Should The U.S. Taper In The Context Of The International Monetary System?

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Includes: TLT
by: David Qian Zhang

By looking into the history of the international monetary system, we can appreciate the global economy better, and thus achieve more stable and evenly distributed growth. More specifically, we will review various monetary regimes in the 20th century, examine how the dollar hegemony has directly interfered with both US and international policies (Triffin's Dilemma), and see if other monetary regimes such as the SDR (Special Drawing Rights) or Bancor are more ideal. We will also see how China is running away from the dollar hegemony, and how the US can counteract through monetary and fiscal policy. Finally, a long position in long-term Treasuries (NYSEARCA:TLT) is proposed as a way to anticipate tapering.

A Repeating Dilemma

While the wealth of nations grew through specialization and trade in modern economics, the international monetary system never converged to an omnipresent super-sovereign currency. Gold was the default choice given its lasting nature, but its limited supply interfered with optimal domestic policies. For example, in 1931, the British Empire had to leave the gold standard, as post-Depression economic slowdown meant Britain could not prop up the sterling to prevent a run on gold. Conversely, a rising America had to devalue the dollar through the Gold Reserve Act in 1934 to create more short-term credit than those backed by gold reserves.

Due in part to their divergent preferences toward maintaining reserve status versus short-term growth, the US was more prepared than Great Britain to finance the rebuilding efforts post-WWII. Consequently, the dollar's worldwide hegemony was established at Bretton Woods in New Hampshire in 1945, just when the British had to borrow $4.4 billion from the US to rebuild its economy. Although British representative John Keynes advocated the Bancor currency based on a basket of goods, Harry White from the US was able to leverage America's economic position and peg all major currencies to the dollar, which was backed by Gold at $35/ounce. Furthermore, White did not want to constrain American exports to debtor nations, as the Bancor system would have penalized countries with excess surplus. Through Bretton Woods, US dollars and goods spread globally while fiscal aid such as the Marshall/Dodge Plan stimulated debtor nations' growth. Finally, the reliance on American military to contain Communism legitimized America's "exorbitant privilege" of borrowing at low rates.

While wars on Communism and Poverty drifted the US into a current account deficit, Europe and Japan regained their economic status by the 1970s. And because the currencies of these new creditor nations were, by design, not allowed to appreciate relative to the dollar to stem their current account surplus, the dollar became so overvalued that a private yet higher price of gold was established in 1968 in London. This so-called gold window was finally closed in 1971 via the Smithsonian agreement that bumped the price of gold to $38/ounce. This new peg only lasted for two years, however, before Bretton Woods finally collapsed and gave way to the current floating exchange rate system.

After a period of dollar depreciation and several oil crises (1973, 1979), the dollar surged as Paul Volcker became Fed governor in 1979 and raised the Fed Funds rate all the way to 20% by 1981. While inflation surrendered, American exporters had such a hard time with a strong dollar that the US had to negotiate a multilateral agreement to devalue the dollar in 1985 at the Plaza Hotel in New York. The Plaza Accord signified a decline of US competitiveness relative to Europe and Japan, but the US was able to shift its dollar hegemony to developing countries, thus making the decline temporary.

Soon again, US domestic policies were at odds with those of other nations that depended on the de-facto dollar reserve system. The falling dollar and rising yen partially caused a decline in Japan's export economy and eventually a total market collapse in 1990. Conversely, part of the 1997 Asian Financial Crisis was caused by the Louvre Accord that reversed the dollar's decline, which made it hard on the developing countries to maintain their dollar-pegged currency while running current account deficits. As a result, developing countries started to entrench themselves in the so-called "Bretton Woods II" by accumulating massive dollar reserves. Just like the Europeans earlier, the developing countries needed American consumers and were unabashed at suppressing their currencies while buying dollars.

The Current Dilemma

Even before surviving the Great Recession of 2008, the US realized that its debt levels were too much for a reserve currency country. A bit of arithmetic hits the point. If US debt held by the public continues to increase at current levels, it's projected by the CBO (Congressional Budget Office) to become $16.6 trillion in 2020. If ten-year Treasury rate rises to the historical norm of 5.6% (since 1950), then Americans would have to pay $930 billion in annual debt service. However, if annual GDP growth remain at historical levels of 3.25%, then it would only cover around 60% of interest payments on US debt.

Concurrently, developing countries need to rebalance from manufacturing and export-driven to service and consumption-driven. To cope with an unequal society, they also need a more sophisticated financial system to unleash savings. Instead of combating upward pressures on their currencies due to trade surplus, they may now worry more about slumping currencies. A rice example may help. When a Chinese farmer sells rice to Costco in the US, Costco has to give dollars to the farmer, who passes on the dollar to the People's Bank of China (PBOC) for yuan. The PBOC then recycles the dollar indirectly back to the hands of Costco via the purchase of US Treasuries. This allows Costco to continue buying rice from the Chinese farmer. But now that the US wants to deleverage, and China wants to transform, the PBOC does not need to buy Treasuries anymore. Furthermore, China would have to worry more about depreciation of the yuan as declines in its trade surplus leads to capital outflow.

As seen in chart above, China has more than $1 trillion US Treasuries at risk of depreciation. While China does not want to sell US Treasuries in bulk, it can stem its massive accumulation via bilateral currency swap agreements. A rice example is helpful again. When Costco in the UK is buying rice from the Chinese farmer via sterling, the Chinese farmer can then exchange sterling for yuan with the local bank. The local bank then takes the sterling to the PBOC, which then would be able to swap it for yuan via the currency swap agreement with the BOE (Bank of England). More than 24 countries have signed up for such swap agreements since the 2008 Crisis as shown in table below.

The Ideal World

As advocated by PBOC Governor Xiaochuan Zhou in 2009, diversifying into the SDR from dollar reserves can minimize reserve losses to creditor nations. Second, it limits higher rates for debtor nations as the IMF can create a "substitution account" to reinvest dollar assets into long-term Treasuries. Third, it acts as a natural current account rebalancing tool, as the weakening currencies of deficit countries will see their weight in the SDR diminish until they undergo economic reforms. Finally, the "exorbitant privilege" could be shared among all countries in the SDR.

There are a few prerequisites before the SDR can expand from its current level of 4% of total global reserves. First, there has to be more liquidity for SDR-denominated securities issued by the public or private sector. Second, SDRs spent by deficit countries has to be replenished over a certain time period to induce policy changes. Third, the US has to be willing to give up its reserve currency status. This could be a reality as it becomes more energy independent, more focused on deleveraging, and more cognizant of Triffin's Dilemma.

Ultimately, as seen in the euro experiment, there could be a new global currency, which Keynes coined the "Bancor". It could be issued by the IMF and would be immune from Triffin's dilemma. It would also distribute the "exorbitant privilege" to all nations as monetary stability lowers borrowing costs for all. However, its fiscal transfer nature would strip away national sovereignty as seen in the European sovereign debt controversy, where creditor nations find it hard to sympathize with the profligate culture of debtor nations.

US Policy in Reality

Domestically, how effective has monetary easing been on job creation if the employment-to-population ratio has been stuck at 59% for the past four years (chart below)? While the unemployment rate can go down with discouraged workers leaving the workforce, the employment-to-population ratio depicts working class conditions more accurately. It's in the American spirit to create structural policies that lift up commoners untouched by rebounds in stocks and housing. Examples include banking re-regulations, science education subsidies, tax abatement on job creation etc. A direct job creation program that pairs up all of those who want a job with public projects related to infrastructure or environment has also been proposed but left on the table.

Will a less dovish environment coupled with structural changes work in reality? A study done by the Congressional Budget Office (also noted by Larry Summers in the Washington Post) projected that "an increase of just 0.2% in annual growth would entirely eliminate the projected long-term budget gap". Hence, by coupling structural changes with tapering, the US may be able to dramatically reduce the long-term fiscal burden of entitlements and debt service, and thus rejuvenate its "exorbitant privilege". While the US Fed's "dual mandate" set in 1977 for stable inflation and full employment may have been intentionally dovish to boost worldwide liquidity and lower debt payments through a weakening dollar, it may be time now in the debt cycle to leave the task of job creation to Congress and thus deleverage. However, given the slow and often political nature of structural reforms, a steadily tighter monetary environment may be the best way to persuade legislative action. Even by being less dovish, the Fed can induce more structural changes, especially when negative market reactions to tapering start to disturb voters and lobbyists.

Conclusion

While an SDR-like currency is still another crisis or two from wide usage, can US policy makers still preserve the dollar hegemony, assuming that it is in their interest? Unlike the gold-strapped British who tried and failed to prop up the sterling in 1931, US hegemony is largely dependent on its relative economic advantage (among others such as military prowess and international acceptance). Therefore, the US can ostensibly show its economic resilience and thus attract capital back from emerging markets by being the first to exit Quantitative Easing, ahead of Europe, Great Britain, and Japan. Even if the US were forced by international pressure to promote the SDR and share the "exorbitant privilege", the appreciation of the dollar and its subsequent higher weighting in the SDR would still help the US reduce its debt burden gradually.

Furthermore, tapering may lead to flight-to-safety (higher long-term treasury prices ) and thus lower the debt service cost that Americans have to pay as seen in previous QE exits (chart below). Therefore, it may be a good time to begin a long-term Treasury position as ideally done by savvy investors in the Spring of 2010 and Summer of 2011. This flight-to-safety rationale is beginning to leave footprints in the market as seen in the instant yet uncharacteristic rebound of long-term Treasuries after their initial drop following the upbeat November Nonfarm Payroll report on December 6th. While the Fed most likely moved closer to tapering (50-50 chance according to Bill Gross of PIMCO) on its next FOMC meeting (December 18th) behind such good news, the market did not respect it enough to let Treasuries fall at all that day. This means that Treasuries may actually rise even if tapering does happen on December 18th. Nonetheless, we cannot rule out external pressures to sell US Treasuries from emerging market countries that may not be so fond of a strong dollar anymore, as they need time to gradually transition from export-driven to consumption-driven. Unless we get the foundation-not just the mortgage plans-of our house in order, that is.

Special thanks to Marc Chandler's NYU course on "Politics of Money" for inspiring this article!

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.