The Next Bubble – Currencies

Way back in the late 1990’s the U.S. experienced what is now referred to as the Tech bubble where internet startups became wildly overvalued in a wave of optimism that ended badly for many investors. Over the last few years a financial crisis has enveloped the globe that many refer to as the bursting of the Debt bubble, a process of dramatic deleveraging from a prior euphoria of financial innovation, shadow banking and subprime securitization that separated risk from debt origination.

These are not the first financial bubbles the world has experienced, nor the last. They are just those still weighing on recent memory. But people tend to move on. Recently published gross domestic product numbers show a much improved level of growth here in the U.S. and in many economies around the world. So should we conclude that our latest problems have passed and we can move on to better times?

The Cure is worse than the disease

We will be debating for years whether or not the enormous government stimulus programs were the appropriate response to the financial crisis which began in 2008. Combined with massive liquidity measures by the world’s central bankers, these government-sponsored solutions were substantial by any historical standards and will have consequences for many years to come. But how will all this play out?  As our global economy has experienced the pain of deleveraging, have we merely shifted debt from the private sector to the public? Government budget deficits world-wide are on the rise. Some of these appear to be at unsustainable levels.

Here in the U.S. there is much concern about our fiscal future. Rising government debt levels and deficits projected far into the future do not instill confidence – even if the U.S. is the largest and most productive economy on the planet.

In a perfect economic world, a government that runs persistent deficits and pursues monetary expansion can expect to be disciplined by the markets through a process of currency devaluation. It is somewhat of an anomaly that the U.S. dollar has not fallen dramatically in light of recent history.

In fact, long before our recent financial problems, the U.S. dollar was under downward pressure – responding to many years of government expansionary policy. But the U.S. was able to carry on running both budget and trade deficits in part because of the unique status of the U.S. dollar as the world’s reserve currency. The demand for dollars from an expanding global economy was immense.  As the world economies became more and more connected, an increasing demand for U.S. currency to facilitate trade and investment sheltered the U.S. from the normal constraints of fiscal impropriety. But still the U.S. dollar was under downward pressure. Central bankers posited accumulating reserves in alternative currencies, or baskets thereof.

Recently, the status of the U.S. dollar in international markets has become increasingly difficult to understand. The financial crisis itself caused a flight to quality that, at least temporarily, boosted the U.S. dollar. Then when retrenchment began again, the Euro stumbled as a comparative currency when government deficits in Greece and elsewhere within the Euro community began to chip away at the confidence factor required to sustain its value. It is not clear today whether the U.S. dollar is appreciating, depreciating or maintaining its position. So what is the proper value of the dollar?

Floating Boats

In centuries past, currencies were backed by gold or silver and could not survive without a right of convertibility to sustain its value. The great global expansion of the 2^nd half of the twentieth century was fueled in large measure by the adoption of the U.S. dollar as the world’s “reserve” (trading) currency. It was formally backed by gold to insure stability. This allowed other nations to tie their currencies to the steadiness of the dollar; whether on a fixed, ranged or free float basis. Any government fiscal impropriety would be punished by automatic currency devaluation against the dollar resulting in lower living standards for its people. There was such a thing as market discipline. But in 1971, the mighty U.S. dollar, to which all these currencies were tethered, was freed from its moorings when Nixon announced the U.S. was abandoning the gold standard. The dollar too would now float. So today we are in a world of pure floating currencies. Like unanchored boats bobbing in an uncertain sea, each nation measures its currency relative to others, including the U.S. dollar. So what is currency worth these days? There is no convertibility of any currency to a measure of stable value. With all boats floating, can we tell if the seas have risen or fallen? Does it matter?

Without any reasonable alternative to the U.S. dollar as a reserve currency, we’ve managed to simply continue along for the last 39 years. However it has become increasingly apparent that an adjustment might be necessary in the future. The European creation of the Euro, the Chinese government statements about moving toward an SDR (special drawing rights of the IMF) solution and the suggestion of some oil exporting countries that a currency basket should replace the U.S. dollar for trading; all of these have been a reaction to the uncomfortable place we find ourselves in with our reliance on paper currencies without a true measure of value.

The Perfect Storm

So here we are at a time in history where our latest crisis has forced governments to take on extraordinary debts, run extraordinary budget deficits and engage in substantial “quantitative easing”. Indeed we are also seeing governments fight for their domestic economies through subtle protectionist policies that include a temptation, perhaps an incentive, to devalue home currencies.

Monetary expansion, simply printing money, has the advantage of dealing with most of the issues facing governments. It has one other advantage, especially in the case of the large debtor nations such as the U.S. Inflation, which one would expect after significant monetary expansion, favors the debtor. What better way to deal with excessive debt than to simply devalue it? Without the nuisance of a gold (or other) standard of convertibility, printing money may be the politically expedient solution. Everyone intuitively knows long term government deficits and monetary expansion make for bad policy, but how bad? And when does one have to pay the piper? And are not steps these justified, at least for now, given our economic conditions?

If the U.S. expands its money supply, won’t every other country be compelled to do likewise just to stay even and avoid the risk of upward currency revaluation with its inherent trading penalties?

Without stable currencies on the one hand or discipline and leadership from the U.S. on the other, we are in uncharted waters. The long-term temptation for governments to expand their money supply could be overwhelming. Volatility and expansion of currency markets could be the norm with long term implications of global inflation. The responsibilities thrust upon the world’s central bankers have never been greater.

Economics – A flawed science in troubled times

As we face troubling economic times, we look to those wise men of economics for guidance.

Economists tend to think of themselves as social scientists. They recognize that their work is more of an art than a science, yet build theories upon the foundations of other theories as a true scientist might. This inevitably leads to problems when such theories are applied which spawns more theories adjusting to the new data.

Of course there is nothing wrong with the study of economics. In fact it is so important to the inhabitants of this planet, that it is surprising far more resources aren’t allocated to its study. Rather than being relegated to a secondary realm of academic interest, it should be elevated to a much higher platform of recognition.

So why has the profession of economics suffered so badly? It is primarily because it has proven to be quite inaccurate in its many predictions, prognostications and analyses. One can scarcely be blamed for not taking the advice of an economist when so many mistakes have been made in the past. But perhaps this charge is to vicious; after all it is an art, not a science.

There are some fundamental flaws in the way we approach economics. These are discussed below.

Economics Flaw Number 1 – Variables

There is an expression used often in the study of economics; “ceteris paribus”. It is the basic assumption that all other variables should be held constant while one analyzes the affect of one variable on another. For example the classic “guns or butter” tradeoff suggests that an economy of fixed size has limited resources to deploy toward output and can use those to manufacture guns (defense spending) on the one hand or butter (consumer goods) on the other. All other economic variables are held constant so that we can derive a tradeoff curve.

Of course the “real world” contains many thousands of variables and they are not held constant and never can be. Thus, though it may sound rational, we are very limited in our ability to actually test any economic hypothesis. The basic assumption that underlies the entire “science” is implausible. This bring us to the next flaw.

Economics Flaw Number 2 – Lack of data

No matter how many theories are put forth, there is never sufficient data to support the theory.  It is often pointed out that Roosevelt’s New Deal spending helped lift the USA out of the depression, and the end of the depression is the proof of that success. Others argue that the New Deal had no effect and it was the massive spending of World War II that brought the USA out of its malaise. Each case can be made by pointing to growth rates for various years and expounding on assumptions as to the lag for spending to have its effects felt.

But there are two huge problems plaguing both of these perspectives. First one must look at the quality of data collected and weigh its merits. But even if one accedes to the value of the data, the number of other variables acting on the economy over the 15 years referenced above is unfathomable. To suggest that either of these was the cause of an outcome so complex over such a long period of time is a huge leap of faith.

And therein lies the main problem. Of all the social economic experiments that have been made over the past 100 years (where the data might be meaningful), there simply is no way to hold all those other variables constant and thus no way to conclude that any action caused any particular result. Furthermore, we have no way to repeat the experiment – ever. All the data is meaningless and all the theories are simply conjecture.

But is this so bad? The conjecture is rational and based on logic and careful thought. It is not useless. It may be very valuable and we may have strong reasons to believe certain basic theories are sound – but simply not have the means to measure the results. Yes economics is an art, but one with much value.

Economics Flaw Number 3 – Education

A brief point worth mentioning is that our society does a very poor job of educating itself in the principles of economics. Most college graduates have less than a rudimentary understanding of the concepts. Many of these college graduates find their way to positions of power in industry and government and have significant influence on major policy decisions without the slightest understanding of well accepted economic fundamentals.

A few examples might illustrate how inept our politicians are. The concept of protectionism is clearly understood as an evil that hurts both parties in a trade war. Yet most politicians are quick to jump in order to “level the playing field” or save jobs. It is like threatening the other party with a gun to your own head. Another example, this time at the municipal level, would be the tendency to pass rent control legislation to protect the poor and working class from the fast rising costs of housing. This action directly exacerbates the problem and disenfranchises the population it was intended to protect.

So maybe it doesn’t matter that economics is an art and not a science. Those empowered to exercise the levers of power wouldn’t know the difference.

Economics Flaw Number 4 – Island Mentality

This last flaw is the biggest and most problematic. Because of the complexity of our world, economic study must begin by breaking down these complexities, aided by its ceteris paribus assumption, and develop its basic theories on a small scale that can be built upon. Thus many students of economics remember some analysis about an island economy – usually involving trading bananas for firewood or some such thing. This is eventually scaled up to a national economy (say the USA) operating with some additional variables mixed in. This is how we arrive at formulas that are taken as truisms such as:

GDP = C + I + G + (X-M)

Our “island” has become the nation state. A nation state is a political subdivision of the planet created through historic events which may or may not relate to economic sphere of operations – but which has become determinative because that is where the national data is collected and summarized, where the currency is managed and where economic policies are developed and instituted. Island mentality economics assume resources are being traded and thus the (X-M) component accounts for shifting of resources between our island and somebody else’s island (also known as the “Rest Of World”).

The problem with this picture is that it doesn’t account for fiat currencies and the special case of a reserve currency, the latter having been enjoyed by the US since 1945. To illustrate, if the US can buy imports (the M in the above equation) simply by printing more money and not utilizing any resources, then why should we have to reduce our GDP figure for this?  In a true island economy, no island can afford to run a net trade deficit for very long. Yet the US has managed to do so for many, many years. How can this be? The answer is that one of those basic underlying assumptions that support the entire foundation of economic theory simply doesn’t hold.  The island that gets to print paper money instead of paying in real resources, like bananas, has an incredible advantage over all the other islands. This will remain true as long as the other islands accept the paper money.

The point is that most of the economic theory being applied today is based on a complete misunderstanding of how the US interacts with the rest of the world.  Most of  the statistics we collect, the data we measure and the conclusions we reach are based on an island mentality view that simply does not apply to the US from 1945 through to present day.

Conclusion

We are in times of great economic turmoil. Our educational system has not produced many capable of dealing with the challenges. Certainly those in government are not up to the challenge, and many of those nestled in academic castles are leaning heavily on faulty foundations. Meanwhile, the rest of the world is showing a growing intolerance of paper money being sprayed around without resources to support it. We are about to face a major adjustment in how business is done. Our island is at risk.

What is Money? A look at the US Dollar

Any discussion of economics and finance necessarily involves reference to money – usually in the form of currency and usually the US dollar. Thus we must establish a framework for what this is. Though this may seem overly-simplistic, it is crucial to understanding some of the looming threats to our economic wellbeing. Please bear with me.

For centuries trade was undertaken by way of commodity trading. No, not the exotic Chicago futures market, but rather a simple concept of I’ll buy your chickens and give you a pig as payment. Perhaps the seller would demand a mule instead and a trade was consummated. Of course this was not a very efficient means of exchange. So over many many years, trading evolved such that a standard medium of exchange was used – generally precious stones or metals. Eventually gold came to be the favorite and most recognized standard of value, recognized by Pharaohs of Egypt as a standard of wealth.

The beginnings of currency

 

Given the popularity of gold as a medium of exchange, it was just a matter of time before political rulers facilitated the trading concept by minting gold (or silver) into coins – thereby creating a standard of measure and acceptability. Coins appeared on the scene about 1,000 BC and became the accepted medium of exchange for almost three thousand years. The central concept that allowed this efficiency and acceptability was that the coin itself was actually a store of value – the value of the metal itself roughly approximated the value assigned to the coin. Occasionally governments would dilute the precious metal content by introducing other “base” metals, but this “debasement” of their coinage could cause it to lose acceptability and its value as a trading medium.

Paper Money

 

Though coins worked fairly well for centuries, they tend to be heavy and somewhat cumbersome. Sometime after 1,000 AD a Chinese emperor introduced the concept of paper money. The government would guarantee that the paper notes were convertible back to gold (or certain other valued commodities). The paper money system or “fiat currency” would be far more efficient than using heavy, bulky coins.  Unfortunately, the emperor was tempted to and eventually did print more of the paper money than he had gold to support and inflation overtook the economy and the paper money fell out of favor.[1]  It seemed it would take a very strong government entity, one with enough discipline to avoid the temptation of printing excessive amounts of paper money, before this concept would really work.

As years passed, numerous government entities continued the experiment with paper currency – sometimes in the form of “bills of credit” or other instruments backed by governments. But over and over these paper currency attempts failed whether they were US “Continentals”, the Confederate dollar or others. Germany introduced the Goldmark in 1871 which was backed by gold and convertible into an equivalent amount of silver coins. This worked well until World War I when the government dropped the convertibility and it became known as the Papiermark. This immediately lost value and Germany went into hyperinflation.

The lessons of history are numerous and obvious. Paper currency cannot sustain without convertibility into a real value store such as gold. A government guarantee of this is essential.

Bretton Woods

 

The world changed as World War II was coming to an end and the victors met to discuss global financial stability after a devastating war. In July 1944 John Maynard Keynes (UK), Harry Dexter White (US) and others hammered out an international concept of money for the first time in history. Though attempts were made to create a new international currency, it was deemed too challenging and instead the US dollar was elevated to a special status as a world-wide trading currency – to be accepted by all. Of course this would hold no weight, all realized, unless the dollar was supported by convertibility to gold – and so this was done. U.S dollars were convertible into gold at a rate of $35 per ounce. With international support, the dollar was now as good as gold and the first true international currency was born. The dollar did not supplant local currencies in their home markets, but their currencies would be fixed (via exchange rates) against the dollar and international trading could proceed. It was a golden age.

The Beginning of a Breakdown

 

This concept worked well and international trade and expansion flourished for 25 years. However, like the Chinese emperor, the requirement for the US to exercise sufficient discipline to maintain the gold convertibility proved too challenging. Heavy US expenditures during the Vietnam War lead to excessive currency (relative to gold to back it) and the world began to lose faith. In 1971, in what has been referred to as the “Nixon Shock”, the president took the dollar off the “gold standard” and the concept of stable international paper money ended. Other governments began to float their currencies against the dollar and the oil exporting countries (OPEC), worried about the value of the dollar and spurred by other political developments, even embarked upon an oil embargo.

But life goes on. The world still needs to trade and have a medium for exchange. Even though the US dollar was no longer backed by a convertible store of value, it was still backed by the full faith and credit of the United States of America – the most powerful economy in the world and one with a stable government and judicial system. Absent anything better, it seemed the U.S dollar would remain in its special place of privilege as the world’s international trading currency. This could remain indefinitely as long as the US exercised a reasonable amount of economic discipline and did not abuse its special privilege by simply printing money.

From 1971 through sometime in the first decade of the 21^st century, the US enjoyed its special privilege as the unquestioned owner of the world’s reserve currency.  Ever so slowly it succumbed to the temptation to print money, but like the anecdote of the frog in water which is slowly heated to the boiling point, no panic ensued. The US standard of living soared, not due to productivity or typical measures of economic health, but simply by use of the purchasing power of its paper money. The US imported cars, TV sets, fine leather clothing – whatever the world would supply and accept US dollars in return.

The world was becoming somewhat uncomfortable with this situation. Murmurs were heard at international meetings. The Euro had been created in 1999 as a possible alternative to the US dollar, but the political diversity of the underlying economies still proved less attractive than the dollar.

For three thousand years of currency trading, the basic concept of stored value or convertibility thereto had been a requirement for stability. Numerous attempts (probably hundreds) to float a paper currency without meeting this fundamental condition had failed. For almost 40 years of this three thousand, we have managed to conduct trade based on a pure paper system supported only by government guarantee. The question now is whether this system is sustainable.

The US Dollar

 

The only thing that could possibly dislodge the US dollar from its privileged role as the world’s reserve currency would be rampant spending (printing of money) by the US government. The increase in money supply would cause a direct inflationary response seen so many times before. So let’s look at the US money supply over the relevant period.

 

Monetary Base 1917 - 2009

An Unfortunate Coincidence

 

Much has been written about the financial crises of 2008 which is focused on the breakdown of the mortgage industry and the financial derivatives marketplace that ballooned along with it. The threats posed to the financial system world-wide were substantial and great minds converged on a Keynesian concept of fiscal spending to counteract what could have been a devastating contraction of markets worldwide. Perhaps this was the proper response.

Unfortunately, we are not acting in a vacuum on this isolated issue of the financial crises. In the chart above, one can see the significant effect this “save the world” plan has had on the US monetary base. Given that the world has been uncomfortably trusting the US dollar for almost 40 years, with that discomfort growing daily, it is unfortunate that such a significant historical event has occurred at this time. One has to wonder what this will mean for the long-term stability of a paper currency unsupported by a store of value the world has demanded for 99% of its trading history.

So, what is money? The question remains.

 

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[1]  Ramsden, Dave (2004). “A Very Short History of Chinese Paper Money”. James J. Puplava Financial Sense.

So let’s begin

This forum is being created to assist in deciphering the complex economic foundations of our financial world such that people other than trained economists can understand the nature of economic environment.  We live in strange times and many events currently unfolding will have significance for generations to come.  It is important that our political leaders grasp the magnitude of their current decisions. An informed public should be an asset in directing and electing their leaders.