From Bretton Woods…
It has been almost 40 years since the Bretton Woods fixed exchange rate agreement that served the world well in the years immediately after WWII fell apart. What’s different today?
–to a new world order
1. The US is no longer the dominant economic force in the world.
a. Germany, Japan, and to a lesser extent the UK, have returned to their former great power status.
b. The major countries of Europe have formed the EU, a loose economic and political confederation aimed at counterbalancing US might and which has encouraged the development of large, multinational firms headquartered there.
c. China and India have emerged as world economic powers, by some measures bigger than all other countries save the US and Japan. Brazil is not far behind. And Russia is reestablishing a more prominent place in the world order.
2. Periodic crises like the collapse of the European Exchange Rate Mechanism in the early Nineties or the Asian crisis in the second half of that decade have shown that fixed currency regimes without sound economic policies underpinning them are a recipe for disaster. It has also become clear that the central banks of even the largest economies have much less power in the currency markets than the international commercial banks. So intervention in the currency markets in pursuit of a national objective have by and large become a thing of the past. Therefore,
3. Ensuring currency stability has become a function of international coordination of sound money and fiscal regimes. This has taken on increasing importance as global growth has been more and more driven by world trade.
4. Currencies are now by and large fiat currencies, no longer convertible into gold or silver, but deriving their value from the economic soundness of the issuer.
5. The universal good will toward the US stemming from its behavior during and after WWII–which, after all, ended almost 65 years ago–and which permeated the Bretton Woods era, is gone. A new generation of leaders, none of whom experienced the war itself or the reconstruction period immediately following, is in charge in most countries, including the US. These leaders, justifiably, see no reason there should be one set of rules of conduct for the US and another for the rest of the world.
Still, the US dollar rules
6. The US dollar remains the dominant world currency.
a. Trade in most industrial raw materials continues to be denominated in dollars.
b. Many foreign-based enterprises that count the US as their major customer–and which therefore must be able to make profits from dollar-based revenues–run themselves as quasi-US firms.
c. Emerging economies still routinely peg their currencies to the dollar, mostly to ensure they retain a labor cost advantage vs. US workers but sometimes also to show their commitment to sound economic development.
Congress is taking a big risk…again
What’s the problem, then?
7. plus ça change… Congress is gaming the system again, just like it did during the Sixties. During the early years of this decade, the US began a war in the Middle East, at the same time it was expanding domestic social programs. The sum of the two substantially exceeded tax collections. As a result, the US used its role as the world’s banker to figuratively authorize an ever larger credit line by issuing Treasury bonds. To the extent that Congress understands what it is doing, it is gambling that the rest of the world has such a big vested interest in dollar stability that it will absorb any amount of new Treasury securities–that is, any amount of deterioration in the national fiscal condition–rather than cause a spike in US interest rates or a decline in the dollar. After all, this strategy did work for almost a decade in the Sixties.
US creditors have begun to smell the coffee
Even before the financial meltdown, the rest of the world had begun to notice. China, which has recently surpassed Japan as our largest foreign creditor, in particular, has started to voice concerns about how/whether it will be paid back. The financial crisis makes the situation worse because the US may end up taking responsibility for, say, $2 trillion in dud securities issued by US financial institutions. To put $2 trillion in perspective, it’s 8x the Federal government’s total income tax receipts during 2008.
I think the unspoken reality is that the Chinese and the Japanese know that they will not be paid back, at least not in full. Congress will ultimately have two choices: either to increase taxes or reduce spending to a point where the government is generating budget surpluses which can be used to repay debt; or to fan the fires of domestic inflation and thereby reduce the real value of the borrowings. I’m not sure there’s any evidence that our elected officials understand what the issue is. But I also can’t imagine there are many people on the planet who would bet Washington will ultimately opt for higher taxes and smaller government.
Why continue to buy Treasuries?
If that’s true, why does China continue to buy Treasury securities? Why not do the sensible financial thing–cut your losses by stopping buying and selling what you can?
China won’t upset the applecart…
For now, it’s not in China’s best interest to do so, for two reasons:
From a narrow financial perspective, once this course of action became known, Treasury prices would plummet and China would suffer large losses on its remaining holdings. Besides, where else would China put the money? There’s no other government securities market deep enough to accommodate the purchases China would have to make. So China is pretty much stuck with the Treasuries it has already accumulated.
From a wider point of view, if China simply removes itself from the Treasury market, bond yields would likely rise a lot. This could likely cause a relapse into recession in the US. If that were all the negative fallout, China–unlike Germany or Japan a generation ago–probably wouldn’t care.
But China is following the time-honored strategy of growing through exporting to the US (see my post on Chinese economic development). So recession in the US would producer a falloff in export orders from China. This, in turn, would cause layoffs and plant closings there, producing the kind of social unrest that is Beijing’s number one priority to avoid.
For the moment, then, China’s best strategy is to act slowly in order to preserve the status quo and prevent a loss of confidence in the dollar. But China is not the only actor in this drama. Congress also has a role to play.
..but Congress might
Most investors have noted recent Congressional efforts to exert–a better word might be “increase”–operational control over the Fed. The consensus is that this attempt is unlikely to succeed, that the Fed will retain its independence and in fact begin to withdraw the high level of monetary stimulus from the economy when the time is right. I think that’s correct.
But will extraordinary fiscal stimulus be withdrawn as well? We’ll know in a year or two. That’s a job for Congress. On this count, the world is not quite so sanguine. But the failure to do so could send a strong message to the rest of the world that the US has no intention of putting its fiscal house in order and begin to repay its debts. That may be what triggers a crisis of confidence in Treasuries and in the dollar that no one wants.