In my Money and Markets column on Saturday I will discuss the massive debt problems we face and describe why this may lead to below-capacity growth in the global economy for years to come. The problem with below-capacity growth: it doesn’t allow countries to garner a margin of safety reserves to help weather an external shock. Thus, globally, one can argue, with the additional leverage in the system since the credit crunch, the systemic risks have increased. It is hard to believe.
Dear Mr. Government and Central Banking “leaders,” what have you done for me lately?
We are already staring down the barrel of the first shock on the way for the global economy; it is the Eurozone sovereign debt-cum-banking crisis. To diverge for a second, I saw a good comment on the entire single currency common market structure rationale recently: It was Europe’s attempt to be a meaningful player in world affairs after realizing just how powerless the countries of Europe were (highlighted by the events of the Suez canal.) Just think: how much deeper would the European countries be in the hole if they actually had provided for their own defense? It would have added to the dismal failure that already haunts them and all countries now, by extension. (I am sure I will receive emails blaming it all on the US in some form or fashion. But I digress …)
Without going into the gory details, I think it suffices to say the euro as a reserve currency will lose favor and the world, unfortunately, will become even more dependent on a single currency for the heavy-lifting of global trade and finance.
It is quite a scary thing to contemplate, given that US fiscal and monetary authorities seem to work overtime trying to drive confidence away from the US dollar on some pretense this manipulation is a proper substitute for serious policy.
Here is a summary of the clear and present dangers of depending on the dollar (or any other single currency, for that matter) as a world reserve currency at this point in time. The 1930’s parallels are palpable given the crisis in Europe. This comes from Professor Barry Eichengreen, writing in the Jan/Feb 2012 issue of Foreign Affairsmagazine, “When Currencies Collapse” [my emphasis]:
The international monetary system rests on just two currencies: the dollar and the euro. Together, they account for nearly 90 percent of the foreign exchange reserves held by central banks and governments. They make up nearly 80 percent of the value of Special Drawing Rights, the reserve asset used in transactions between the International Monetary Fund (IMF) and its members. Of all debt securities denominated in a foreign currency, more than three-quarters are in dollars and euros. The two currencies together account for nearly two-thirds of all trading in foreign exchange markets worldwide. They are the essential lubricants of global trade and finance. Were they not widely accepted, the global economy could not sustain current levels of international trade and investment.
… The international monetary system of the late 1920s and early 1930s resembled the current system in important ways. It, too, was organized around two currencies: the British pound and the U.S. dollar. With the United Kingdom and the United States making sterling and dollars available — and other countries accumulating them — global foreign exchange reserves more than doubled between 1924 and 1930. Trade credit was readily available, allowing deficit countries to finance additional imports. As a result, during the 1920s, global trade rose twice as fast as global output of goods and services. International capital flows similarly expanded more rapidly than global output, peaking in early 1928.
The boom in trade and in the movement of capital created global imbalances similar to those of recent years. Some surplus countries, notably France, accumulated vast quantities of reserves. Others, such as the United States, recycled their surpluses by lending to the deficit countries of central Europe, mainly Germany. But the deficit countries spent the capital they imported on consumption rather than investment. The world saw the rapid expansion of credit and an alarming run-up in asset prices. As the decade drew to a close, doubts grew about the resilience of this precariously balanced system.
… Initially, the international monetary system withstood these pressures. In 1931, however, what had been mainly a crisis of output and employment suddenly acquired an alarming financial overlay. In May, there was a run on Austria’s leading bank, the Creditanstalt. If a bank could go down in Vienna, investors concluded, the same could happen in Berlin, given the superficial similarity of the Austrian and German financial systems. As capital fled and foreign credit become unavailable, the German government was forced to respond with exchange controls and an agreement, negotiated with foreign bankers, effectively freezing Germany’s international loans. British banks had extended some of those loans. Uncertain about the condition of the British banking system, investors began shifting money out of London, steadily draining reserves from the Bank of England. After a pair of belated interest-rate hikes failed to lure back this fleeing capital, the imminent exhaustion of its gold reserves forced the Bank of England to abandon the gold standard in mid-September.
This sounds oddly familiar doesn’t it? The next excerpt seems to be describing a current theme: investors and central banks searching for a safe haven. They are pouring into currencies such as Canadian, Australian, and New Zealand dollars and in Europe the Norwegian krone et al. But these markets are small and can’t hold that much capital. And bidding up these currencies relative to euro and US dollar creates seeds of its own destruction with a negative feedback loop of slowing global growth even more.
Back to Prof. E:
As international liquidity grew scarce, central banks and private investors searched desperately for other assets, that is, alternatives to the dollar and sterling that were liquid and promised to hold their value. They found them in the currencies of countries still on the gold standard: Belgium, France, the Netherlands, and Switzerland. The share of foreign exchange reserves held in those countries’ currencies rose from ten percent of the total in 1931 to 20 percent in 1932 and 30 percent in 1933.
The problem was that these were not large markets. As their larger trading partners adopted a beggar-thy-neighbor strategy of devaluing their own currencies, these smaller countries experienced more and more trouble competing. Countries still on the gold standard saw their exports stagnate and experienced rapidly rising unemployment. By 1933, these states, once seen as bastions of stability, looked increasingly vulnerable. Capital started flowing out, not in, as central banks moved to liquidate their balances in these countries to avoid further losses.
Will this be the next shoe to drop?
…The resulting vacuum was disastrous. The chaotic liquidation of foreign exchange reserves made credit scarce and put upward pressure on interest rates at the worst possible time, making it hard for firms to finance not only international transactions but domestic investment, as well. Disorderly exchange-rate movements disrupted trade flows, making it harder for countries to export their way out of the Depression.
Guess what? We are very close to a “1930s redux” according to our purveying Professor of historical doom and gloom:
If doubts about the stability of these currencies deepen further and central banks curtail their holdings of them, those central banks will have less capacity to intervene in financial markets and buffer the effects of volatile capital flows on their economies. In response, governments are likely to limit those flows via capital controls, as they did following the liquidation of foreign exchange reserves in the 1930s. Trade credit would become more costly, since commercial banks would demand additional compensation for holding dollar and euro investments. This situation would resemble the wake of the failure of Lehman Brothers in late 2008 and early 2009, when dollar credits became scarce and international trade declined precipitously. But what was then a temporary problem would instead be a permanent condition.
Yikes! If we overlay the negative global social mood, which leads to exclusion at the sake of inclusion, on top of massive unemployment in many industrialized and emerging countries, how much longer will it be until we see serious trade and capital controls pass through our illustrious legislative bodies?
And given the US War Machine (aka military industrial complex, aka American hubris gone wild) is itching for another campaign, with Iran as the new target, it is looking more and more like its “stock up on cans and head to the bunker” time. Let’s hope I have this very wrong – I do have lots of experience in that field.
