamentals
    • 2008 financial crisis punctured the reserve currency aura
    • Search for an alternative to the dollar lacks coherence
    • The status quo is not sustainable, but a messy launch of any alternative would destabilize global markets
    • Reserve currency battle would cause Fed to lose control over rates

    On September 3, Aquarium Investments published an article on Seeking Alpha entitled "The Dollar's Dominance Is Coming To An End". This is a hackneyed theme that some observers are loathe to take seriously because it has proved misleading so often in the past. And even people who anticipate the dollar's eventual decline often dismiss the danger, as though the scenario would represent little more than another currency crisis. Still, there's something to consider here. The dollar's fundamentals have looked dodgy now for some time. The large and chronic budget and trade deficits racked up for decades by the U.S. would have long ago undermined the currency of a normal country.

    The Power Of King Dollar

    The United States, however, is not a normal country, and since the end of World War II, the dollar has enjoyed a privileged status that has made the fundamentals largely irrelevant. The 1944 Bretton Woods conference enshrined the dollar as a global reserve currency, based on what were at the time America's overwhelming gold reserves and a commitment to use them as fixed backing for the currency. In 1971 the dollar managed an extraordinary feat when the U.S. reneged on this gold commitment without undermining the currency's status. There was indeed a decade of instability and accelerating inflation as the non-Communist world adapted to the idea of pure fiat money as a reserve currency. But the dollar in its new fiat-money guise hung tough for another four decades, thanks to America's economic might and the power of its political alliances. The currency went on to become stronger than ever, even as the fundamentals generally deteriorated further with expanding trade and budget deficits.

    A New World Since 2008

    Inertia is a dangerous force in financial markets. It causes complacency and desensitizes us to subtle changes that sometimes foreshadow seismic shocks. And much has been afoot since the 2008-09 financial crisis. The turmoil of that period shook the world's confidence in America's ability to serve as guarantor of orderly finance and commerce. Indeed, many came to see the taste of America's banks for aggressive leverage and unregulated trading as the very cause of the crisis. Foreign governments, already weary of the Dollar's dominance, became emboldened to test the aura of self-reinforcing confidence supporting it. Most importantly, China and Russia, off-and-on strategic rivals themselves, began a coy minuet with one another characterized by expressions of a new strategic alignment. Together with the other members of the so-called "BRICS" coalition - Brazil, India and South Africa - they announced formation of the New Development Bank, supposedly an embryonic rival to the International Monetary Fund that would begin weaning developing nations away from U.S.-dominated institutions. These nations also have made completely clear their intention to seek an alternative to the dollar as the main world reserve currency. Photos emanating from the 2014 BRICS conference in Fortaleza showed Mssrs. Putin, Xi, Modi, Zuma and Madam Rousseff all with criss-crossed hands, grinning triumphantly out, as if directly at Americans, like this season's championship basketball team.

    System Up For Grabs?

    Of course, no one should overestimate the ability of this discordant band of anti-dollar conspirators, if such they can be called, to engineer anything resembling a smooth transition to a new global monetary order. However, therein lies the problem, since they are committed to try something anyway, and a botched transition surely represents the most dangerous scenario of all. The last turn of the world reserve currency wheel occurred in the aftermath of the Bretton Woods Conference, as the British pound gave way to the dollar. In that case, however, Britain and the United States were firm allies and mutually committed to an orderly realignment protecting the interests of both nations and that of the non-Communist world as a whole. Today, no such amity exists between the kingpins the old and the new orders, or even among the nations who are supposedly the architects of the new. China, generally seen as the rising superpower in the world today, has the most to lose from a mismanaged conversion and might logically be expected to function as the adult in the room at the present time.

    The Joker In The Deck

    However, the player we should all be watching is Russia. Judging from certain of his own public statements, Mr. Putin lost much of what he held dear when the Soviet Union was torn asunder, thanks in his view to American machinations. Now that same aggressor nation, again in his view, is trying to thwart him in the Ukraine, the very heart of his own 'Near Abroad'. Mr. Putin certainly wants no part of a direct military confrontation with the United States, but he may well see a softer and more valuable target in the nation's currency.

    China, for its part, feels more secure with its current place in the world, but that nation also has cause to resent American meddling in its sphere of influence. The U.S. has a mutual defense treaty with Japan, China's chief rival in its home region, and as late as 2001, America's president at the time was quoted in an interview re-affirming his willingness if necessary actually to go to war over Taiwan, an island the Chinese claim as integral to their very nation. That threat, empty though it was, still hangs impudently in the air. The Chinese know they're playing the game right now with time on their side and are therefore inclined to take the patient long view when evaluating risk. However, it's not hard to imagine them feeling tempted at the present time to collude with the impatient Mr. Putin in speeding up the timetable for re-arranging the world's monetary regime.

    The Disorderly Shape Of A Post-Dollar World

    Nobody knows what a post-dollar world might look like. For all the media and blog chatter there is out there about reserve currencies, there is little in the way of informed analysis being made public. Everyone seems in agreement that there is no single currency, including the euro or the RNB, capable of fully taking over the dollar's role. Most serious speculation seems to posit a basket of currencies, perhaps a redesigned version of the existing IMF Special Drawing Rights, or some analogous vehicle managed by a different institution. Taking note of the fact that both Russia and China have been systematically increasing the size of their gold holdings, some observers have even concluded that some form of new gold-backed reserve currency could be in the works.

    But this is all guesswork. What is certain is that stability in the world's monetary system is critical to its economic cohesion, and that this stability is currently at risk. Should China and Russia somehow agree on the framework for a new system, the other BRICS nations would undoubtedly fall in line, as would certain other of the oil producing states, like Iran and Venezuela, who would be happy enough to posture as wave-of-the-future nations while sticking fingers into the eye of the United States. Even America's long-time strategic allies would be tempted, since they are probably already questioning its resolve to carry on with the burden of economic leadership.

    Impact Of A Reserve Currency Shift

    In the event some new form of international reserve asset does make an appearance in the near future, the immediate impact would be an acceleration of the trend already underway for central banks and sovereign funds to re-structure their holdings. This would appear benign in the beginning, but it would not take long for a tipping point to be reached when financial markets woke up to the fact that something out of the ordinary was up with the dollar. Declining demand for U.S. Treasuries would trigger fear of them as prices dropped, and the much-chattered-about upsurge in long rates would finally be upon us. America's FED would spring into action, of course, abandoning all talk of 'tapering' and reinvigorating Quantitative Easing with a vengeance. However, the Fed would be battling global markets at this point and would find the scenario difficult to control. With an economy quite dependent on the continuation of low rates, the knock-on effects from all this would be unnerving and utterly unpredictable. And Mr. Putin would start feeling better.

    Investors Bereft Of Analytic Tools

    Those of us trained in financial analysis take a certain comfort in the tools we employ to manage our portfolios, perhaps PE ratios and relative growth rates, or else chart patterns for those of us of a technical bent. However, none of us can afford to lose sight of how quickly our favored methods would turn useless in a chaotic environment. Exhaustively-studied past relationships suddenly have no relevance when markets fall under the sway of radical new variables. We may have little ability to do anything but stick prudently to our methods for now, but we must be prepared to avoid paralysis when hit with sudden shocks, as will certainly occur in the event of a full-fledged dollar crisis.

    Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Sep 12 11:44 AM | Link | Comment!
  • Forcing Prudent Money Out Into The Cold: To What Effect?
    James Bullard, President of the St. Louis Fed, last week issued a public statement suggesting that the Fed consider resuming its Quantitative Easing program. The trial balloon has since kicked up a storm of interest among investors and pundits.
    "Quantitative Easing" is a currently voguish term for a central bank practice that has actually been around for a long time. In both the U.S. and Europe the idea was dusted off in 2008 and employed as one prong of the coordinated attack governments unleashed against the threat of deflation. Within the context of its Quantitative Easing program, the U.S. Fed nearly tripled the size of its balance sheet during 2008, simultaneously stabilizing the banking system with a massive injection of new reserves and supporting the mortgage market with the acquisition of illiquid assets that threatened to clog it.
    What is the Quantitative Easing though? And what does it mean that monetary officials are floating the idea again, even before the impact of its earlier implementation has been fully understood?
    The concept is simpler than the obscure technical term suggests. Central bank operations routinely involve dealing in very short-term government securities as the primary tool of monetary policy. The U.S. Fed trades short-term Treasuries as necessary to keep the inter-bank lending rate, i.e., the Fed Funds rate, in line with its policy target. When the system is working according to spec, bank lending and money supply growth respond in a predictable fashion, and longer-term rates align themselves in a rational, if at times erratic, relationship to the base rate.
    The problem is that the system does not always work according to spec. The Fed directly controls the quantity of reserves in the banking system and, somewhat less directly, the level of short-term rates.  In managing the money supply and the level of longer-term rates, however, the Fed must rely on the interaction between its own programs and the behavior of private banks and bond market investors. These other players have priorities which at times run counter to the Fed's objectives. The resort to Quantitative Easing in 2008 was an unmistakable indication that the Fed's conventional tools had stripped their gears and that financial markets, along with the real economy,  were cutting loose from its rein. With Quantitative Easing, the Fed re-asserted itself by intervening in non-traditional sectors and acquiring longer-dated securities.
    Quantitative Easing is a potentially radioactive tool that central banks have with good reason used rarely and cautiously in the past. The fact the Fed is now considering a second round of it in less than two years highlights the severity of the double-bind we are now in. Policymakers are obviously beginning fear that failure to pull the lever a second time risks near-term deflation and everything that entails. Moving forward with a second round, however, threatens later unintended consequences.
    What are these, and why worry?
    The most obvious danger is inflation, since Quantitative Easing by its nature entails debt monetization. While this threat seems the farthest thing from most of our minds at the present time,  its very remoteness is what aggravates the risk. If pulling the lever hasn't triggered any obvious ill effects, yet hasn't really done the job either, the temptation becomes overwhelming to pull it again and harder. This syndrome made its appearance with Mr. Bullard's recent announcement.  The prevailing belief that the Fed can easily reverse course whenever necessary to forestall inflation surely underestimates the complexity of the forces likely to be at work if monetary easing is pushed to extreme proportions.
    The more insidious danger from accelerated monetary intervention on the part of the Fed is that critical market signals start becoming lost in the noise. One does not have to be a market purist to believe that market-driven interest rates convey information that is vital to rational investment allocation. While short-term rates are, of course, already policy-driven, the Fed's unlimited power to create fiat money is likely to become a rogue force if used to hammer down longer-term rates as well. Neither Mr. Bullard nor any responsible official is advocating anything to this degree, but the danger is in the incrementalism seemingly underway now.
    We do not have to look very far back in our history to understand the hazard here.
    For several years leading up the 2008 financial crisis, the markets were awash with cheap money yet deprived of prudent investment vehicles for putting it to work. Institutional investors were desperate for the returns needed to satisfy assumptions built into pension plans or insurance policies. Individuals were trying to build portfolios and plan for retirement. All wanted to invest profitably and to limit risk. Understanding what was expected of them, investment bankers became adept at creating investment options that seemed to offer relatively high returns and manageable risk. As we know now, the real risks were often simply submerged and the realized returns disastrously negative. If investment bankers are indeed the devils of currently popular imagining, however, we need to have a little sympathy for the systemic pressures that drove them.
    Economic policy disconnects are becoming commonplace in the present environment. Our policymakers and our politicians routinely chastise market players for the reckless investment behavior believed to have been at the root of the 2008 crisis. Few of them acknowledge, or even seem to understand, the role that official monetary policy played in setting the stage for the crisis.
    Presently, the official monomaniacal war against deflation threatens to create some of the preconditions for another crisis. Deflation is indeed a real threat, but it's certainly not the only one. The possibilities of inflation and another financial collapse cannot be ignored.  Should either or both of these scenarios materialize, the renewed crisis is likely to be more severe and harder to fix than anything we've experienced to date.  Investors need to plan accordingly.

    Disclosure: No Positions
    Aug 05 1:56 PM | Link | Comment!
  • The Present Danger Of Ideological Gridlock
    Ideas, good and bad, have real power in the world.
    It is, of course, politicians who control the levers of power. But the best politicians know their limits. They generally understand they lack the expertise and the attention span necessary to solve complex problems. They know they need experts with ideas.
    This need is particularly great in the area of economics, where most politicians don't even pretend to know very much. In normal times, their ignorance seems to matter little. If the economy is working, most of us are ready to go on trusting either in the Invisible Hand or in our skilled technocrats, depending on our predilections. We're implicitly grateful to politicians for the strategic management of our economic affairs.  
    Everything changes, however, when the economy breaks down. Depending again on our predilections, we see either the Invisible Hand or the technocrats as having fumbled the ball. Who's there to pick it up? To their disquiet, politicians now actually have to start paying attention to economists, since a failing economy puts political careers at risk. Economists look up from their graphs and equations to find that real power has arrived unbidden.
    People are suddenly looking to economists for practical answers.
    Past crises have spawned new schools of creative economic thought. Economic theorists have risen to prominence by coming to grips with crisis. The Great Depression gave first-generation Keynesians the opportunity to test their theories about interventionist government and demand-side management. These gentlemen didn't exactly end the Depression, but they did make constructive contributions. When World War II was over, and with it the Depression finally, the Keynesians stepped forward to claim vindication for their ideas.
    A generation later, the economy was in trouble again, this time mired in the chronic stagflation of the 1970s and early 80's. Latter-day Keynesians couldn't explain it and, more importantly, didn't seem to know how to fix it.
    Ronald Reagan came to power in 1981. Like Franklin Roosevelt, Reagan too had little patience for economic theory, but he had a strong will and an instinct for what he wanted. The economists he called to service preached de-regulation, non-interventionist fiscal and monetary policy, and lower taxes. After a gut-churning mini-depression from 1980 to 1982, low and behold, the economy again revived. A long era of non-inflationary growth got underway. Like the Keynesians before them,  the monetarists and new "supply side" theorists now stepped forward to claim their time in the sun.
    Unfortunately, once again, arrogance and self-satisfaction foreshadowed a fall. The intellectual heirs to Reagan's economists were unprepared for the financial collapse of 2008. Reduced taxes and self-regulating markets had failed to stabilize the system. When a severe recession followed, prosperity too seemed out the window. Alan Greenspan, once the most influential economist of his day, essentially recanted much of his life's work before the United States Congress in October of 2008.
    You wouldn't know it from listening to economists argue, but Roosevelt and Reagan are receding ever further into history. Barak Obama is President of the United States. Nancy Pelosi is Speaker of the House. Harry Reid is Majority Leader of the Senate. None of them are economists, but they have power, and they're making big decisions.
    What kind of economic advice are they getting?
    The behind-the-scenes dialogue is hard to discern, but one can only assume it largely mirrors ideas being expressed in public. The most visible current-day economist probably is Nobel Laureate Paul Krugman. Arguing from his bully pulpit at the New York Times, Krugman articulates the contemporary neo-Keynesian line. He seems to believe there is no current economic problem that heroic government and more deficit spending can't solve, if only given free rein.  
    His opponents, moderately cowed by recent circumstances, are less visible today. They offer up a brand of nostalgic Reaganism: lower taxes and smaller government. They downplay the deregulation theme nowadays and exhibit a newfound passion for deficit control, albeit only via spending cuts. Still, they manage to speak with some of their old abrasive self-assurance.
    The problem is that all these people - Krugman, his allies and his opponents - are like revanchist generals re-enacting old wars.
    And there is a more serious problem:  All of them are becoming increasingly invested in failureWhen they should be developing fresh approaches to our current problems, they seem more interesting in sharpening their swords for what they apparently consider to be the approaching battle over the academic question of who lost the economy.

    The respective narratives are already clear: One side will have it that laissez-faire ideology wrecked our economy beyond the ability of even enlightened interventionist government to fix. The other side will have it that overweening government smothered American enterprise to death with taxes and debt.
    Few seem to acknowledge that our economy has entered into uncharted territory and that the old paradigms no longer hold.
    George Washington, our first president, was 67 years old when he died on December 14, 1799. Modern historians believe that he was afflicted by only a cold or a flu. But he had the benefit of the best medical science of the day. His doctors bled him, trying to "balance his humours", or whatever scientific mumbo-jumbo was used then to explain this counterintuitive therapy. Washington failed to respond, and they bled him again. Then again. Then he died, a victim not of his illness but of doctors who had dogmatic faith in bad medicine.
    Our contemporary economists should consider their own records and learn some humility. They also should develop some respect for their opponents, and the best among them should figure out how to collaborate in a way that yields fresh thinking. I've read enough history to believe that our current-day politicians are not much better or worse generally than their predecessors from earlier eras. But in the face of present challenges, they are entirely capable of driving our economy off a cliff without constructive guidance.


    Disclosure: No Positions
    Jul 06 3:41 PM | Link | 3 Comments
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