Signs of the Future: Emerging Countries vs. Developed Countries

The world goes on.  Whereas the news has tended to be dominated by what is happening in Europe, with some attention going to the United States, things are still going on in other parts of the world. 

For example, “Standard & Poor’s has become the third rating agency this year to upgrade Brazil’s sovereign debt…” (http://www.ft.com/intl/cms/s/0/a1c1a890-116a-11e1-9d04-00144feabdc0.html#axzz1e48y8AYK)

“Brazil’s debt fundamentals are already seen by markets as superior to many European countries with spreads on the Latin American country’s debt trading tighter than those of many eurozone countries.”

“The move…emphasizes the growing divergence between the fast-growing large emerging markets, led by China, Brazil, and India, and the advanced economies.”

Meanwhile, the central banks in emerging markets are buying gold in the largest quantities for forty years.  The forty years is important for that refers back to 1971 when President Richard Nixon severed the tie between the United States dollar and gold. 

“The scale of the purchases was bigger than previously disclosed and puts central banks on track to buy more gold than at any time since the collapse of the Bretton Woods system 40 years ago, when the value of the dollar was last linked to gold.”  (http://www.ft.com/intl/cms/s/0/c0025500-10ef-11e1-a95c-00144feabdc0.html#axzz1e48y8AYK)

Many emerging countries, especially the BRICs, now believe that they are over-exposed to the dollar in their central bank reserves and are trying to build up gold reserves at times when the price of gold dips.  Also, there is incentive to buy as concerns grow over the role of the United States dollar as a reserve currency.

“It is a mark of creeping distrust in the unofficial reserve currency, which nervous central bankers see being printed by trillions even as America’s political leadership shows no sign of dealing with its daunting fiscal challenges.  Fiscal worries are even more acute for the number two and three reserve currencies, the euro and the yen.” (http://www.ft.com/intl/cms/s/3/59f07c7e-113f-11e1-a95c-00144feabdc0.html#axzz1e48y8AYK)

But, “Central bankers are late to the gold party.  Private buyers of ETFs alone have accumulated 15 times as much since their advent a decade ago as government bought last quarter.  But their shift should be of far more concern.” http://www.ft.com/intl/cms/s/3/59f07c7e-113f-11e1-a95c-00144feabdc0.html#axzz1e48y8AYK)

Seemingly oblivious to these happenings, the United States continues to pursue policies that will devalue its currency.  Fed Chairman Ben Bernanke appears to be focused on keeping the world abundantly supplied with U. S. dollars while Treasury Secretary Timothy Geithner continues to swear that U. S. policy is to maintain a “strong” dollar while the Obama administration continues to issue more and more debt. 

Others within the Federal Reserve System continue to back up the Fed effort to continue to inflate the world.  The President of the Federal Reserve Bank of New York, William Dudley, says that “the central bank isn’t out of ammunition “ and that “monetary policy must do its part” to support economic growth. (http://professional.wsj.com/article/SB10001424052970204517204577044481934030256.html?KEYWORDS=michael+derby&mg=reno-secaucus-wsj)

And, the pressure in Europe is intense to get the European Central Bank to engage in much more aggressive actions to save the European Union and the euro.  Is quantitative easing in the future for Europe? (http://professional.wsj.com/article/SB10001424052970203611404577042302226590104.html?mod=ITP_pageone_0&mg=reno-secaucus-wsj)

The emerging nations are seeing the “crack in the door” and are steadily moving to take advantage of the fact that the developed countries must currently keep their focus on current distractions.  By following such a policy they see “the door” opening wider and wider.

To me, the real report card is the value of the dollar.  The credit inflation of the last fifty years in the United States, first, forced the United States off the gold standard, and, second, resulted in a secular decline in the value of the dollar.  The U. S dollar still fluctuates near the lows reached over the past forty years since its value was floated.

 

Looking at the value of the dollar against twenty major currencies one can see that news lows were hit around August of this year.  One can note that the three periods of recovery from the lows reached in 2008 were periods when there was a “rush to quality”.  The first was during the “Great Recession” and the other two spikes came during the sovereign debt crises in Europe. 

The economic policies of the United States government aim at a devaluation of the United States dollar.  Still the United States dollar is the reserve currency of the world and is the currency of the country that remains the strongest country economically.  This is why the United States dollar is still the haven for others when there is a movement to “quality.” 

Since the second world war, the United States…with western Europe tagging along…has dominated the world, economically as well as militarily.  During this time, the United States has basically acted independently of all others.  It is still “Number One” in these areas but is finding that its voice is growing weaker and weaker.  Current examples of this are the position the U. S. had to take in the actions in Libya and the back seat it took in the G20 meetings in Cannes, France.  And, more and more it is finding that with its fiscal position that it just does not have the money to “throw at things” that it used to have in the past. 

One way or another, the separation between the developed countries and the emerging countries is going to be a major factor in the world going forward.  Most analysts have moved up the time they expect some of the larger emerging nations to catch up with America and western Europe.  Within this environment, the currency conflicts and the financial conflicts are just going to grow

European Choices Continue to Narrow

On May 24, my post stated that debt ultimately leaves you with no good options. (http://seekingalpha.com/article/271651-debt-ultimately-leaves-you-with-no-good-options)

Martin Wolf in the Financial Times reduces the choices now available to the European Union to two: “The eurozone confronts a choice between two intolerable options: either default and partial dissolution or open-ended official support.  The existence of this choice proves that an enduring union will at the very least need deeper financial integration and greater fiscal support than was originally envisaged.” (See “Intolerable choices for the eurozone,” http://www.ft.com/intl/cms/s/0/1a61825a-8bb7-11e0-a725-00144feab49a.html#axzz1O1hWLIwZ.)

The “original” design of the union, Wolf contends, is for all purposes, dead.  That could only be achieved by removing some of the countries now in the union.

To achieve the second of the two choices he mentions above is going to require a contortionist.  First, Wolf argues, European banks cannot remain national.  Whoa!  Second, he argues that the current system of European System of Central Banks (ESCB) must be eclipsed by a “sufficiently large public fund” that manage “cross-border” financial crisis.  Double Whoa!  And, third, the finance of the “weak countries” must be taken out of the market for years, “even a decade.”  Whoa! Whoa! Whoa!  What would result would be something Wolf calls a “support union.”

This certainly is “deeper financial integration and greater fiscal support than was originally envisaged” by the creators of the European Union. 

The question is, “could this ‘support union’ ever be achieved short of all countries in the eurozone coming under a common government. 

But, even so, I do not see that this “solution” reflects any change in the underlying economic philosophy of the current leaders of Europe concerning the propagation of the credit inflation that the leaders of Europe have perpetrated for the last fifty years or so.  With no basic change in philosophy, I cannot see how this second choice achieves anything except the postponement of the “day of reckoning” in which the range of options available to the European Union drops to one. 

Does this mean that the European Union will eventually be providing investors with a “sure-fire”, riskless investment similar to the one given George Soros by the British government in 1992?

It seems to me to be a real possibility.

John Plender, who also writes for the Financial Times, argues that the European Union can “Muddle along for now; but a Greek default is inevitable.” (http://www.ft.com/intl/cms/s/0/21922f88-8ba4-11e0-a725-00144feab49a.html#axzz1O1hWLIwZ)

Plender writes that the burden of the policies imposed upon the Greek government by the IMF will only produce “great demands on the population” which is already enduring a deep recession.  Greek workers will have to ‘endure wage deflation” so as to restore the competitiveness of the Greek economy and the privatization program being discussed will put the transfer of Greek assets in the hands of an external agent. 

However, the other option, debt restructuring, is not currently acceptable to Plender, either.

He sees it as the only real choice for the time being: “If a package is agreed in June, which seems probable, the challenge will be to bring Greece to a primary budget surplus...” and “at that point, it would be sensible for Greece to bow out of the monetary union and take advantage of currency devaluation.” 

He goes on, “For that to work, though, European banks would need in the interim to have bolstered their capital.  And the execution risks are phenomenal.  This is policymaking on a wing and a prayer.”

The leaders of the United States need to absorb this lesson.  No matter that the United States is richer and deeper in resources than Europe.  No matter that the United States is bigger.  No matter that the United States has the reserve currency of the world.  The debt burden catches up with you.  As, as the debt burden is catching up with you…your options become fewer in number and they become less and less desirable.

The United States is not exempt from this outcome…unless it changes course before all the options go away. 

In all financial crises, the initial response of the central bank and the government must be to provide sufficient liquidity to keep the banks open and to avoid cumulative downturns in companies and the economy.  Bailouts and quantitative easing may be appropriate…for the short run.

But, there is a difference I have written about many times, between a “liquidity” crisis and a “solvency” crisis.  A liquidity crisis is a short-run phenomenon, which gets an economy over the short-run shock of a financial event. 

The longer-run problem is the solvency problem.  And, solvency is tied up with debt…debt loads that must be worked off.  And, working off debt loads takes time…lots of time.  And, working off debt loads cannot really be achieved by flooding the financial markets with more credit and more liquidity.  This is a “postponing” strategy.

To solve the “debt” problem and to prevent it occurring again in the future, leaders must change their basic economic philosophy about the creation of debt.  Credit inflation always leads to debt problems, and further credit inflation aimed at solving debt problems only leads to diminishing options and eventual collapse.  Insolvency cannot be solved by more debt. 

It should be obvious that more debt is not the solution to a problem if the options one has decline in number and the desirability of the options also declines.  To continue to pile on more and more debt is like the person in the hole, digging the hole deeper and deeper in an effort to get out of the hole. 

Europe is finding this out.  It, apparently, must be the case that the United States will have to learn this lesson as well.

If anything is going to give the emerging countries of the world the chance to close the gap on the developed countries it is a continuance of the credit inflation policies of Europe and America.  The ironic thing is that the shoe used to be on the other foot…the developed countries had control over their credit inflation whereas the emerging nations were reliant on excessive amounts of credit inflation.  This relative performance was given as an important reason why the developing countries could not hope to catch up with the developed world. 

China is catching up with the west faster than most analysts believed it would.  So with India…and Brazil….  If the European Union…and the United States…continue to push the edge of debt creation and continue to shrink their options, the tipping point  to this emerging world might occur sooner than most of us imagine.     

The Future of Finance is Getting Closer

I know that not all of these facts that I present below are new, but reading about the following five in the morning papers just reconfirmed my position on the future of the financial markets.

First and second, stock exchanges have become dominated by high-frequency trading and index funds.

Third, the combination of the Deutsche Bȍrse and the NYSE Euronext will continue the trend for exchanges to turn to derivatives and technology business. The model here seems to be the CME Group, “the world's leading and most diverse derivatives marketplace” which has a market capitalization that is larger than either of the two combining institutions.

Fourth, the Shanghai Stock Exchange and the BM&F Bovespa, Latin Americas largest exchange is going to announce an agreement which will include the fact that stocks will be cross-listed on both exchanges. This will put Brazilian and Chinese interests together, world-wide.

Fifth, the IBM computer named Watson beat the two “greatest” players on the TV program “Jeopardy!” This, of course, comes only a few years after an IBM computer beat the world champion of chess at his own game. And, this most recent battle of “wits” has set off a plethora of articles on the state of artificial intelligence. The advances are mind-boggling!

A sixth fact could be the unrest in the Middle East where a very serious challenge in being raised against local autocratic leaders. Part of the cause, information technology.

Why are these “facts” important to me?

They are all just another indication the spread of information and information technology continues and cannot be stopped. Not only are things happening faster, they are becoming more ubiquitous.

Once again, for those that have not yet read the book titled “The Quants”, you should because it gives us a glimpse of what the future is going to be like. (See my review: http://seekingalpha.com/article/188342-model-misbehavior-the-quants-how-a-new-breed-of-math-whizzes-conquered-wall-street-and-nearly-destroyed-it-by-scott-patterson.)

And, this is the world that Congress (and other bodies around the world) is trying to regulate?

But, regulating to prevent 2007 and beyond from happening again is not going to protect usin the future.

It is the world that Mr. Gary Gensler, the chairman of the CFTC is trying to get his arms around and control.

But, how do you grab hold of a “whiff of smoke”?

The above facts are dramatically showing that finance is information and that the storing, processing, analysis, use and dissemination of information is going to become more and more technologically advanced as time passes. In fact, it is going to happen faster and faster.

In the future, more and more finance is going to be “quantified”; trades are going to occur at even greater speeds; and information is going to be stored…somewhere…and transactions are going to happen…well, someplace.

Regulation cannot just focus on “outcomes”. Regulation cannot eliminate “systematic” risk.
Furthermore, regulation of the kind we are used to in the United States only takes place “after-the-fact.”

The only way to really gain some insight into what is going on in financial markets is to observe what the market is saying. That is, the only way to get some kind of “advance warning” about market trouble is to watch market information.

Such systems have been suggested. One such suggestion has been given for an “early warning” methodology for the banking system. I have discussed this methodology in several posts over the past year. I will refer to just one of these posts (http://seekingalpha.com/article/242467-america-must-start-again-on-financial-regulation) that references the work of Oliver Hart and Luigi Zingales. The system proposed by Hart and Zingales is a market-based system that can raise “red flags” that regulators can respond to. In this way their system is “anticipatory” and not “reactive.”

Still, this world of the future must avoid some of the problems of the past. No regulatory system is going to be able to survive a regime of undisciplined governmental policy like we have seen in the United States over the past fifty years. Credit inflation undermines an economy and destroys discipline. (See my post http://seekingalpha.com/article/253145-deficits-credit-inflation-and-the-dollar.)

This must be considered within a world that is going through a period of transition that is monumental. Major shifts are taking place everywhere and we really don’t know what the ultimate result is going to be. However, we are moving away from a “labor”-based, manufacturing system to a “knowledge”-based society embedded within whatever the current information technology allows. The government cannot continue to base macro-economic policy on the assumption that the structure of the world still rests on the old, labor-based manufacturing system. It will just perpetuate the errors of the past.

As advancing technology allows us to do “finance” faster and in more ubiquitous ways, the techniques and tools of finance will just be used to take advantage of the credit inflation created by governments. Remember it is the wealthiest, the most trained, and the best positioned that will be able to take full advantage of the incentives created by further credit inflation.

What proof do I have for this?

Take a look at the last fifty years of credit inflation. What have been two of the fastest growing sectors in the economy?

The answer is: information technology and finance. And, these two sectors have complemented each other very well. Computer-based financial innovation has thrived in this environment of credit inflation. In fact, no other environment is so conducive to financial innovation than is an environment based on credit inflation.

And, the results of the past fifty years?

The purchasing power of the dollar has declined by about 85%. Under-employment of the working force is somewhere in excess twenty percent. And, the income distribution has become radically skewed toward the wealthier end of the scale. Need I say more?

The Bubbles Are Real

On Thursday, three-month forward contracts put the yield spread between Brazilian and United States rates at 8.75 percentage points. And, you have questions about the existence of the carry trade, the borrowing at excessively low interest rates in one country to invest at much higher rates in another country.

Well, these yield spreads are not quite as attractive as they once were because Brazil has placed a tax on foreign investment in sovereign bonds. This tax was initiated in 2009 and after two increases is now 6 percent. Several fund managers told the Financial Times outlet that “the appeal of the carry trade had diminished considerably as a result.” (http://www.ft.com/cms/s/0/ec755d4a-1f40-11e0-8c1c-00144feab49a.html#axzz1B0wmwdeP)

Two points on this: first, there is no doubt in my mind that the quantitative easing (QE2) on the part of the Federal Reserve System has created bubbles in other parts of the world: and second, countries around the world have reacted to these bubbles by selectively trying various policy tools to try and contain the capital flows into their financial markets confirming, to me, that the bubbles are real.



Yesterday, the Brazilian central bank introduced a new effort to slow down the rise in the Real “by offering to buy as much as $1 billion in the currency futures market. (“Brazil Central Bank Intervenes,” http://professional.wsj.com/article/SB20001424052748703583404576079511405101244.html.)

But, governments all over the world are trying to clamp down on “hot money flows”. Gillian Tett writes about “New Ways to Control Hot Money Bubbles,” in the Financial Times this morning. (http://www.ft.com/cms/s/0/8bfc81e2-1f30-11e0-8c1c-00144feab49a.html#axzz1B0wmwdeP)

South Korea, in particular, is “launching” experiments aimed at stemming rising currency prices or frothy stock markets or other cross-border flows of funds. The effort is to find ways to apply more activist and “macro-prudential” policies to banks or the banking system.

Even the International Monetary Fund, this week, recognized the legitimacy of and the need for


countries to control capital flows when other countries are following independent economic policies aimed at resolving domestic economic problems that have impacts on others.

The problem is “what constitutes a bubble?”

A bubble seems to be like pornography, it depends upon who is looking at it. Former Federal Reserve Board Chairman Alan Greenspan never saw a bubble, at least while it was taking place. Apparently, the current chairman Ben Bernanke can’t see one either.

Now, it seems, that there are other economic phenomenon that are maybe not so easy to identify. United States Treasury Secretary Tim Geithner has stated that it is hard to identify financial institutions that are “systemically important” in advance of a crisis. “It depends too much on the state of the world at the time. You won’t be able to make a judgment about what’s systemic and what’s not until you know the nature of the shock.” Well, so much for “too big to fail.” (http://www.ft.com/cms/s/0/1122ed96-1f7e-11e0-87ca-00144feab49a.html#axzz1B0wmwdeP)



Still, there are flows of funds that seem very “bubble-like” Take a look at the following chart. Notice the flows of funds into emerging markets in 2009 and 2010. It was December 2008 that the Federal Reserve forced the effective Federal Funds rate into the range of 15 basis points to 25 basis points. Fund flows into emerging markets took off to new highs once this policy was in place. Who says the international flow of funds is restricted.


The next point, however, is the movement in the exchange rates in these emerging countries relative to the dollar. Note, the figures presented are the percent change over the past two years.

One definition of a bubble is when fund flows into a nation or a sector exceed the ability of real economic activity in that nation or sector to grow. In the case of funds flowing into these emerging nations it certainly appears as if the funds flowing into the countries exceed the ability these countries have to grow.

Raghuram Rajan and Luigi Zingales, in their book “Saving Capitalism from the Capitalists” argue that bubbles occur when you get people investing in markets that are not familiar with the markets, people who don’t really understand the fundamental characteristics of the new market they are investing in. As a consequence, people make money as prices continue to rise and this fact draws more and more people into the market place. In this respect, bubbles can possibly be observed by paying attention to who is being drawn into the market. This can be another piece of evidence in attempting to discern “bubbles.”

Thus, the carry trade has proven to be very attractive, has produced a lot of profitable positions, and has gained a lot of publicity in the popular press and in the investment community. One could argue that investments in the bonds and equities in emerging nations have drawn a lot of new investors over the past two years. More are coming into the markets every day.

One can also make a similar case for the flurry of activity in world commodity markets.

In fact, one could argue that in many of these situations policy makers are setting up attractive “one-way bets” for investors and these are drawing new money into these areas from investors not familiar with the markets. (http://seekingalpha.com/article/237076-interventionists-are-setting-up-one-way-bets-for-traders)

It seems to me that in present circumstances it is harder to argue that bubbles ARE NOT real than that they really exist.

Bubble Ben, the Bubble Maker

It seems like all Ben Bernanke can do is blow bubbles. He joined the Board of Governors of the Federal Reserve System in September 2002 and served until June 2005. The effective Federal Funds rate was 1.75% at the time of his arrival. By July 2003, this rate was 1.00%. The effective Federal Funds rate remained at 1.00% until July 2004.

Bernanke not only supported this exceedingly low rate during the year it served as the Federal Reserve target, he provided a large portion of the intellectual support for such a policy. Remember Bubble Ben was an historical expert of the Great Depression and former head of the Princeton Economics Department.

The consequence of the Federal Reserve policy? Bubbles in both the stock market and the housing market.

He then went off to become the Chairman of the President’s Council of Economic Advisors, another tough executive position with lots of leadership challenges, where he stayed until January 2006 when he was appointed as the Chairman of the Board of Governors of the Federal Reserve System, the second most powerful executive position in the United States government.
In February 2006, the effective Federal Funds rate was 4.50%. Now, of course, Bernanke’s major concern was inflation, so the effective Federal Funds rate was pushed up to 5.25% until July 2007 after the bubble had already burst. He stayed too long at the dance! The Fed Funds rate dropped below 4.00% in January 2008 and below 3.00% in February 2008.

Once the financial crisis spread Bernanke saw the Fed Funds rate drop below 1.00% in October 2008 and by December 2008 the effective Federal Funds rate dropped below 25 basis points where it has remained ever since.

Now we have another “Spaghetti” experiment called “Quantitative Easing 2, where we have Bernanke saying that the Fed will buy up to $900 billion in United States Treasury securities over the next eight months or so. (See “Bernanke’s Next Round of Spaghetti Tossing”, http://seekingalpha.com/article/233773-bernanke-s-next-round-of-spaghetti-tossing. Also see http://seekingalpha.com/article/234814-the-fed-s-850-billion-bet-negative-long-term-implications.)

Mr. Bernanke, “Bubble Ben”, is erratic and subject to panic. He seems calm and rational and “in control” but his actions imply something else. His volatility in response to what he considers to be a crisis, whether it is a financial collapse or inflationary pressures is not consistent with outstanding leadership qualities. But, why should we expect such leadership qualities from someone who has only been tested in the confines of the economics department at Princeton?

The problem is that what Bubble Ben is doing is impacting the whole world. The American stock market is booming. Commodity markets are booming. The price of gold hit an all-time high. The bond market is soaring…”A bevy of household names rushed to sell cheap debt on Thursday after the Federal Reserve said it would pump at least $600 billion into the financial system…At least $12 billion in high-grade bonds came to market making it one of the busiest days in nearly two months.” (http://professional.wsj.com/article/SB10001424052748703805704575594111859145030.html?mod=ITP_moneyandinvesting_5&mg=reno-wsj) And you can expect a lot more high-grade companies coming to the market to issue more debt in coming days.

And the value of the dollar is tanking. Against major currencies, the value of the dollar is down by about 7% since late August.

The expectation is that massive amounts of dollars will flow out of the United States into, especially, emerging nations. “The US Federal Reserve’s decision to pump an extra $600 billion into the economy has galvanized emerging market central banks into preparing defensive measures…China, Brazil and Germany criticized the Fed’s action on Thursday, and a string of east Asian central banks said they were preparing measures to defend their economies against large capital inflows.” (http://www.ft.com/cms/s/0/981ca8f4-e83e-11df-8995-00144feab49a.html#axzz14PXUVIN6) The expected outflow is already resulting in substantial stock market gains in emerging nations.

This move by the Fed is certainly not going to foster good feelings and co-operation among the leaders of the world as they get ready to “go-to-meeting” in Seoul, South Korea for the assembling of the G-20.

This surge in capital flows is being called “inappropriate and short-sighted” by many countries and the move is seemingly resulting in additional currency tensions and a high risk of capital controls and trade protectionism. This is not just a “textbook” exercise. This is real stuff. As Martin Wolf has said in the Financial Times, America is exporting inflation to the rest of the world.

The rest of the world is not going to stand by and let this happen.

But, this leads into another point. The United States is contributing to its declining influence in the global economy. The United States will not be dropped from its leadership position in the world, but other nations are becoming relatively important and are becoming more and more assertive in standing up to the United States in more and more important issues.

With this action the United States is making the unity of the G-20 impossible. America has taken its stance. It is solely focusing on its navel. Why should other countries bow down to it anymore?

In fact, if this action does anything, it seems that it is drawing these other nations together to possibly counteract the Fed’s actions.

For those nations that want to see the United States weakened, the Federal Reserve is playing right into their hands. In fact, I cannot think of a policy that would be more helpful in reducing the influence of the United States in the world as the one the Federal Reserve has set out on.

We can joke about “Bubble Ben” and how he likes to blow bubbles. Unfortunately, bubbles don’t last. Bubbles pop! And, when they pop many, many people suffer.

Unfortunately, there seem to be lots of bubbles forming and they seem to be spreading throughout the world. What is really going on here?

The IMF Bowl: the United States versus China

With the IMF annual meeting taking place this weekend in Washington, D. C., it is hard to pick on any other topic than what is happening in economics and finance in the world.

The underlying story: the United States has not been challenged, financially as well as economically, in many years and has grown comfortable with its position as the Number One Player (NOP) in the World.

Plot line: the United States will not fall from its position as NOP but other countries are becoming relatively stronger, especially China.

Scenario: China smells weakness in the United States position. When an “opponent” smells weakness, that “opponent” steps up its game. Most experts expected China to “step up its game” at some time in the future, but they did not expect this behavior to happen so soon.

Response: the NOP calls “foul”! The first reaction of the NOP is to claim that the “opponent” is cheating or playing dirty. The NOP tries to get those on the sideline into the game in order to overcome the pressure that the “opponent” is applying to the NOP. China bashing has become de rigueur in the United States, especially for those running for office in this fall’s elections. (“China-Bashing Gains Bipartisan Support,” http://professional.wsj.com/article/SB10001424052748704689804575536283175049718.html?mod=ITP_pageone_2&mg=reno-wsj.)

Script: the battle goes on. This conflict is not going to be resolved this weekend. Nor is the conflict going to be resolved at the G-20 meetings in November. The conflict, for the time being, is going to be played out on the playing fields. The “opponent” is going to push the NOP and is going to hit the NOP on many different fronts.

For example, another move by the “opponent’ is the effort by the Chinese to make its currency, the yuan, more global. Last week, electronic trading of the yuan began. Further efforts are underway to expand this trading to banks in the United States and in Europe. (“Yuan Goes Electronic in Global Market Bid,” http://professional.wsj.com/article/SB10001424052748704011904575537754269611906.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj.)

“China’s government has made a series of moves in the past year to encourage the yuan’s use outside China, an effort to become less dependent on the dollar for trade and investment. The moves are allowing pools of yuan to accumulate in bank accounts outside of China, particularly in Hong Kong.

Hong Kong banks have been trading the currency among themselves, but through over-the-counter trades where the banks contact each other directly or through brokers.”

This new move will mean that prices and trading amounts will be posted for all to see.

The effort to improve its relative position in the world is not going to stop. China is making efforts on many fronts to strengthen its position in the world. The contest is on.

Leaders in the Obama administration, from the President to the Secretary of the Treasury on down, are speaking out more forcefully against the actions of the Chinese.

World leaders are observing this conflict and are trying to keep the discussions civil and “in bounds”. This is why someone like the managing director of the IMF, Dominique Strauss-Kahn, as well as others, are attempting to temper the rhetoric and bring things into the existing organizations that deal with trade and international finance. (“IMF Chief Steps into Dispute over China’s Currency Policy,” http://www.nytimes.com/2010/10/08/business/global/08currency.html?ref=business.)

Players crying “foul” can only achieve so much. Sooner or later the NOP will have to modify its game plan and raise its play to another level. The “opponent” is not going to lessen its pressure as long as weakness in perceived in the NOP.

And, where does this weakness show? One very prominent place this weakness shows is in the value of the dollar. Since the early 1970s when the dollar was taken off the gold standard, the value of the dollar has declined by about 40%. Except for the “flight to quality” periods experienced during the financial unpleasantness of the 2008-2009 period, the dollar has continued to be in decline from the level it reached during the Clinton years. The international investment community is not “in love” with the fiscal and monetary policy of the United States government.

This contest between China and the United States is for real. The pressure from the Chinese is not going to abate anytime soon. The “rest-of-the-world” is not in any position to contain this conflict unless it shuts down world trade, something it will not do.

This means that the United States must get its act in order. The United States cannot compete with 20% to 25% of its industrial capacity not being used. The United States cannot compete with 20% to 25% of its labor force under-employed and not trained sufficiently to work in the modern economy. The United States cannot compete when its government creates incentives for people to protect themselves from credit inflation rather than engage in productive pursuits.
And, fiscal stimulus by the government and quantitative easing on the part of the monetary authorities will not correct these problems. They will only indicate to the Chinese how weak the United States has become.

This contest between China and the United States is for real. The only way the United States can “raise its game” is by focusing on what can make it more competitive. I don’t believe that the United States will ever again get the “free ride” it benefitted from over the past thirty years or so. So, the United States government must change the way it does business.

The Chinese are only the first in line to “take us on”. Right behind them are the Brazilians, the Indians, and, of course, the Russians, again. And, right behind them is a whole host of other nations.

The Shadow of Lula

It is remarkable to see the accolades being heaped on retiring Brazilian President Luiz Inácio Lula da Silva. Who would have believed this would be the case eight years ago.

Even the Financial Times has as its lead editorial “Brazil Dazzles Global Finance” (See http://www.ft.com/cms/s/0/9de004be-ca68-11df-a860-00144feab49a.html). “Brazilian finance will be felt increasingly in international centers.” Brazil’s development bank, with a balance sheet larger than the World Bank, has chosen London as its main foreign office.

Brazil is a player. Statements like this cannot be put in a future tense any more like “Brazil wants to be a player in the world.”

And, the Brazilian Finance Minister Guido Mantega gained global headlines this morning with his comments about “a trade war and an exchange rate war.” Brazil has one of the stronger currencies in the world right now. The value of the dollar has fallen by about 25% relative to the
Brazilian real since the beginning of last year.

Brazil is now listened to around the world.

This is just one more indication of how the world has changed.

Every day, we, particularly in the United States, must remember that things are different now. Although the United States is still a very powerful nation, quite a few other countries have increased significantly in power so that the relative position of the United States is not the same as it once was.

And, there are other hints. JPMorgan Chase has reorganized so that it can become more of an international force. Economically, it cannot just rely on its position in the slow growing United States economy anymore.

We also see the changes in leadership in the United States. For example, the bank that formerly was the largest bank in the United States has someone born in India as its CEO, Vikram Pandit, who was brought into this position to save Citigroup and turn it around.

And what about the biggest, most aggressive investment bank (now a bank holding company) in the United States, Goldman Sachs. There are rumors that a Canadian by birth, someone who has been Goldman’s Asian chief, Michael Evans, is playing a larger part in the management of the company and might even be a successor to Lloyd Blankfein, the current chief executive. Also, Mr. Evans does not have a back ground in Goldman’s trading unit, a place many other Goldman Sachs’ leaders have come from.

The world is open. People and products and services are flowing more easily from country to country.

We still see individuals that resist this fact.

It is hard to believe that this growing global integration can be ignored by investors, governments, and financial institutions, manufacturing concerns, and others who want to perform well in these times.

Well done Mr. Lula!

China is Changing the World

Earlier, on March 25, I raised the question “Why Should China Change?” in my post, “Why Should China Change?” (http://seekingalpha.com/article/193689-why-should-china-change)
The thrust of the post was captured in the following:

“The world has changed and we in the United States have not accepted the fact.

Why should China change direction at this time?

China is growing stronger and stronger. The United States, and most of the rest of the west, is in a weakened state. The United States, and most of the rest of the west, has gone through a very severe financial crisis and the worst recession since the 1930s.”

The United States is still the number one power in the world, both economically and politically, but its relative position has changed. And we continue to see that in our relationship with China (and India and Brazil and Russia).

The current ‘high-level’ meeting in Beijing of representatives from China and the United States highlights the changing relations between the governments of China and the United States. As reported in the New York Times, “the opening session laid bare a recurring theme…the United States came with a long wish list for China…while China mostly wants to be left along…” (http://www.nytimes.com/2010/05/25/world/asia/25diplo.html?ref=business)

China is “turning into an economic superpower” according to the Times article and wants to continue along on its merry way. The United States, other than initiating an all out trade war, seems incapable of slowing down the Chinese economic machine or even getting the attention of the Chinese leaders.

Chinese President Hu Jintao did pledge to continue reform of China’s currency, but then repeated the standard operating response: “China will continue to steadily push forward reform of the renminbi exchange-rate formation mechanism in a self-initiated, controllable and gradual manner.” That is, we will change things when we want to change things and no sooner.

Secretary of the Treasury Geithner graciously replied: “We welcome the fact that China’s leaders have recognized that reform of the exchange rate is an important part of their broader reform agenda.” What else could he say?

The United States, and most of the rest of the west, is in a weakened state. But, this weakened state goes beyond the short-run. The United States is facing longer run, structural problems it must deal with. Economic growth and financial strength are important factors in world economic power. However, when a nation extends itself and stretches itself too far due to over-commitment and over-leverage, thinking it can do too much, it exposes itself to other nations that are not in a similar position.

It is the United States, the number one world power that is asking China to change. China is in a position where it does not feel the need to cave into the American requests. China is strong and disciplined. The United States is strong, but undisciplined. Therein lies the difference.

And, the (supposed) allies of the United States are little or no help. Europe is attempting to resolve the problems it created for itself. As a consequence it is slowly fading into the background. The G-7 group of nations, the United States, Canada, France, Germany, Italy, Japan, and England, is losing relevance in the world. The G-20 includes the seven, but more importantly includes several emerging nations that are more strategic to the future than is the “old boyz club” from Europe.

De-emphasize the G-7 and raise up the G-20!

The ultimate problem of the United States is its lack of discipline. For the past fifty years or so, the United States has lived for “the short-run” because, we have been told, that “in the long-run we are all dead.” The economic policy of the United States has been designed to combat short-run increases in unemployment with a constant pressure to achieve high rates of economic growth. But, this creates an inflationary bias in economic policy. Because of this the United States has seen the purchasing power of its dollar drop 85% from January 1961 until the present time, underemployment has grown to about 20% of the working age population and the capacity utilization of its industrial base has declined to less than 75% at present (but rose to only slightly more than 80% in its most recent cyclical peak).

These are not signs of economic strength. Furthermore, the value of the dollar over the past forty years has dropped by approximately 35%. Huge amounts of United States debt, both public and private, have been financed “off shore”. These developments do not put America in a very strong bargaining position.

China thinks in decades. The United States thinks in terms of the next election. Discipline does matter.

There are still many economists in the United States who argue that the government must spend more and create more debt to get the country going once again. Their fundamentalist view of how the world works blinds them to the fact that it was the loss of fiscal discipline, the exorbitant creation of huge amounts of government debt and the subsequent credit inflation that this encouraged, that put the United States into the position it now finds itself.

More spending and more debt are not going to make the situation any better. I examined this issue in my May 13 post “Government Deficits and Economic Activity”: http://seekingalpha.com/article/204948-government-deficits-and-economic-activity. My basic conclusion was that in the present situation where the Federal Reserve has pumped so much liquidity into the banks that big banks and big companies can play games in world financial markets and cause major problems for areas like the euro-zone. The continued creation of deficits and more government debt is not going to solve this problem for Europe…or the United States.

Until it gets it act under control and in order, the United States will be the one asking China to change the way it does things. China, given the present circumstances, will continue to do things in their own interest and at their own speed. In addition, it is my guess that other, emerging nations will begin to exert themselves in similar ways. And, the United States will not be in a position to resist their efforts.

As I said earlier, “The world has changed and we in the United States have not accepted that fact.”

All we can really control is ourselves and if we fail to do that we give up the chance to influence others.

Goldman Had A Perfect Quarter

This may sound like a ridiculous headline, but it appeared in the Wall Street Journal today. (See http://online.wsj.com/article/SB20001424052748703880304575236132462861088.html#mod=todays_us_money_and_investing.)
The reason for the headline is that the Goldman Sachs traders made money every day the firm traded in the first quarter of 2010!

The article states: “Traders raked in more than $100 million daily for 35 days and made no less than $25 million daily during the rest of the three-month period, according to the regulatory filing on Monday. The streak was a first for the Wall Street firm, which typically loses funds on at least a handful of days in a given period.”

On that basis Morgan Stanley had a more typical quarter. Morgan Stanley lost as much as $30 million daily on four days during the quarter. The other days, well, they made money far in excess of the losses.

What the government takes away with one hand the government gives back with another.

While the government chastises Goldman and its management and sues it for securities-fraud, the Federal Reserve subsidizes Goldman with super-low interest rates.

During the first quarter of 2010, Goldman could borrow money for up to six months for 20 to 50 basis points. They could lend these funds out for almost 400 basis points, RISK FREE. And the Federal Reserve promised them that these spreads would continue to exist for an “extended period” of time!

Goldman Sachs should send Mr. Bernanke a big basket of fruit accompanying a big “THANK YOU, MR. BERNANKE” card.

Wish I could play this game!

And, now the European Central Bank seems to be getting wise to the game. And, our Federal Reserve system is going to support the ECB through currency swaps!

And, then the figures come in on Fannie and Freddie! And, with all the new spending programs coming from the Obama administration it is hard to take seriously the feeble coins that are tossed to the study of how to get the federal deficit under control. Official forecasts place the federal deficit under $10 trillion for the next ten years. I still believe that deficits will accumulate more toward the $15 trillion to $18trillion range.

The Fed is going to “tighten up” in the face of all this junk? Or, will they pull a “Trichet”. Or, has Jean-Claude Trichet, the Chairman of the ECB, pulled a “Bernanke”?

The problem, as I have written many times before, is that when a nation puts itself into a position like the United States (and many of the European nations and England) finds itself, there are really no good choices to left for it. However, the tendency is that once a nation finds itself in such a hole, they continue to dig deeper as the United States (and the European community) is now doing.

Peter Boone and Simon Johnson write in the Financial Times this morning about “How the euro-zone set off a race to the bottom.” (See http://www.ft.com/cms/s/0/5d666d5a-5c69-11df-93f6-00144feab49a.html.) The EU dug its own hole and now they continue to dig the hole deeper and deeper.

The Euro-zone system “encourages “a race to the bottom”—led by governments in smaller countries, which relax fiscal and credit standards to win re-election.”

I would add that this claim could be leveled against the United States and Great Britain just as well as they raced to provide more and more social services and housing to the electorate in order to get re-elected and justified borrowing massive amounts of money, both domestically and internationally, through Keynesian arguments that there was an infinite supply of funds available to governments.

The governmental emphasis on generating huge deficits, on financial innovation and creating massive incentives to inflate the amount of credit outstanding, changed the whole environment of finance. And, of course, the very people that created this environment, the various presidential administrations of the past fifty years and their co-conspirators in Congress, now condemn what they have created and sue it. Yet, they also continue to underwrite it through bailouts and subsidies like the monetary policy of the Federal Reserve called “Quantitative Easing.”

All I can say about the quantitative easing is that there must be a very large number of the remaining 8,000 “small” banks in the banking system that are in very serious financial difficulty for the Fed to continue to maintain this policy and subsidize the further growth of the “big” banks!

There are no good decisions left. And, I fear, that the ultimate resolution of this situation, as Boone and Johnson argue, is for these profligate nations to default, “either through repudiations or inflation.”

However, things don’t stop here. What this situation points to is the weakening of the influence of the Western nations, especially that of the United States. Given the current situation, why should China bow to any wishes made to it by the United States government except to those that are particularly in their interest? (See my post, “Why Should China Change?”: http://seekingalpha.com/article/193689-why-should-china-change.) The same applies to India (see a very interesting article in the Financial Times this morning, “India: The Loom of Youth”: http://www.ft.com/cms/s/0/8aefdf1e-5c68-11df-93f6-00144feab49a.html) and Brazil. The United States (and Western Europe) have made these countries relatively more powerful and independent. And, given the current position of the United States (and Western Europe) why should the countries be generous to the dominant power in the world?

The world has changed over the past fifty years and the United States has contributed significantly to its own relative decline. (Watch this played out in future meetings, like that of the G-20.)

And, it has contributed to Goldman being perfect!

Discipline is Needed for Real Economic Performance

There is an interesting article inside the Wall Street Journal this morning comparing the fortunes of Brazil and Argentina. (See “Argentina Falters as Old Rival Rises,” http://online.wsj.com/article/SB125798960525944513.html#mod=todays_us_page_one.) In the article a research paper published in Argentina is quoted: “Since the middle of the last century, Argentina’s economy has endured a notable decline relative to the rest of the region, falling into ‘insignificance in the international context.’”

During this time period the government of Argentina followed a very undisciplined approach to economic policy while it kept itself in power and suppressed dissent. In 2001, Argentina declared the largest sovereign debt default in history. Things have not gotten much better since.

Brazil’s government, on the other hand, after years of self-serving activity started to get its act in order about 15 years ago under the leadership of former President Fernando Henrique Cardoso. Runaway inflation was brought under control and more orthodox and conservative economic policies were put into place. The current president, Luiz Inảcio Lula da Silva, has maintained these policies. (See ”Olympic Accolade Sets Seal on Progress” in Financial Times: http://www.ft.com/cms/s/0/d16a27a6-c8d9-11de-8f9d-00144feabdc0.html.)

The central bank in Brazil is treated as independent and the stability that has been created has brought about lower interest rates and a growing mortgage market that has stimulated a construction boom. An emerging middle class has emerged and has supported the effort to obtain the Olympics and other international initiatives that will lead to a vast expansion of the Brazilian infrastructure in upcoming years.

Over and over again we see examples of the benefits of discipline in economic and financial affairs. We also see that the loss of discipline does nothing but eventually lead the undisciplined into undesirable situations in which all of the alternative options that are available to correct the condition are undesirable. In other words, there are no good choices to get one out of the difficulty in which one finds oneself.

Inflation represents a loss of discipline that always ends up hurting a large number of people. Furthermore, the consequences of inflation can leave a wreckage in which policymakers are left with no good alternative policies to follow. Often, the path of least resistance in such situations is to reflate.

Historically, governments have always excelled in spending more than they could bring in through taxes and other levies. Thus, going into debt is a normal governmental activity. Other than outright default on debt, governments got very good at inflating themselves out of excessive amounts of debt. And, the ability to inflate was helped in the twentieth century by developments in information technology: so governments got better and better at inflating their economies. (See “This Time is Different” by Reinhart and Rogoff: http://seekingalpha.com/article/171610-crisis-in-context-this-time-is-different-eight-centuries-of-financial-folly-by-carmen-m-reinhart-and-kenneth-s-rogoff.)

Philosophically, this bias toward inflation was supported by Keynesian economics as the argument was made that twentieth century governments could not allow wages and prices to fall. (See http://seekingalpha.com/article/167893-john-maynard-keynes-and-international-relations-economic-paths-to-war-and-peace-by-donald-markwell.) (Also see op-ed piece in Wall Street Journal “The Fed’s Woody Allen Policy”: http://online.wsj.com/article/SB10001424052748704402404574529510954803156.html.) So the twentieth century saw not only an improved technology to inflate but also a respected philosophy that supported a government policy that had a bias toward inflation.

The point is that inflation creates an incentive for economic units to grow and to take on greater and greater amounts of risk. This is, of course, because inflation favors debtors versus creditors. It pays individuals and businesses to take on more and more debt. And, this policy is particularly successful, at least in the early stages, when the central bank forces interest rates to stay excessively low.

Risk is minimized because inflation creates a situation of moral hazard by “bailing out” people who take on large amounts of exposure to risk. For example, one rule of thumb that floats around the banking world from time-to-time is that “In a time of inflation, anyone can become a contractor for building houses. One only learns who is bad at it is when inflation slows down or stops.” The idea can be expanded to say that in inflationary times, anyone can appear to be successful. As Citigroup’s CEO Charles O. Prince III blithely stated: “As long as the music is still playing, we are all still dancing…” Risk takes a back seat.

Second, size becomes all important! Since inflation reduces the real value of debt it becomes silly for individuals or businesses not to leverage up. What is it to create $30 of debt for $1 of equity you have? And, why not $35…or, $40? Using such leverage magnifies performance! Using such leverage magnifies bonuses! Using such leverage allows us to reach a size where we become “Too Big to Fail”!

Finally, inflation allows individuals and businesses to forget about producing good quality goods and services and diverts attention to “speculative trading” and “financial games”. Since outsize rewards and bonuses go to areas that prosper during inflationary times, more and more “talent” moves into areas connected with finance or with trading. Less and less emphasis is placed upon production and quality because rising prices contribute more to profits than does improvements in what goods and services are offered. As a consequence, the composition of the nation’s workforce becomes tilted toward finance and the financial industries.

In effect, inflation destroys discipline. And, once discipline is reduced, problems occur and until discipline is renewed the problems just cumulate and re-enforce one another. This happens in families, in businesses, and in governments.

But, as is usual in economics, the consequences associated with destructive incentives are not always easy to identify. (See “Feakonomics” or “Superfreakonomics”: http://seekingalpha.com/article/166993-the-power-of-unintended-consequences-superfreakonomics-by-steven-d-levitt-and-stephen-j-dubner.) It is so much easier to blame executive greed for the troubles we have been experiencing. This explanation covers so much territory: the growth of finance in the economy relative to “productive” jobs; the taking on of more and more leverage; the taking on of more and more risky deals; the emphasis on speculative trading rather than productive producing; and the payment of excessive salaries and bonuses.

In fact, it is often hard to identify the benefits of greater discipline unless examples of that discipline are placed alongside examples of a lack of discipline. This is why the Argentina/Brazil contrast caught my attention.

Such stories, however, cause one to worry about whether the United States will once again be able to regain its economic discipline. The fear is that as long as governmental policies contain an inflationary bias, the solution to the problems caused by this inflationary bias will continue to be re-flation. If this is so, discipline will continue to be lacking in this country, both personally and corporately. Maybe it is not so surprising that Brazil won the voting for the Olympics over the United States!

Is Treasury's TARP Debt Already Monetized? Part III

The discussion continues for one more post. I ended the last post with these words:

“The hope is that as the banking system works through its problems, TARP funds will be returned and the mortgage-backed securities will mature or be sold back into the market allowing the balance sheet of the Federal Reserve to contract back to where it was in the summer of 2008. The banking system is apparently holding onto reserves to protect itself and that is why they are really not lending. The idea is that if they don’t need these excess reserves they will return them. This is what the Federal Reserve is planning to happen. Let’s hope that they are correct!”

On this issue, let me point out the post by Jonathan Weil on Bloomberg this morning, “Crisis Won’t End Until Balance Sheets Get Real” (http://www.bloomberg.com/apps/news?pid=20601039&sid=azsX7o.atu7U). After presenting interesting data on the state of commercial bank balance sheets he argues the following:

“Banks and insurers got Congress to browbeat the Financial Accounting Standards Board into making rule changes that will let them plump earnings and regulatory capital. There also was Fed Chairman Ben Bernanke’s line in March about “green shoots,” which sparked a media epidemic of alleged sightings.

For all this, we still have hundreds of financial companies trading as though the worst of their losses are still to come. Just imagine what their prognosis might be if the government hadn’t pulled out all the stops.”

And, then Weil closes:

“Truth is, there’s no way to know if the economy has turned the corner, or if last quarter’s market rally will prove sustainable. Yet when this many banks still have balance sheets that defy belief, it means the industry probably hasn’t re- established trust with the investing public.

Trust, you may recall, is the financial system’s most precious asset. On that score, we still have a long way to go before we can say this banking crisis is over.”

This is the short run problem and it is the one that is going to determine whether or not the Federal Reserve is going to be able to shrink its balance sheet. This has been the point of my last two posts. And why are we facing such uncertainty at this point? Because the Mark-to-Market rule was pulled and because there is not enough openness and transparency in the public financial reporting of financial institutions. If there are going to be regulatory changes in the future, a lot is going to have to be changed as far as the reporting requirements for financial institutions is concerned.

But, this is just the short run problem.

The longer run problem is the projected budget deficits of the Federal government. Even if things work out as the Federal Reserve has planned as far as bank reserves are concerned and Federal Reserve credit retreats back to where it was in August 2008, there is the massive problem facing the country about how prospective government deficits are going to be financed. The bet is that the Fed will finance a substantial portion of the deficits to come. Let the printing presses roll!

The fear? Inflation.

But many say, we are in a severe economic contraction now. The fear should be deflation and not inflation.

The only response to this counter argument is that in the latter half of the 20th century, any nation that has run substantial deficits has, sooner or later, run into problems related to inflation. Monetary authorities are never so independent of their central governments that imprudent fiscal policies are not in one way or another underwritten through some form of monetization. And, since this happens time after time, how can the international investing community sit on the sidelines and do nothing? Yes, the United States is in a severe recession right now, but what are your odds for the monetization of a lot of the Federal debt over the next three years? Over the next five years? Over the next ten years?

Where do you look for such for an indication of market sentiment on this? Look at the value of the United States dollar. The dollar fell by about 15% against major currencies in the latter part of the 1970s as the Carter budget deficits seemed to get out-of-hand. As we know, Paul Volker played the savior there by conducting a very restrictive monetary policy to bring the value of the dollar back in line. However, the Reagan budgets became so severe by 1985 that the value of the dollar began to plummet. In the face of continuing deficits and the realization that this would continue to result in a weak dollar, Volker gave up the reins of the Federal Reserve in August 1987. The dollar did not pick up strength again until fiscal restraint was returned to Washington with the Clinton administration as the value of the dollar rose over 25% from April 1995 until the end of 2000. The massive budget deficits of Bush 43 were translated into another precipitous decline in the value of the dollar which fell by almost 40% between the middle of 2002 to March 2008.

The fiscal policy of a nation does matter to the international investment community!

But, you say, look at all the other major countries having economic problems and their budgets are out of balance as well. Look at England, Germany, Italy, France, and others.

The response to this? This is not the case for many of the major emerging countries of the world, specifically the BRIC countries. Perhaps one leaves Russia out of this, but China, India, and Brazil are going to emerge from this period much stronger relative to the United States than could have been thought even a year ago or so. So is Canada and several other important countries. This world crisis is going to shift world economic power in a way that has not been seen since the shifts in world power that took place in the 1920s and 1930s. And, international investors are realizing this!

Yes, the dollar will still be used as the reserve currency of the world…for a while longer. The Chinese, and the Russians, and the Brazilians, and the Indians all realize this. And, even though they keep talking about establishing a new reserve currency, they seem to back off and say that the dollar cannot be replaced right now. Yet, the Chinese have called for the Group of 8 to talk about a new reserve currency at its upcoming meeting. The issue IS on the table and my guess is that it is not going to go away.

Which brings me back to the deficits. In my mind, the budget deficits of the United States government are out-of-control right now and there is great concern that this administration will not be able to regain control of them in the near future. There is no “reversal” mechanism that is built into these budgets as the Fed has attempted to build in a “reversal” mechanism in its efforts. As a consequence, great pressure will be put on the monetary authorities over the next several years to monetize a substantial portion of the debt that will be created. The history of the past fifty years or so is that the Fed will not be able to avoid the pressure. This is perception that the international investing community will be bringing to the market when it place its bets. This can be translated into higher long term interest rates in the United States and a continuation in the decline in the value of the United States dollar.

The BRICs Are On The Move!

In the midst of the current economic and financial crisis the world is radically changing. Comparisons are constantly being made between the collapse of the global economy that is now being experienced and the collapse the world went through in the 1930s. Whereas most of the discussion has limited itself to the extent of the downturn and the methods being used by policymakers to avoid a repeat of the severity of the earlier depression, I would like to focus on another area in which comparisons can be made. The specific area I would like to focus upon is the relative shifts that are taking place in economic and financial power in the world.

At the start of World War I there was no question that Great Britain was the number one economic and financial power in the world. The 1920s and the 1930s represented a turning point in the economic structure of the world and a change in the location of the center of financial power. The change in economic structure related to the final triumph of the industrial sector over the agricultural sector in the most advanced countries in the world. This movement favored the United States over Europe. The center of financial power in the world shifted from London to the United States. The changes in industrial structure helped to explain parts of the economic dislocations of the Great Depression that were not fully absorbed until World War II. The shift in financial power was not really recognized until after the war.

An important and interesting history of this period can be found in the book “Lords of Finance” by Liaquat Ahamed. I have written a review of this book for Seeking Alpha and this can be found at http://seekingalpha.com/article/121616-financial-collapse-a-lesson-from-the-20s.

I am bringing up this history because I believe there is a similar shift in economic structure and financial power that is going on in the world at the present time. It is important to understand these changes because they are going to influence what is going on in the world for a long time.

Like the 1920s and 1930s there is an economic restructuring going on. To me, the emerging dislocations in the world are related to advances in information technology and the global changes in energy needs. I have no idea how these dislocations are going to work themselves out but there are huge changes coming. The innovation in financial instruments markets over the past forty years or so are the result of the new information technology and the intense study of what are now called “Information Markets” is going to lead to transactions and trading opportunities that have not fully been realized yet. I believe that the collapse of the auto industry is just one part of the mammoth changes that are coming in the area of energy sources and uses.

The other shift that is taking place is in the location of financial power within the global marketplace. Yesterday it was announced that Russia and Brazil will each acquire $10 billion of bonds from the International Monetary Fund (See Brazil, Russia Trade T-Bills for IMF Clout, http://online.wsj.com/article/SB124463884266502011.html). China is planning to purchase $50 billion in IMF bonds and it is said that India will also make a similar purchase. The BRIC countries are on the move!

The reason given for the purchase of the IMF bonds is to increase the clout that these emerging nations have on world economic and financial affairs. The BRIC nations believe that they have earned and therefore deserve to play a bigger role in what is going on globally. Hence, the movements of these countries are not surprising and are not uncoordinated. The leaders of the BRIC nations have been meeting regularly and communicating frequently. Their next group meeting begins June 16 in Russia.

The important thing for the leadership in the United States to realize is that they must take the world into consideration when making decisions relating to U. S. fiscal and monetary policy. I have gotten comments on my recent posts about the dollar that question the need for policy makers to be concerned about the value of the dollar in their decision making. I agree with Paul Volcker that the most important price in a country is the price of its currency. The United States, even more than in the past, will not be able to afford to ignore what the rest of the world is saying about the direction its budget policy and monetary policy are going. All too often in the past, and especially in the past eight years, American leadership has thumbed its nose at world opinion. The rise of the BRICs indicates that this time is over and real attention needs to be paid to what others are saying and doing. Although the United States will continue, in the near term to be the major financial power in the world, the times are changing and will continue to move in the current direction over the next ten to twenty years.

There are two reasons for saying this. First, Brazil, Russia, India, and China are going to continue to become more powerful economically and financially. Whereas there may not be an absolute shift in world power in these areas, there will be a relative shift with the BRIC nations becoming relatively more powerful. This, in my mind, is not going to stop.

Second, some form of international organization is going to evolve that will oversee global financial institutions and financial markets. The IMF is a natural place to look for such leadership. In the past it has not quite lived up to its possibilities. Now, however, it looks as if there is a new focus on the possibilities it presents. The BRIC nations seem to be eying the IMF as a place where they might be able to exert their growing economic and financial clout to attain the recognition and influence they want and believe they deserve. The IMF is certainly not an unwilling recipient of such attention and is actively seeking more funding.

What does all this mean for investors? I would like to focus on just two points related to the financial issues. First, the United States seems headed for a clash with the rest of the world in terms of monetary and fiscal policy. The current and future budget deficits appear to be unsustainable and the Obama administration has not yet presented any credible plans to reduce the amount of debt the government will be creating. In addition, the Federal Reserve has already put so much liquidity into the financial system that Bernanke’s statements about removing the liquidity as the crisis retreats seem less than serious. The added concern is what role the Fed will play in helping the Treasury place all the debt that it must issue. As I have stated before, history has repeatedly shown that this is not a good combination either for keeping interest rates low or for keeping the value of the currency up. Such movements over time will be brought on by the international markets. The only response that will avoid this is to bring the budget under control and take the pressure off the central bank to support the placing of the debt.

The second point refers to the shift in world economic power. If the BRIC countries find that they can work with the IMF, a new power structure will emerge in global finance. Financial and non-financial companies in emerging markets will become much more relevant. Important financial centers will be distributed throughout the world rather than being concentrated in just one or two cities. As with the evolution of the financial power in the 1920s and 1930s, these changes will not take place overnight. What I am suggesting, however, is that we are seeing the beginning of a shift in financial power in the world that will continue to evolve over the next ten to twenty years.

This has important ramifications for the regulation or re-regulation of the United States financial system. As usual, Congress and the Administration are fighting the last war. Right now the policy makers in charge in Washington D. C. are responding to the populist discontent being expressed in the country. Get rid of greed! Regulate salaries and bonuses! Emasculate the role of derivatives! This is not the way to prepare the economic and financial system for the future.

Yes, the world is changing. The economic base of the global economy is shifting and the resulting need to restructure is the reason for the severity of the current recession. Financial power in the world is being re-distributed and this trend is just beginning to show itself. These movements are going to define the conditions for investment in the coming years. It will require new and creative thinking.

BRIC, the Dollar, and U. S. Monetary Policy

Over the past several months I have written regularly that the value of the United States dollar will decline over an extended period of time. The basic argument for this is that over the past forty years or so, any country that has run excessive governmental budget deficits and has not had an independent central bank has seen the value of its currency come under pressure in international financial markets. During this time, country after country has had to regain discipline over its fiscal affairs and see to it that its central bank acted more independently of the government’s budgetary affairs.

The United States has not been immune to this pressure throughout this time period. Of recent note, reference has often been made of the pressure the Clinton administration faced early on that resulted in a fiscal discipline that brought about a surplus in the government’s budget in the latter years of the administration. Of course, that discipline completely disappeared in the Bush 43 years supported by a compliant Federal Reserve System. As a consequence the value of the United States dollar decline in a relatively steady fashion from late 2001 through August 2008.

The rebound in the value of the dollar only came about as the world wide financial crisis created a movement toward United States Treasury securities and credit quality. As this movement has subsided, the dollar has shown some weakness once again.

The bet right now is that given the massive budget deficits projected for the next several years the Obama administration will find itself in the same fiscal stance that the Bush 43 administration was. But, even worse, the Federal Reserve has already liquefied the financial system and now seems to be in a position where it has to provide even more liquidity to banks in order to assist the placement of all the new governmental debt coming to market.

As almost everyone knows the Federal Reserve has more than doubled the size of its balance sheet since the first week in September last year going from about $880 billion in assets to around $2,060 billion on June 3, 2009. Total reserves in the banking system have increased by roughly 1,900% since then and excess reserve in the banking system recently have averaged slightly below the size of the whole Federal Reserve balance sheet in that first week of September last year (up from just $2 billion then). The ominous change, however, is that recently the Fed’s holdings of U. S. Treasury securities has begun to rise once again as the Fed has given more support for the bond market. The increase in the Fed’s portfolio of Treasury securities was almost $46 billion from Wednesday May 6 to Wednesday June 3.

So, the Fed has supplied a tremendous amount of liquidity to the banking system that is just sitting out there waiting to see what further solvency shocks it will have to face. (See my post of June 4, 2009, http://maseportfolio.blogspot.com/.) Even though Chairman Bernanke has promised that the liquidity will be removed from the financial system once the need for it goes away, it is hard to see how all these funds will be taken away in a reasonable period of time. Furthermore, if the Federal Reserve is under pressure to support the forthcoming supply of new Treasury issues it is hard to see how it can both reduce its balance sheet while at the same time provide support to the bond market: especially if it has already started with this support.

It, therefore, seems as if there is some justification for participants in international financial markets to be concerned about a further decline in the value of the United States dollar. The scenario unfolding in the United States has all the components to it that international markets reacted against in the past forty years or so. And, the promises of the Obama administration to bring the federal budget under control with savings resulting from the, as-yet, unknown health care program appear to be grossly optimistic, at best.

There is another factor looming on the horizon that has not been present in earlier discussions about the value of the dollar. Over the past forty years or so there never has been a question raised about the role that the United States dollar plays in the international financial system. Over the past six months this topic, something that was unthinkable before, has been raised by the leaders of several countries.

In my estimation we are a long way from de-throning the United States dollar from its lofty position. However, one must take into consideration the fact that this idea is even being seriously floated in the world today. This points up the fact that the fiscal and monetary position of the United States government is being questioned and this only provides additional evidence of the weakness of the dollar in world markets.

The primary concern is being expressed by the BRIC countries, Brazil, Russia, India, and China. These are the countries that are closing the economic gap between themselves and the United States. Not that the United States will lose its Number One position as an economic power: just that these countries are coming on fast to reduce the difference. And, as these nations become more powerful relative to the United States, more and more attention is going to have to be paid to their economic and financial issues and concerns.

The BRIC countries are in a bind right now and the tension is only going to grow. These countries tend to be exporting countries and therefore must accumulate foreign exchange. The United States dollar has been the currency of choice in the past. Now, however, their large dollar holdings are “at risk” because a decline in the value of the dollar will only hurt them. As a consequence they have kept the dollar from falling further than it would have otherwise by buying large amounts of U. S. dollars. In May, the BRIC countries increased foreign reserves by more that $60 billion in an effort keep the dollar from falling further than it did. In fact, these nations are adding to their dollar reserves at their fasted pace ever.

Yet, at present, there is no alternative for them to chose. One analyst has stated that discontent with the dollar is increasing, yet nobody knows what needs to be done. Hence, the frustration with the situation has been expressed by leaders from Russia, China, and Brazil. This feeling has risen to the surface in Germany where last week German Chancellor Angela Merkel verbally took on the central banks of the United States and England for their loose monetary policies.

This is a situation that is only going to get worse before it gets any better. One can talk all they want to about the possibility of inflation and when or if inflation is actually a fear that should be present in the United States at this time. The problem is that the correlation between excessively large governmental budget deficits and loose monetary policy is too high for participants in international financial markets to ignore. Furthermore, the power of the BRIC countries is growing and their needs and desires are going to have to be accounted for. And, within these latter countries there is the stunning rise of China. Given all the economic and financial turmoil in the world, China is probably going to achieve a more prominent world role even faster than anyone expected.

The world has indeed changed. Whereas the United States has not given enough attention over the last forty years to the value of the dollar in international financial markets, it is going to have to do so going forward. The Obama administration cannot afford to casually claim to want a strong dollar and then ignore the fact that it continually declined in value the way Bush 43 did. The rest of the world will not allow this to happen.