So the world may turn.The US is in a serious consumer led debt deflation. Unemployment will rise further. The realization has now come that the US third quarter GDP numbers were juiced up by the government’s cash for clunkers program, the $8000 credit to new homeowners and a modest inventory swing. These weren’t such good numbers as the market figured out a day later. Now we are starting to hear about a “W” recovery.
This does not refer to a cool hotel that has been popping up in world financial centers. W means a statistical up at the end of 2009 followed by another relapse.
The US dollar may not be able to survive on false optimism much longer
Ironically, a cheap currency and an export driven economy—what up until now has been called the Asian export model– may be what will get the US and the world out of their economic funk.
Invest in Asia for the growth of domestic consumption and infrastructure. Invest in the US companies which have big export potential. That may be the optimistic scenario for the future.
But some changes to the international monetary system must occur to allow this process to happen.
China Holds the Key
In my opinion there is no substitute for the fiat money global international monetary system that now prevails. But it needs “reform.” It is inherently bubble prone and inflationary. It not suited for a US export led future. It is not suited to an Asian consumption driven model.
Let’s review how the current system has worked. China and other Asian countries have held down the value of their currencies thus making their exports cheaper. To do this they have had to buy dollars, invest those dollars in the US thus holding down US interest rates and increasing their own domestic monetary bases. The growth in foreign exchange reserves over the last ten years has been staggering. For example according to the IMF total foreign exchange holdings were $1.78 trillion at the end of 1999 vs. $6.80 trillion as of 2Q2009. The growth of global foreign exchange reserves has been flat over the last year as the US recession trimmed its trade deficit and capital flows sometimes favored the US. But the potential for further inflationary/bubble producing growth is still there.
The growth in FX reserves is not the same as the growth of the global money supply. But it is a major source. A second potential source is the so called quantitative easing by the US and other “advanced” nations. Inasmuch as bubbles are at least partly a monetary phenomenon, there are more to come unless the current international monetary system changes.
So far there has been a lot of complaining about US fiscal and monetary irresponsibility but no real action. Actions speak louder than words. The only real action that makes sense is for China to revalue the renminbi, remove the capital controls and allow the renminbi to compete with the dollar as a reserve currency. This cannot be done in one day, obviously. But if all the books about the rise of China are worth anything, China must move in this direction. Small countries can peg to big country currencies but big countries which aspire to be major powers do not have this luxury.
Lately, if anything China has moved in the opposite direction. The dollar, after rallying earlier in the year, has been declining on a trade-weighted basis. But the renminbi, at 6.82-3 to the dollar for the last year, has automatically been declining with the dollar.
In some ways China resembles the US at the beginning of the twentieth century. At that time the US had become the most important industrial economy in the world. But mentally the US was still protectionist and isolationist. It refused to step up to international leadership after World War I when Britain was too broke and too exhausted from the war to continue to carry out this role. China today has to realize that its new economic muscles imply new responsibilities.
The only practical “reform” of the international monetary system will be a revaluation of the renminbi and other Asian currencies against the US dollar. This will diminish the tendency towards bubbles, boost the exports of the debt laden US economy and boost the consumption model in Asia.
Reviewing the International Monetary System
The international monetary system is a dry subject, one that induces somnolence in most citizens. Unfortunately it is of crucial importance. Perhaps a brief review here would be helpful.
“You can’t beat someone with no one.” The above is an old political axiom. But it may explain why the dollar has remained number one. There is only one serious currency competitor to the US dollar and that is the euro. That is too bad. The dollar needs an Asian competitor. But the renminbi is non-convertible on capital account, and the Japanese yen is the currency of a declining, medium sized country with deeper problems than the US. IMF Special Drawing Rights (SDRs) are not a real currency and must be backed by real currencies including the dollar. Unfortunately for the euro, the European capital market is actually a collection of fragmented national markets. Foreign central banks can buy US Treasuries. But if they own euros they have to choose to invest them among the whole gamut of European national markets, e.g., Germany, France or—heaven help them – fiscal disasters like Italy.
The dollar seems to have its own rules. In recent weeks we have see the dollar rally and US interest rates go down, the stock market rally and US interest rates go up and US interest rates go down when a stronger than expected GDP number was recorded. The financial media has explained this in terms of global investors’ attitude towards risk. When the world looks more dangerous, investors run to buy dollars and Treasuries. The US for all its faults is still the world’s safe haven. And when the safe haven looked better – as the first take on the 3Q2009 GDP numbers suggested it did – at least for a day global investors went and bought US stocks, bonds and dollars. As I wrote last year, the US is still the one-eyed man in the land of the blind. What the world may be looking for is one or two more one-eyed men. Or women.
A Note on Gold
As I have argued in the past, the post Bretton Woods fiat money standard –currently dollar based– will not be replaced by a gold standard. Investors may choose to hold an ever larger amount of gold in place of fiat currencies. Investors may choose gold and other commodities over fiat currencies. Central banks may choose to hold part of their reserves in gold. But countries will not choose to go back to a legitimate self regulating gold standard. The gold standard to work properly must be blindly followed by all countries that are participants. Gold automatically must flow out of countries with higher inflation and trade deficits and reduce their monetary base. It must automatically increase the monetary base of countries running trade surpluses and low inflation. Under a gold standard countries give up an independent monetary policy and currency stability takes priority over employment considerations. It worked in the nineteenth century when most countries had limited suffrage and submitted to the golden discipline. From 1871-1914 there was really only one currency used among Western countries – gold. The gold standard will never be adopted today with most countries governed under universal suffrage. Electorates don’t want to hear about automatic deflationary mechanisms when unemployment is rising.
The Hong Kong Dollar – One Indicator of US Dollar Weakness
One indication of the weakness of the US dollar against the renminbi and other “managed” Asian currencies is the situation with the HK dollar. Hong Kong operates a rule-based quasi currency board system which until recently has worked very well. The Hong Kong Monetary Authority (HKMA) must keep the HK dollar (Honkie as it’s known locally) in a range of 7.75 to 7.85 against the US dollar. For the last year or so the Hong Kong dollar has been right on the strong end of the range at 7.75. The HKMA to keep the HK dollar from appreciating further has had to buy US dollars by the boatload thus expanding the Hong Kong monetary base by 145 % year over year. Partly as the result of this, an asset boom in stocks and luxury real estate has been set off in Hong Kong even as the territory has experienced little or no CPI inflation and until recently a rise in unemployment.
Hong Kong’s currency board system works automatically like the gold standard is supposed to. Only instead of being pegged to gold, the HK dollar is pegged to the US dollar. Once upon a time, the Hong Kong dollar was actually pegged to silver. Those yearning for the return of the gold standard should familiarize themselves with the Hong Kong monetary system. Hong Kong does not have universal suffrage.
Investing in a Bubble World
The US Stock Market
I’ve taken the view that a negative view on the US economy implied a negative view on the US stock market. So far in 2009 that has been wrong. Still the US market in the coming months may be more of a collection of submarkets – some doing well, some not. Blanket statements about the US market may not be useful. For example, no question the outlook for export oriented US companies has to be brighter especially if the Chinese and Asian currencies make the big upward move thus balancing the international monetary system. And of course the US technology sector remains at the epicenter of innovation. On the other hand the U S financial system is hardly out of the woods given the looming iceberg of defaulting commercial and Alt A mortgages.
The dollar will either move down against the Chinese currency or China will experience a major inflation and/or a protectionist oriented trade war with the US. A revaluation of the renminbi will be a major bullish event for the US exporters and Asian consumption driven stocks.
US Treasury Interest Rates
My view is that the Fed will not raise short term US interest rates over the next twelve months. This would be politically intolerable and the world knows it. Raising US rates means the end of the recovery such as it is. On the other hand a falling dollar and continued fiscal excess in the US will eventually drive up long term rates. The question is when. Perhaps later rather than sooner.
Gold is usually represented as a hedge against inflation. Near term there is not likely to be much inflation in the US. But longer term it looks like fiscal and monetary irresponsibility is the order of the day with the US. And a falling dollar will push up the price of gold. Gold is the dollar-based investor’s hedge against irresponsible fiscal and monetary policies.
Emerging Market Stocks
Not as cheap now as they were. The long run story is consumption driven, especially Asia. But again. A global currency change is needed.