Where America Went Wrong
Losing the Global Currency War
by George Karahalios. May 8, 2007
(Like many serious investors, I insanely obsess over my decision-making, frequently questioning myself out loud to determine if my biases have led me to make bad investment choices. The following is a synopsis of those conversations in which I have tirelessly engaged myself through two somewhat imaginary characters.)
BUBBLE: "Capitan Apocalypse," it’s so nice of you to take the time to share your thoughts with our Bubble TV viewers; we think it’s so important to expose investors to alternative viewpoints and are delighted that you granted us this extensive interview.
BUST: Thank you for having me, but I would prefer that, given your predisposed view of perpetual optimism, you do not refer to me by my nickname because it might imply an adversarial relationship between the two of us. Though I often write about the progressive phases of the economic cycle, I think it’s a misnomer to associate me only with times of "doom."
BUBBLE: Wonderful, then perhaps we can concentrate on the positive for a change and bridge the differences between the two of us through a meaningful discussion of things that you are currently optimistic about!
BUST: I am very optimistic about the future of the developing world, which has emerged from a prolonged period of darkness under a combination of totalitarianism, socialism, and communism to societies with more capitalistic leanings. This is very bullish for humanity in the sense that a few billion people will soon no longer be living in abject poverty. This has spawned one of the greatest investment themes of our lifetime – globalization, which is nothing more than the integration among people in disparate locations around the world. It has profound investment implications.
BUBBLE: How delightful it is that the world is finally embracing capitalism a la America. Soon everybody will engage in free trade and experience the productivity miracles delivered by the capitalistic system. How glorious for the world.
BUST: Indeed it will be glorious for many, but for others who have grown accustomed to utilizing the earth's limited resources for themselves, the adjustment process might cause some tribulations. Further, to classify America as a capitalistic society is an overstatement. It might be more correct to say that America, which is representative of the West, has been comparatively more capitalistic than the East over the past fifty to one hundred years.
BUBBLE: We can argue about whether or not America is capitalistic enough in a moment. Besides globalization, are there any other investment themes that you embrace?
BUST: Yes! We are also experiencing a currency trade war between nations that is spawning a global disequilibrium. Consequently, while many of the poorer parts of the world produce and save, some of the richer countries consume and spend. It is an unnatural occurrence, an unsustainable disequilibrium that eventually must be righted.
BUBBLE: I assume that you are referring to the manipulation of currencies by the Asians, correct? If so, you are precisely right; they are engaging in an unfair trade practice which our politicians must force them to correct right now. These cheaters are ruining it for the entire world.
BUST: It might be a bit naïve to assume that abruptly ending this manipulation will result in a smooth transition. Furthermore, to exclusively blame the East is highly problematic. Many believe, as a result of creating the Federal Reserve System, it is the US that unwittingly finds itself engaged in the process of central planning.
BUBBLE: I beg your pardon. America is a democracy and the greatest capitalistic society on the face of the earth. We are a highly decentralized nation that leaves adjustments to the marketplace.
BUST: Don't you find it interesting that when America's Federal Reserve Board releases its periodic statements, it attracts the eyes and ears of global investors, foreign central bankers, private bankers, and economists who then carefully dissect each word to determine the future direction of interest rates? Why, in an allegedly free-market economy, do people feel so compelled to respond to the policies set by a central banker and his board?
Consider this: If, instead of affecting lending rates, the Fed dictated the prices of individual commodities such as lumber, cement, corn, or wheat, or the wages of real estate agents, information technology workers, or painting contractors, everybody would cry foul! It would be labeled "socialism," the very system you claim America defeated.
BUBBLE: Now you have officially gone off the deep end. I think that you should revisit your history. The Fed exists to smooth the business cycle. It's no coincidence that with the enhanced powers of the Fed under a fiat money system, we have not had to re-live the Great Depression.
BUST: While that may seem to be the case, the Fed's existence can also encourage the government to grow unabated and the banking system to reap an ever-increasing share of corporate profits. By removing or adding liquidity at just the wrong time, the Fed can exaggerate the business cycle and create periods of boom and bust. During the boom it is often the inflationary pressure of rising wages that serves to cool the economy.
BUBBLE: So you admit that you believe in trickle-down, that the laborer is a beneficiary of capitalism!
BUST: Economists have long been aware of the "election cycle," the tendency of incumbent presidents, seeking re-election, to ratchet up deficit spending that, when aided by the process of fractional reserve banking, works to "juice" the economy and create a boom. The money that is "produced" out of thin air is distributed by the banking system and reaches some before others; the early recipients of the new money gain at the expense of those who do not initially have access to these funds or choose not to borrow them. This is not trickle down economics; this is a redistribution of wealth from those who have earned their savings through hard work and productive processes to others who have simply gained easy access to the printing presses through the banking system.
In a closed economy, the money does find its way to labor, and real wages eventually re-gain their purchasing power lost during the initial phase of money creation. Fretting that the wage gains by labor will erode corporate profits, big business encourages politicians to "cool" the overheating economy. This can be accomplished by reining in government spending, increasing tax rates, or raising interest rates – all of which can work to tighten the money supply and quell the boom. Hence, in an indirect way labor serves as a "check" on the expansionary power of the banking alliance formed between private bankers and the federal government under the Fed.
BUBBLE: By your own admission, during such times as the 1970s, labor might benefit disproportionately from the boom at the expense of U.S. corporate profits. So what is business to do?
BUST: Ideally, in a monetary system backed by gold, market forces would contract the money supply. Even though bankers are against this policy (they prefer ever-expanding credit subsidized by the federal government), big business would support it. In our current monetary system, the government must tighten the money supply, slow the economy, and allow a fair equilibrium to develop between labor's wages and corporate profits.
BUBBLE: Isn't that what happened? Paul Volcker, our monetary savior, mopped up the excessive credit in the system and set the stage for a new growth, one that would eventually reward Americans with unprecedented profits in the US stock and real estate markets. Labor's share of total corporate profits contracted, and the country boomed. Unimpeded capitalism at work is a thing of beauty.
BUST: If only it were that simple. First, we should recognize that the US changed the rules in the early 1970s when it repealed Bretton Woods II, thereby removing the banking system from its last remaining accountability to the gold standard. While it is true that Mr. Volcker would eventually serve as the Messiah for the US banking system by instituting monetary discipline, the rules had been previously altered so that, under certain economic conditions, an unwitting Fed appointee might recklessly expand credit.
BUBBLE: But the laws of supply and demand have not changed. Globalization mitigates labor's power by providing new competition. No longer does the Fed, along with big business' acquiescence, have to contract credit in fear that the economy might overheat. Instead, globalization obviates the need for the Fed to mediate the rift between labor and big business.
BUST: In a moment we will discuss whether market forces, with the repeal of the gold standard, are at work with respect to monetary policy. As globalization was set to expand, another more conventional macroeconomic trend had emerged that would eventually set the stage for central bankers around the world to launch a full-scale power grab and elevate themselves to their now rock star-like status. It involved currency manipulation as part of a greater trade strategy.
By the 1970s Japan had recognized America's vulnerabilities and orchestrated an assault on its inefficiencies' its labor union's strength, its increasing regulatory environment, and its high tax structure. Through a combination of tariffs, subsidies, and currency manipulation, the Japanese government encouraged both the growth and vertical integration of its corporations to gain at the expense of American competitors. It was a textbook victory achieved by employing both classical Ricardian economics and currency manipulation.
However, like many centrally-aided models, Japanese corporations created excesses by expanding their investments globally using the savings that they had generated from their large trade war profits. Not only did they bid the price of their own assets to absurd levels, but also asset prices worldwide. When these prices finally collapsed, the Japanese government then tried to re-inflate them through excessive credit creation (money printing). Unfortunately, this policy did not work to stimulate the general economy as it was bogged down in excess capacity and inefficiencies. Since the Japanese people have been big savers, the additional liquidity sat idle, only serving to re-capitalize, but not reform, the failing banks. It is this ill-advised policy of money printing by the Japanese government that helped to create the perfect circumstance from which a global currency war would develop. In fact, Japan's excess liquidity gave birth to a "carry-trade" that would distort global asset prices once again.
BUBBLE: Why is this relevant? Good old American capitalism proved to be too much competition for Japan!
BUST: It might be more accurate to say that by winning a conventional trade war against inefficient competition, Japan forced America to institute reforms that addressed the increasing power of organized labor, which had grown into a social program for redistributing corporate profits. Through globalization, big business outsourced its production to the third world. The often oppressive governments in these countries had little choice but to open their economies to feed their impoverished people. Further, to hold down the cost of domestically provided services, America allowed a large influx of unskilled immigrants to cross its borders.
BUBBLE: This is the efficient marketplace at work. By circumventing the rules of free trade, Japan pushed America to embrace globalization and utilize the world's resources so that it could recapture its dominance. Through free trade, market forces were once again at work to determine competitive wages and to allow credit to seek its own proper level!
BUST: As long as capital is allowed to freely adjust, your theory would have proved true. However, by manipulating or "pegging" their currencies and imposing capital controls, various countries were impeding the self-correcting mechanism of the marketplace in order to accrue exaggerated rewards to their economies. Soon other countries were forced to respond in kind and the makings of a global currency war emerged. Those with the best currency-war strategy stood to benefit the most.
BUBBLE: Given my free market biases, I am forced to agree with your conclusion. But where you go wrong is to assume that Asia is the big winner in this era of globalization and currency manipulation. America benefits from the world's cheap labor. This permits it to specialize in the highly profitable businesses of idea creation. While the rest of the world labors, we think and profit. Look at the great success stories like DELL, EBAY and GOOGLE. These are American success stories; it isn't by coincidence that America is home to the world's most progressive companies.
BUST: I would buy into your counter-argument, but the facts speak to the contrary. American platform companies have benefited from a unique global circumstance that has allowed them to leverage cheap foreign labor. While this may benefit those specific companies, it is certainly not a panacea for the remainder of America. It's only logical that the richest country in the world produces some of the most innovative companies. It is a mistake, though, to think that foreign firms will not gain knowledge from the production that has been outsourced to them, particularly if their reformed economies are producing a better educated workforce than America.
Currently, Americans earn poor test scores when compared to the improved standards in much of the developing world. With the absorption of so many poor immigrants into the country, the quality of America's education has sunk to appeasing the weakest student in the classroom. The teachers' unions and administrators seem to have a stranglehold on education reform, much like labor had on big business during the mid 1900s. Also, in protecting the freedom of expression, lawyers have aided parents in making a mockery out of the classroom by supporting their children's disruptive actions. So it’s hard for me to believe that homegrown knowledge is going to be the one factor that propels America to succeed over its competition.
BUBBLE: While there are some problems that need to be addressed, there are many potential solutions on the horizon. Consider the many courses now offered on the internet for higher education. Additionally, private elementary schools are popping up throughout the country as an alternative to the poor-performing public schools. Where you see failure, I see hope.
Meanwhile, people in the developing world work for cheap and produce at a loss. China's entire banking system is a centrally-planned house of cards waiting to implode. America is well-positioned to continue asserting its global dominance.
BUST: I am not saying that China's currency pegs did not come without some costs. It's possible that Chinese workers suffer from the low relative purchasing power of what their wages would be if exchange rates were free to float or that capital controls have earned them low returns on their savings. But I think you are missing the big picture. Whenever exchange rates and capital flows are manipulated, someone can gain at another's expense.
When the Fed began infusing liquidity into the U.S. economy, the Chinese found that many of those dollars ended up in their own government's reserve account. What safer an investment for these funds than to use them to purchase US bonds? The more reserves the Chinese accumulated and re-circulated back to US treasuries, the more villagers China found it could employ in its factories to produce export goods to be sold in America.
Further, as part of the central plan to employ its populace, the state-owned banking system greatly extended credit to the potential producers of goods, though many of these loans may prove questionable. No doubt, this has squeezed profit margins in developing Asia.
BUBBLE: Now there's an understatement.
BUST: But even a low profit margin is better than no profit, particularly if it morphs into part of a larger strategy to hollow out America's industrial base. The point here is that neither of these two global regions, East nor West, is completely capitalistic, and, in fact, both are proceeding in opposite directions. Yet Americans believe they live in a capitalistic society--free to buy the consumer goods of their choice, switch jobs as they please, and allocate their investments as they see fit. Even to others, America is the capitalistic envy of the world.
In reality the framework for America's form of capitalism changed when it abandoned the honesty of the gold standard. Interestingly, this weakness wasn't exploited until years later when the perfect global circumstance presented itself. With the additional implementation of currency pegging and the accompanying capital controls, many of the counterbalances provided by rising wages over the Fed's ability to engage in monetary expansion were now removed. So by circumstance, the Fed became anointed with a power that it previously never had – the power to increase liquidity without immediately suffering the secondary effects of rising domestic wages or increasing interest rates. In essence, by endlessly increasing the money supply, the Fed now had the power to control interest rates, the main factor that affects how capitalists allocate their funds.
BUBBLE: This whole trade war thesis seems like a stretch to me. So far you have discussed America, Japan, and China, but a global currency war between only a few nations cannot sustain itself for long without the "participation" of other countries.
BUST: It's also important to recognize that another trend had captivated the emerging economies of the world – dollarization. Subsequent to the explosion in global trade that started in the 1970s, many developing countries would suffer immensely by borrowing in American dollars without first engaging in adequate structural economic reforms. Eventually their currencies imploded, and they were saddled with debt that had to be repaid in appreciated dollars. It was the kiss of death for their economies. From these experiences developing countries would derive two lessons – to engage in real economic reform and to adopt the dollar as their national currency.
BUBBLE: So are you saying that the stage had been set on a number of fronts, perhaps by coincidence, to allow a global trade war to develop?
BUST: Precisely. By the early 1990s a number of circumstances simultaneously converged that would entice every major economy into a global trade war characterized by currency pegs, liquidity creation, and capital controls. America's loose monetary policy quickly translated into lower interest rates and more Chinese manufacturing jobs. Developing Asia followed China's lead to become competitive by also engaging in currency devaluation. Japan continued to fight its deflation that was the consequence of its previous trade war with America by running the printing presses at full steam. Both Latin American and Middle-Eastern countries became co-sponsors of the trade war by embracing the dollarization of their economies. Even the European community, which has a history of severe inflations, was forced to participate in liquidity creation. If the Euro were to remain the sole currency free to fluctuate, then European exports would become too pricy to sustain job creation. Thus, at the very least the Europeans would succumb to the pressure to create liquidity in order to stimulate their economies.
Thus, as long as each region finds it to be in its own self-interest to continue weakening its currency or producing excess liquidity, it’s quite likely that the currency trade wars will continue along with a synchronous global boom. Broad money measures will continue to expand around the world until one country flinches and changes its tactics, thus triggering a chain reaction that could cause all nations to reassess their strategies as the circumstances change. Until this moment occurs, the debt super-cycle is poised to grow.
BUBBLE: But why would America ever abandon its participation in this global currency war? After all, buying cheap foreign goods or borrowing at below free market rates doesn't sound like too bad a deal to me.
BUST: Your point is a good one. Unfortunately, when money is printed out of thin air by an accommodative Fed, it does not represent savings. Given the global circumstance, this liquidity flowed into assets, allowing Americans to borrow at increasingly lower real rates. One could have made many arguments as to why America should not have wanted to leverage its economy in order to consume itself to death. Now that it has happened, and America has lost most of its industrial base, it could prove very painful for its asset-inflation dependant economy to sustain itself if it suddenly withdraws from a global strategy that subsidizes both its currency and its interest rate.
As long as increasing the debt produces some GDP growth, it may prove in America's best short-term interest to continue piling up debt. Even if all of the parties to this currency trade war continue their participation, eventually more debt will result in flat or even negative GDP production. This, of course, might be ample reason to motivate foreigners to abandon their strategy of currency manipulation, but even if they don't, it may finally behoove US politicians to withdraw their support for debt creation and adopt a coherent, long-term strategy.
BUBBLE: Not if the adoption of this alternative creates a Great Depression!
BUST: Certainly not. In fact, it’s more likely that the U.S. might try to re-direct some of its liquidity before its imbalances cause the general economy to deteriorate badly. Prior to the imposition of the currency wars, America's infrastructure had been decaying. The left objected to public contracts for private firms that did not pay union scale wages, while the right would advocate for government expenditures that benefited oligopolies, such as defense contractors. Both parties refused to engage in the concept of "incrementalism," accepting change via small steps, often through compromise. This resulted in complete polarization on certain issues.
If ever there has been a time for America to invest in its infrastructure by issuing debt, the low real interest rates that are a by product of the global currency wars certainly now provide this opportunity. In fact, the Governor of California, a European transplant I might add, recently supported billions of dollars in bonds to improve the state's deteriorating schools, highways, bridges, aqueducts and other infrastructure. In spite of the opposition of his own party members, these bonds passed overwhelmingly.
BUBBLE: That's a problem with America – our leftist politicians always resort to their socialist leanings. If there's one thing that will doom America, it’s adopting an even greater socialist framework.
BUST: The governor believes that if his state can borrow at long term rates near 5% and make investments that will yield more than that for his constituents over the long run, it might be in his state's best interest to proceed. As long as it is foreigners who continue to subsidize these low real interest rates, it is a viable strategy for the US to pursue. In fact, as other states and the federal government embark on this strategy, it is possible that the current decline in GDP growth per dollar of new debt added could slow. In essence, given the circumstance of the currency war, additional public sector debt could deliver more effective wealth and job creation than increased private sector debt.
BUBBLE: Heresy! This whole thing sounds like socialism to me. America's greatness is in its capitalistic virtues. I'm against all of this. What you seem to be saying is that it is nearly inevitable that America will move towards greater socialism while Asia grows evermore capitalistic.
BUST: I think you finally understand the dangerous ramifications of a fiat money system as opposed to a gold standard. A fiat money system is a form of socialism for the banking industry. Once a democracy becomes mired in socialism, the principle of majority rule can work to reinforce those socialistic qualities. The US is losing this global currency war because, relative basis to the East, it has already become increasingly less capitalistic. While the East had been suffering under both totalitarianism and communism, America's success reinforced its beliefs in manifest destiny, leading it to embrace globalization and to expose the vulnerabilities of its monetary system.
In truth, both parts of the world, East and West, live in a hybrid form of capitalism which shares some socialistic qualities. But the leaders of the East, many of whom do not have to answer to the whims of an electorate, are better able to execute a seamless long-term trade war strategy through currency manipulation and other central planning techniques.
If one day I woke up to be King of the West, perhaps I would try to employ a long-term strategy that would right America's imbalances and re-establish its more capitalistic features. I might consider implementing a gold standard, lining up all the creditors and debtors in a room, and slamming down the proverbial judge's mallet in favor of the domestic creditors while declaring foreigners' claims to be worthless. Unfortunately, I would have a revolution on my hands among my own citizens. Further, foreign creditors might not be so enthusiastic to continue selling goods to my country, which would be a real problem since most production now occurs overseas.
Instead, it might be easier to inflate the debt away, thereby unilaterally declaring victory to the debtors as they could pay off their burdens with devalued dollars. Simultaneously, I might reform the tax code to encourage savings and discourage consumption. Perhaps I would replace the extremely high tax rates on the wages of the working class with a national sales tax on goods. This would constitute a tariff on production since most goods are produced overseas. I would limit the tax deductibility of future debt to wean my country from this debt-addiction habit, but not until I first encouraged citizens to fix the interest rates on their obligations by making variable rate loans non-tax deductible. Further, I would immediately issue vast amounts of public debt to improve the infrastructure and insist on truly free-market contractors to bid the work. Finally, after some time I would slowly remove the sales tax on goods, institute a flat tax on income, eliminate taxes on any interest earned and capital gains, remove restrictions on debt, reform the exorbitant payroll taxes, and implement a gold standard.
BUBBLE: Though I have always been in favor of benevolent Kings, I still prefer the strength inherent in democracy and the attributes of a free society.
BUST: In America, you have a democracy with limited freedoms; in Asia, they have great freedoms but limited democracy. Since I am troubled when choosing between scandalous politicians, I can live with a little less voting power, especially if I must fear the outcomes that might be generated by a biased majority.
BUBBLE: Regardless of our political system, unfortunately, if you are right, America's current path to deal with its growing socialism is, well, more socialism! Add in a Smoot-Hawley type tariff and we might even be "lucky" enough to re-live the Great Depression.
BUST: While a depression remains a possibility, in today's world it’s more likely that the US will employ Roosevelt's socialistic cures before a depression strikes. Thus, instead of a quick, severe correction that is then followed by a gradually growing socialism, it is more plausible that a growing socialism fosters a prolonged, gradual decline in the living standards of Americans.
Unless foreigners counter America's strategy with a changed strategy of their own, this is the most likely outcome. When weighing America's options in this trade war, one must consider both its political system and its economic circumstance: America has a large amount of debt relative to its GDP. Excessive growth in broad money supply is feeding asset inflation. Real median wages are falling and creating a wealth gap. Production jobs are growing overseas as evidenced by the high trade deficit relative to its GDP.
Meanwhile, homeowners comprise nearly 70% of the nation, and most voters are homeowners, many of whom are hocked high in debt relative to their incomes. These likely voters are in favor of any trade policy that maintains real interest rates low. Since most politicians favor re-election over the alternative, they will cave in to their constituents' demands. So it is quite likely that as long as this currency-trade war proceeds, Americans will favor the policy of debt creation. I could imagine even ardent conservatives eventually favoring infrastructure investment financed by public debt if it helps to keep the social order.
Unfortunately for Americans, while they may live in a world of bubbles, they certainly do not live in a vacuum (test-tube), and it’s possible that foreigners will begin changing their trade war strategy before America is able to execute an escape route. If so, then the burden of issuing more governmental debt might fall on the American economy, not foreigners who will have begun divesting themselves of dollar-denominated debt. If this happens, it will be very painful for Americans. America clearly needs negative real interest rates that are financed by foreigners if it is to regain any of its lost ground without suffering immensely.
BUBBLE: What I fear most is that America retaliates by protecting certain industries, hoping to re-build its manufacturing base. This could lead to a control economy that works to America's long-term detriment. These jobs America will never regain, nor should it want to in a world of globalization.
BUST: You would make a good King. The best way for America to respond to this macro economic trade war is to institute macro economic measures, similar to those that I proposed earlier, that would restore its long-term health without micro-managing its economy.
BUBBLE: So far you have discussed everything from an American perspective, but how do the foreigners play their strategy? It seems to me that China still has too many remnants of its communist history to win a sustained economic battle against the US. After all, its government-owned banking system is loaded with bad loans derived from its poor policy of lending to just anyone willing to engage in the business of production. Any slowdown in the US consumption might be just the catalyst necessary to bankrupt these central planners. Moreover, with a growing globalization pressuring commodity prices, Chinese companies, which are very inefficient users of oil, will find their production to be even less profitable as oil prices continue to climb. Eventually this could lead to the collapse of their economy.
BUST: What you are arguing to be China's greatest weakness might, in fact, turn out to be its greatest strength. While the adjustment process from a centrally planned economy to a market-based economy, which answers to the profit mechanism, may prove painful in the short run, the model seems more sustainable than the consumer-based model employed by the US, which is heavily dependant on debt creation. Further, you are simply making a strong case for why the Chinese might need to raise prices to compensate for higher oil costs. What better way to do so than to revalue the yuan against the dollar and thereby charge Americans more for the goods they import?
Until 2006, the Chinese stock market had greatly under performed other developing nations. This was likely a reflection of the weaknesses you have identified. The widely accepted belief is that the Chinese were engaging in a profitless prosperity, working themselves to death to the advantage of the West. However, it might not be so coincidental that once the Chinese began privatizing their banking system and slowly re-valuing their currency, their stock market exploded, outperforming the entire world last year! The marketplace may be acknowledging the eventual success of their strategy.
BUBBLE: Let me point out that were it not for the help of American banks, with their recent investment in Chinese financial institutions, China might flounder, decaying into an abyss of bad debt!
BUST: It is rather amazing that the Chinese would actually enlist their trade war competitor, the USA, to help them reform their own banks. It reveals just how committed the Chinese central planners are to developing a long-term strategy to better their position. As banking reforms are implemented, China's profitless prosperity might, after a few road-bumps, one day turn into eternal bliss. Perhaps the equity markets took notice last year.
The reality is that these currency wars were never the intent of the Chinese government; rather they were just a circumstance that evolved from happenstance. As long as an increased dollar of US debt produces more consumer spending in America, the Chinese will likely continue to support the dollar. However, if increased US debt fails to produce more US consumption, the Chinese will likely change their trade war strategy as it will no longer be in their interest to subsidize cheap US interest rates.
BUBBLE: And what will they do with these dollar reserves, burn them?
BUST: Very humorous, but you make a valid point. If the Chinese believe that liquidating their dollar investments might cause too much disruption to their own economy, it’s possible that they will just sit on them until inflation eventually erodes their value. Ironically, this would be tantamount to what the US does every so often with its loans to third world countries – it just writes them off.
Recently, though, the Chinese government announced that it is establishing an investment fund to diversify up to 1/3 of its current one trillion dollars in reserves, and any future reserves earned, which are now growing at over $100 billion dollars per year. If the Chinese follow through with their proposal, it is possible that many of these US dollar reserves will eventually be re-cycled through the global markets and returned to the US where they will be used to purchase US companies, well located US property, or even US infrastructure wherever possible.
BUBBLE: How likely is it that the US people would stand idle and allow their country to be sold out? This is extremely unrealistic.
BUST: Voter participation in America is very low. So far, the rich have been able to effect economic policy – central bankers forever expand the money supply to benefit the banks, capitalists have lobbied for lower capital gain taxes and preferential dividend treatment that have supplemented the boom in asset prices, while the poor have been victims of a falling dollar and an increased immigration that keeps their real wages low.
So it’s not totally inconceivable that the rich pursue policies that allow America to right its economic imbalances by eventually selling out to foreign competition.
The rich advocate such a solution because it enables them to continue parlaying their assets without the fear of an enormous economic contraction.
It's a trend that is now in place; America has gone from a great net creditor nation that owned much of the world to a net debtor nation which is quickly becoming owned by everybody else. This resolution is an easy sell for politicians. How could any good liberal oppose an open door policy that turns America into an even greater multinational nation than it already is? Or how could any good conservative oppose the free flow of capital back to America? As America becomes more multi-national, it will be difficult to distinguish between foreigners, who are becoming the owners of assets, and Americans, who will have become a society of wage earners and renters. To the naked eye, they will all appear to be part of the America's great (global) melting pot.
If this wholesale sellout transpires, most Americans might not recognize change while it is occurring. For example, while the Asians villagers are moving from their huts to luxury living arrangements within their newly formed cities, Americans might only realize slight improvements in the quality of their life, such as having better and cheaper televisions and computing power. Also, Americans might have to work more hours to pay for certain homes that previous generations could have more easily afforded. As long as Americans refrain from traveling abroad to rent hotel rooms which are now in demand by a much richer global populace, they might remain oblivious to the relative changes that are actually occurring around the globe.
BUBBLE: You think this is the way it works out, that the global imbalances of the world are righted by unifying the East and the West (the creditors and the debtors)? In theory, I suppose it’s plausible. For every debtor in the world, by definition, there must be an offsetting creditor. So by forcing the East to reform itself and abandon its remaining centrally planned attributes, the result is a better life for its laborers. Meanwhile, asset prices go up in much of America as dollar reserves return to America. One world, one balance sheet! And everybody progresses toward a more Western version of capitalism. Wow, I think I can embrace this solution!
BUST: The foreigners don't need to "sell" their strategy. They have you. If this proves to be the eventual resolution of the Great Currency War – that America sells herself out – then there is a chance that a peaceful transition takes place. Since America's strongest attributes are her rule of law and her defense superiority, why not market her as the great international hub where foreign capital can seek refuge from an uncertain world?
BUBBLE: This would prove all of doomsayers to be wrong. Alan Greenspan's easy credit will be hailed as the policy that escalated the growth of globalization and the spread of capitalism to the entire world!
BUST: This was an inevitable trend that would have occurred whether or not Mr. Greenspan or his successor pursued such a tragic policy. While it may have benefited the poor nations of the world, it may have come at the expense of the working class within the US. Further, so far we have assumed the best-case scenario – a peaceful resolution of the trade war.
There is great risk to the global economy from the imbalances produced in America. The wealth gap between the rich and poor has greatly escalated. Inflation has eroded the purchasing power of wages earned by average working Americans. The cost of domestic services, which cannot be imported, such as education and health care, has skyrocketed, though partly as a result of the socialized manner in which these services are provided. Should the poor begin to rebel by voting, America could find itself traveling the path of the Soviets, imposing more "socialistic" policies to balance the wealth inequity.
Beyond that, even though asset bubbles have rotated from sector to sector, new paradigmers claim that it is the efficiency of America's financial system that has kept these bubbles "contained." While this is true in the sense that they have not all imploded simultaneously, it is hard to accept that this rolling correction, from sector to sector over time, is evidence of containment. The value of nominal insurance coverage provided by the derivative's market, which some estimate to be nearly three times as large as US GDP, continues to grow in a parabolic manner. While on a micro level it is true that information technology has enabled each participant to spread his risk, on a macro level it can be argued also that in effect, America has transformed itself from a production-based society to one which engages in the sale of insurance (derivatives) to protect its asset-based economy that is financed through debt creation. During this transformation, various service jobs have been created, but ultimately many are dependant upon the continuation of escalating asset prices. When the US finally achieves "stable" asset prices (no longer engaging in money printing), it may obviate the need to sell insurance (derivatives) and render the financial portion of the US economy unavoidably vulnerable to contraction.
BUBBLE: But if globalization continues to grow and capitalism continues to spread, how can you consider it to be bad for the world?
BUST: In the least it’s bad because a great misallocation of resources has transpired for no good reason. In addition, it is also possible that the transition out of this currency war may not be as smooth as I have suggested; instead a more adversarial relationship might evolve among the currency-warring regions. Suppose that the US catches a case of xenophobia and prevents foreign capital from purchasing its assets. The result could be a sudden decline in asset prices, sparking a severe US depression. Or, imagine America rebelling against its declining living standards by exercising its military might to secure natural resources. This could alienate foreigners and discourage them from wanting to own US assets, thus bringing an end to US asset inflation. Further, suppose the East does not move quickly enough with capitalistic reforms and it produces overcapacity which creates a worldwide recession. Finally, one must consider the possibility of an exogenous supply shock, such as an oil crisis or a pandemic, which could wreak havoc on both Asia's thin profit margins and America's leverage.
BUBBLE: I am still having trouble digesting this theory of a global currency conspiracy that has generated global disequilibrium. How do you counter the argument that the developing world does not hold enough assets to materially affect US interest rates?
BUST: Once currency manipulation and capital controls were put in place overseas, liquidity added by the Fed led consumers to purchase imported goods and investors to purchase assets. Very little of these Western funds were allocated to property, plant and equipment (PP&E) within the US, or overseas. Most PP&E investments were made overseas and financed by nationalized banks that did not have to answer to the profit mechanism of the free-market. US funds were allocated to PP&E only when US companies had a technological advantage that the foreigners could not duplicate, and often the wave of liquidity would create in a gigantic bubble (tech and telecom).
Thus, foreigners do not necessarily have to control a massive amount of dollar reserves to affect global interest rates; instead their policies worked to divert the flow of funds within the Western countries, particularly in America, from the production process to asset markets. It is now the return on these assets which determines interest rates in the West. Consequently, the US now epitomizes the "tail-wagged" dog, where the asset-based economy (the tail) leads (or wags) the general economy (the dog). It rightfully seems that the rules of capitalism have been turned backwards.
BUBBLE: So what does this mean for investors?
BUST: One fact is quite clear: this is not your grandfather's economy. In the old world, fluctuations in the business cycle created sharp price declines that purged the bad debt. In the last decade, sharp price declines have been mitigated by increased credit, making it impossible for capitalists to make rational investment decisions. This is the conspiracy of paper.
In the "new world" where competing nations attempt to gain an advantage by instituting a combination of credit growth and currency and capital controls, absolute price declines have become a thing of the past. Instead, bad debt is "saved" by issuing even more bad debt, all at the expense of the efficient allocation of capital. As this bad debt continues to grow, a series of bubbles perpetuates itself – from the emerging market bubble, to the high tech bubble, to the property bubble, all in the context of an ever-increasing credit bubble.
Capitalists intent on believing that we still live in yesterday's world of more honest money grow frustrated as they wait patiently for a financial reckoning day to occur. As long as global printing presses continue to run at lightening speed, it will be difficult to make any judgments relative to the value of depreciating paper currencies; rather all price adjustments among asset classes should be measured on a relative basis only. "Shorting" against the value of paper should be saved for only the direst circumstances.
BUBBLE: It sure seems like those who shorted the sub-prime lenders have been greatly rewarded, as many of these stocks have become worthless. Perhaps you would like to retract your own commentary.
BUST: Clearly there will be sectors in which the imbalances grow so great, that even increased credit to the overall financial system will not prevent nominal price declines. However, to bet on the nominal price deterioration of the entire economy is a fool's game under a fiat money system, particularly one that is being manipulated by global forces.
That being said, once credit starts contracting in a specific area of the private sector, it will be nearly impossible to re-inflate that sector to its previous price highs without engaging in a nationalistic social policy to support this area. For example, the housing sector is likely to continue contracting, unless a nationalistic policy of extending credit is adapted rapidly enough in the public sector to replace the credit contraction that is now happening in the private sector.
BUBBLE: Which investment classes have benefited the most from this global trade war, and which might likely gain from its demise?
BUST: The private sector would not compete with the nationalistic overseas banks making questionable loans to businesses engaged in production; so liquidity that entered the private sector flowed mostly into assets. Worldwide equities, bonds, and real estate all benefited, though somewhat unevenly, from this liquidity boom. Some private capital was invested in property, plant, and equipment, but usually in sectors in which Western business had a technological or knowledge-based advantage over the East, thus precluding the East from competing.
As globalization spreads, commodity prices have also increased. The commodity bull market will likely continue until either demand abates, supply increases, or alternatives are developed.
Long-term investments in the economies of those nations winning the global trade war should outperform the markets of the losers on a relative basis. That does not mean that there will not be wild price corrections along the way, but, in the end, these markets should outperform on a relative basis.
Further, the precious metals are a play on the global disequilibrium that has developed. As debt becomes relatively unproductive in the real economy, or as individual countries, in their own self interest, refrain from engaging in the global trade war, more liquidity should flow into the precious metals as an alternative asset class. In fact, it’s possible that the ultimate spike in the precious metals will prove to be parabolic in nature once the era of currency trade wars ends and real interest rates return are determined by free-markets. Meanwhile, brief periods of credit contraction should greatly benefit the precious metals relative to other asset classes.
BUBBLE: What should we look for to indicate that the "rules" of investing are changing again, that the era of nominal price corrections is returning and the era of relative price adjustments is ending?
BUST: We should look for any hints that the global trade war is winding down. A number of early signs are already taking place. For example, now that China has begun privatizing its banking system, both the banks and the producers of goods will be lobbying government officials to revalue the Yuan so that businesses can pay for its increased borrowing costs by charging higher prices to the foreign consumers of its products. Also, the Japanese are now signaling that they may abandon their long-term strategy of inducing asset appreciation through easy monetary policy; this should put an end to the global carry trade and perhaps induce others to abandon their trade policy of excess liquidity creation. Finally, if the US government develops a policy to direct excess liquidity to towards the domestic production of goods or services, foreign trade partners will stop supporting the dollar.
Thus, there are many factors that could induce any region to abandon its strategy of credit expansion. Once this occurs, it becomes more expensive for the remaining nations to collectively bare the cost of continuing such a strategy. In short, as some members acting in their own self-interest withdraw their support, it is likely that the currency wars will quickly unravel, pressuring the remaining warring members to secede.
Meanwhile, by both circumstance and poor policy decisions by the West, we live in a world of disequilibrium that is held together by the many individual participants invoking their best version of capital controls through currency manipulation and credit expansion. In this global trade war, central bankers and cooperating foreign governments are the super-glue that holds this perpetual state of disequilibrium intact. Thus, every investor must now balance his perception of value against the world's geopolitical conditions.
BUBBLE: The one factor that you have neglected to account for is change. The beauty of democracy is that things can change for the better. I wouldn't bury the West just yet.
BUST: You are right to point out that "change" is the wild card. History is replete with reactions – some are for the better, but many have been for the worse. What I fear most is that some in the West will adopt more national socialistic policies just as those in the East begin to adopt more democracy and free-market reforms. The transitions may not be so peaceful.
BUBBLE: Once again, "Captain Apocalypse," you have resorted to your negative views. On that note, I must cut our conversation short. It's now past my bedtime, but before I sleep I must practice my nightly ritual of reciting the "Star Spangled Banner" and saying my nightly prayer. Tonight I will pray that the world embraces both democracy and capitalism and that together we prosper as one unified people.
BUST: I will hope for much of the same. If globalization is to continue, an adjustment process that rights the global imbalances will likely ensue. These adjustments will either be induced by market forces or by the individual nations abandoning their centralized strategies. It is the reaction to these necessary adjustments that I fear so much, both for my financial well being and for the state of humanity. Thus, as an investor I must continually monitor the global currency war and adapt my investing strategy as it changes. Meanwhile, I too must run. I believe that the bars here in New York close in the middle of the morning; for the sake of humanity, I hope to make last call.
© 2007 George Karahalios
George Karahalios | Huntington Beach, CA USA | E-mail