Peter T Treadway, PhD
Historical Analytics LLC
August 15, 2011
Quite a lot has happened since my last essay in mid- July. I thought I would just outline some key developments as I see them.
—The S&P downgrade of US Treasury obligations, though of little practical significance, should be viewed as a prophecy. A prophecy of what will happen if confidence in the cornerstone of the international monetary system – the US dollar –is lost.
“Abandon all hope, ye who enter here” inscribed the Italian poet Dante Alighieri over the entrance to hell. (in his Inferno, written c. 1310-1321) Monetary hell appears to be where we are headed. The world got a taste of it last week when all the global markets went haywire. It has been said that the financial markets are the nerve center of capitalism. Last week the markets had a nervous breakdown.
In 1945 under the Bretton Woods System the US dollar effectively displaced gold as the centerpiece of the international monetary system. Any remaining official role for gold was terminated in 1971 with the refusal of the US to honor its Bretton Woods obligation to sell gold at $35 per ounce. Since then the world has been on a 100 percent fiat-money, dollar-centric system.
Fiat-money is that created out of thin air by governments, backed by nothing. It only has value if people are willing to accept it in return for goods and services. Amazingly, people and nations are willing to accept government issued fiat-money so long as governments do not egregiously abuse their position and over-issue this money. But invariably governments do exactly that. The populist urge to overspend and print money to finance the overspending proves overwhelming. The history of fiat money begins with the Sung Dynasty in China in the eleventh century. It always has had the same unhappy ending with an inexorable decline to worthlessness.
—The US will not default in a legal sense. Along with my colleague Dr. Michael Wong, I teach a workshop for institutional investors on sovereign debt risk. This course outlines five circumstances that from an economic perspective can be viewed as a sovereign default: 1) Legal default, 2) bailouts, 3) significant unanticipated inflation, 4) financial repression and 5) debasement.
The US (and also Japan) will never default in a legal sense because it can print all the dollars it owes. The nation states of Europe can legally default because the individual nation states like Greece borrow in euros and only the European Central Bank can print euros.
A bailout is a legal default that is avoided by the action of some entity such as the IMF intervening to provide funds to prevent a legal default. Who’s going to bailout the US?
Significant unanticipated inflation can result from egregiously excessive money printing. QE1 and QE2 are examples of egregiously excessive money printing. Only the US and Japan have this power although collectively the Eurozone has it as well as the ECB can print all the money it likes.
Financial repression refers to the totality of government actions that force citizens to take suboptimal decisions (from their point of view) to fund government debt. Forcing retirement accounts to buy government bonds, penalizing or prohibiting the purchase of gold, restrictions on the purchase of foreign assets are examples. Unfortunately, measures such as these can be expected in the future in most Western countries (including Japan). Americans in particular should be wary of government attempts to raid their IRA and 401k plans and restrictions or taxation of their gold holdings.
Debasement refers to the reduction in gold and silver content in coins. Since modern coins don’t have gold and silver for the most part, this is a form of default that no longer is a major threat. One thing Bernanke and Geithner won’t have to do is stay up nights clipping coins.
—Default on government debt is not the only kind of default that lies ahead. Governments have made huge “promises” in terms of social and health entitlements. These promises will not be fully honored. Consider this a default.
— Gold should be viewed as an alternative currency. Certainly that’s the way the markets seemed to be treating it last week. One of the standard objections to gold is that it produces nothing and has no cash flow return. My answer: so what! Take out a dollar (or a renminbi) from your wallet. Hold it up in the air. What does it produce? What is its cash flow? Zero, nada. It isn’t the function of money to produce anything. That’s not money’s job. In a sense, both gold and central bank money are fiat – their values are equal to what people assign to them. Money’s job is to be a store of value and a means of payment. Lots of things could and have served as money. Cigarettes for example in 1945 post-war Germany.
The difference between gold and high powered fiat money created by central banks is that the central banks can and do create endless supplies of fiat money while increases in the supply of gold are constrained by the amount that can be dug out of the ground. Digging gold out of the ground is not cost free. It’s true that, in the delightful imaginary world of economists’ models, central bank high powered money is costless to produce therefore makes more economic sense than , in Keynes’ words, the “barbarous metal” of gold. But economists’ models don’t allow for the overwhelming political power of populist spending urges. If history is any guide, the inevitable response of the political process is to over issue and thereby destroys the value of the central bank money that was “costless” to produce.
—Fiscal stimulus financed by government borrowing won’t work. US private and public sector debt has reached astronomical levels relative to US income. More debt is unacceptable. Many economists have concluded that the so-called multipliers on stimulus spending are approximately zero. Past stimulus either was used to bail out the states and their excessive union contracts or wasn’t spent at all (Remember President Obama’s ill-advised “shovel ready” joke.) The public can see that stimulus equals waste and more government debt. Say what you want about the Tea Party and its kamikaze approach to the debt ceiling, it has added a pejorative tinge to the word stimulus.
— The US unemployment rate isn’t coming down and the US economy will be lucky to avoid a double dip back into recession. Typically, economic recoveries are led by housing. But not this time. Excess inventories and excess debt plague the housing sector. It isn’t coming back any time soon. According to economist A Gary Shilling who has been dead right on the housing debacle, there are some 2 to 2.5 million excess units of housing inventory in the US. And a substantial portion of existing homeowners’ houses is underwater relative to their mortgages.
The states are another weak spot. States are shedding jobs as they hit budgetary walls. In the long run I would argue that the US total factor productivity is enhanced as labor is shifted from the bloated state sector to the more efficient private sector. This shift is a good thing. But the near term effect of the states’ layoffs is to add to unemployment.
Add to all this slowdowns if not recessions in Europe and China.
Economists debate the exact number but basically, given the rate of population growth, if the US economy cannot grow at more than 3 percent, unemployment cannot come down. In my opinion, over the next year or so 3 percent GDP growth can’t happen.
— Populist-driven Western democracies, including the US and Japan, are too dysfunctional to achieve the necessary fiscal reforms in the coming years. As we have seen with Greece, only denial or curtailment of debt market access will force the politicians to act. The recent debt ceiling fiasco in the US in fact achieved very little in terms of fiscal reform. Across Western countries, enormous public and private sector debts have already been built up thanks to profligate government spending and the 2008 global downturn. To these will be added the entitlement tsunami produced by unfavorable demographic trends in the coming years. Defaults, either on government debt or on promised entitlement programs, are inevitable but will not be undertaken voluntarily.
—The euro will survive. The Europeans are making a mess of their fiscal problems and growth is sputtering in the eurozone. As I have argued repeatedly, they should have let Greece default, and bailed out their banks directly. The markets would have directly imposed austerity on Greece. The ECB would not have had to load up with unwanted Greek and other European sovereign debt.
The US states have defaulted more than once in US history and the country still managed to live happily ever after. But the Europeans instead have elected to force the ECB to buy Greek, and other weak country’s debt, set up bailout mechanisms to transfer funds to Greece directly, and impose fiscal austerity on Greece. A solution dictated by politics, not markets. Wrong approach in my opinion.
But the euro is too valuable to give up. As I have repeatedly argued in prior essays, replacing the myriad European currencies with one currency represents a quantum leap in terms of economic efficiency. Moreover, as the dollar slowly loses the world’s respect, it is clear that countries like China prefer to have an alternative reserve currency. Giving up the euro would be an act of economic self-destruction.
The argument is frequently made that Europe lacks the linguistic and cultural homogeneity of the United States and that a single currency monetary union cannot work. This argument has some merits. But remember these countries are all geographic neighbors and are their number one trading partners. Their economies have been significantly integrated. In my opinion the Europeans cannot go backward. Just add up the toll of death and destruction from WWI and WWII. Inevitably some kind of political unification has to occur.
The cynics will say the Europeans made all the wrong choices in the twentieth century so why won’t they keep on making bad choices in the twenty first. Europeans have made acts of self-destruction a specialty. We’ll see.
People making the heterogeneity argument should take a look at India. Building on the British colonial legacy, a collection of independent states and cultures were turned into one country. Bengal for example is as linguistically and culturally different from Tamil Nadu as Germany is from Greece. But the Indian union and the rupee have survived and the Indians have overcome their cultural, religious and linguistic differences. (Speaking English in spite of themselves!) The Europeans—a lot richer and better educated than the Indians — can do the same.
Of course, in a perfect world – let’s say one operating under the classic gold standard—all major currencies would have a fixed relation to gold and there would be no need for a euro. But that’s the perfect plan. The perfect plan should never be the enemy of the good plan. The euro is the good plan.
—The Middle East remains an unstable long term source of energy. Egypt today is a big question mark. Shi’ite Iran is building a nuclear bomb despite US sanctions. Iran will use its bomb to intimidate Sunni Arab states and Israel. Syria is engaged in what is really religious war. President Assad is Alawite, a Shia offshoot supported by Iran and counting about 15% of Syria’s population as adherents. We’ve seen in Iraq and elsewhere that differing branches of Islam do not always treat one another kindly. The Alawites know how they will be treated if their leader loses power. They will face physical extinction. They will fight to the death. An analogous situation exists in Libya where tribes affiliated with Qadaffi stand to lose substantially if he is deposed. Don’t expect the Syrian and Libyan situation to get cleared up soon and don’t expect the solution to be pretty. Yemen is a complicated mess on the Saudi border where Al Qaida seems to be making inroads. Saudi Arabia, the major source of Middle East oil, rides on two horses. It tries to be a dependable source of energy for the world economy and needs US support to offset a more powerful Iran. At the same time the Saudi monarchy has made a bargain with the extreme Wahhabi form of Islam which it funds. Wahhabi Islam has made its influence felt far and wide and, suffice to say, it is not pro-Western. Singapore’s Lee Kwan Yew has been outspoken in his criticism of Saudi financed Wahhabi influence in Southeast Asia and has noted a turning away from more relaxed Southeast Asian Islam even in Singapore.
—China: caution still the best policy. There’s one very important difference between the US and Chinese economies. Because the US has relatively copious and reliable statistics, we have a pretty good idea how bad things are in the US. With China, that’s not the case. We really cannot be sure. My own view is that China’s expansive monetary and lending policy of the last few years, the resultant inflation and necessary current tightening, its restraints on information flows, its environmental problems and its efforts to hold down the value of the renminbi against the dollar spell trouble. A cyclical tightening is intersecting with long term structural faults.
The recent high speed rail accident in particular raises a number of issues. For example, has the massive bank financed infrastructure program been a long run plus for the Chinese economy or has it been a colossal waste of resources? Is the banking system potentially insolvent because of the poor quality of loans made to local entities and the Ministry of Railroads to finance the stimulus?
Two of my favorite books on China are Red Capitalism, the Fragile Foundation of China’s Extraordinary Rise by Carl E Walter and Fraser J T Howie and Jaws of the Dragon by Eamonn Fingleton. The books paint an unhappy picture of massive misallocation of resources through the state owned banking system and misguided industrial policies.
So far the prophets of negativity have been largely wrong about China for two reasons. First China has been at the “easy stage” of economic development whereby massive of underemployed people move to the cities and higher productivity jobs. China’s authoritarian approach to decision making works well in this environment. Second, China is peopled by hard working, relatively well educated people who are obsessed with getting rich. This factor offsets a multitude of policy sins.
But the first reason won’t last forever. In fact, there are some who think the rural to urban migration may be a spent force. Again good data is not available. In any case, China’s authoritarian approach may have worked well for a nation of peasant to urban migrants. But it will not work so well for a modern, information economy and an increasingly better educated populace.
Peter T Treadway also serves as Chief Economist, CT RISKS Solutions, Hong Kong
pttreadway -at- hotmail.com