China and Others are Waiting to See How the West Solves Its Problems

“Germany’s continued prosperity has helped fuel growing anger in countries like Greece and Spain against what is increasingly viewed as harsh German domination.  More and more, Germany is cast in the role of villain, whether by protesters in the streets of Athens or by exasperated politicians in the halls at the Group of 20 meetings in Cannes, France.” (http://www.nytimes.com/2011/11/16/world/europe/germanys-success-and-advice-anger-european-partners.html?_r=1&hp)

This quotes reminds me of a quote of Warren Buffet’s: You have to wait until the tide goes out to find out who is wearing a bathing suit and who is not wearing a bathing suit.

During an extended period of credit inflation like the one experienced by the United States, the UK, and Europe over the past fifty years “success” seems to apply to everybody.

An example I have experienced in my years as a bank executive is the area of residential real estate construction.  During this fifty-year period of credit inflation it seemed as if almost everyone and his brother or sister could build houses and become a successful real estate construction executive. 

One found out, however, when the credit inflation stopped who was a good builder and who was just coasting along on the inflationary wave and who really built very good houses. 

And those that just “put up” houses resented the success of the really good builders and gripped about those that continued to prosper when times were not so lush.

We are seeing this shake out in Europe these days as Germany, known for the discipline of its people and the work ethic embedded within the society, continues to prosper with a relatively healthy economy and a strong export component of its Gross Domestic Product. 

“When the tide goes out” there is a higher probability that the hard working and disciplined nation will come out on top.  And, we are seeing that in the case of the eurozone. 

The difficulty in maintaining that discipline and commitment to hard work is that during the period of credit inflation you see other nations getting by with a lot less discipline and a lot less work.  It is very easy during this time period to reflect on the fact that the others are getting by much more cheaply and are still doing pretty well.  And, the move to the “easy side” does not have to come all at once…it is easy to give up a little here and a little there…and slide, incrementally into the opposite pattern.

One can think of the comment by former Citigroup Chairman and CEO “Chuck” Prince who famously said that one must keep dancing as long as the music is playing. 

As long as the period of credit inflation continues, increased risk taking, increased financial leverage, and increased interest rate risk taking pays off.  Financial betting also pays as manufacturing firms, like General Motors and General Electric, reduce their focus on production and increasingly become financial companies.  

Some nations and some corporations do maintain their discipline during these times and although they indulge in the credit inflation game, they control their risk exposure so that once the “dancing” stops, they can maintain their position and continue to prosper.  JPMorganChase is an example of this.  Also, there were a number of manufacturing companies that did not “over indulge” in the financial frenzy created by their governments.  These companies now are sitting on piles of cash, buying back their stock or engaging in a very “ripe” acquisition market. 

During such an extended time, one cannot totally ignore the environment of credit inflation that has been created.  The task is not to be overcome by the exuberance and excesses of the time, and maintain and control the exposure of the nation or corporation to the environment and incentives that has been created by the economic policies of the other governments and corporations.

There is no question that this is a very hard thing to do.  Yet, that is what the ultimate winners do!  Super Bowl champions are invariably built on strong defenses with a good offense.  The winners do not often come from teams that are just built to score a lot of points.  Companies that continually push the edge of financial leverage and risk-taking to gain a few more basis points for their return on equity do not survive over the longer-run.

When the bubble bursts, as it has done now, those that have maintained their discipline throughout the “loose” times are the ones that are usually left to dictate the terms of the future, whether it be the future of nations, or, the future of industries.  And, those that achieve that dominate position are not liked, are resented, and are only grudgingly followed.       

“As the overall health of Germany’s economy and its fiscal position widen the rift with Europe’s poorer periphery, Germans have a ready response.  They say that they already made the structural changes in work-force rules and pension reforms that they are now recommending for the slow-growth countries, and that, by the way, they actually pay their taxes. So if the laggards want Germany’s money, they have to play by German rules.”

This is hard-nose stuff!  And, it seems heartless to those that have to go though the “wrenching” economic changes that are being proposed for the “laggards”.  For, what about those people who were just “unlucky” and were in the wrong spot at the wrong time.  And, what about the “disadvantaged” that had nothing to do with the regime of credit inflation? Just saying that the governments should have been thinking about these people when they went on their credit inflation binge is not very satisfying to these people.

Yet, nations…and corporations…and people…that control their excesses and remain disciplined over time have a better track record than those that don’t.  The loss of control and the loss of discipline seem to come when nations…and corporations…and people…become short-sighted and think that they can continuously maintain short-term gains over the longer-haul. 

But, the philosophy that we should not worry about the longer-haul because “in the long-run we are all dead” is not pragmatic…either for us…or for those coming after us.  The long-run does come about…and we pay…and we may pay a lot…if we have just focused on the “highs” we get from short-term excesses.

The United States, the UK, and Europe are all paying for the excesses of the credit inflation of the past.  The question that remains to be answered is whether or not these excesses will be corrected in the near term.  Others…China…Russia…Brazil…India…and others…are waiting to see what happens.  

"Europe's Plot to take over the World"

There is an interesting article in this morning’s Financial Times (10/6): “Europe’s plot to take over the world” (see http://www.ft.com/cms/s/0/a47079b2-b1e6-11de-a271-00144feab49a.html.) It was interesting to me because it has always seemed to me that the one who controls the writing of the agenda for a meeting is the one that most often ends up controlling the results that come out of the meeting.

And, according to my reading of Gideon Rachman’s comments, this is exactly what Europe is trying to do.

The thrust of Rachman’s argument ties in with my post of October 5 (see “What’s the dollar’s place in the new financial order”: http://seekingalpha.com/article/164848-what-s-the-dollar-s-place-in-the-new-financial-order.) where I discussed the changing nature of the world’s economic and financial relationships as observed in the changes occurring within the G-20 (and the lessening of importance of the G-7) and the jockeying of nations for position within the World Bank and the International Monetary Fund.

Whereas so much attention has been given to the rising strength of the BRIC countries of Brazil, Russia, India, and China, Rachman focuses on the bureaucratic reality of the evolving organizational structure of the G-20 itself. There are three points the author makes that I think are worthy of consideration.

First, Europe dominates the leadership of the G-20. Whereas Brazil, China, India, and the United States are represented by one leader each, the Europeans had eight positions at the conference table: Britain, France, Germany, Italy, Spain, the Netherlands, the president of the European Commission and the president of the European Council. Furthermore, the primary international civil servants at the meeting were Dominique Strass-Kahn, the head of the IMF, Pascal Lamy, the head of the World Trade Organization, and Mario Draghi, the head of the Financial Stability Board and these are all Europeans. The only other civil servant of similar weight was Robert Zoellick, the President of the World Bank, and an American.

Second, the Europeans seem to have a grasp of what is going on in the world than do the other participants at the G-20 conference. Rachman ties this back to the experience of the Europeans at European Union summits. The Europeans seem to be well advanced in the techniques of “bureaucratic paper-shuffling”, a process of introducing issues that they never let go of and which have important political implications in the upcoming years. Rachman argues that the European Union “advanced” from the very start “through small, apparently technical, steps focusing on economic issues.” The method used was to build the union through “the common management of common problems.”

Third, Rachman states that “the kernel of something new has been created. To understand its potential, it is worth going back to the Schuman Declaration of 1950, which started the process of European integration. ‘Europe,’ it said, ‘will not be made all at once, or according to a single plan. It will be built through concrete achievements, which first create a de facto solidarity.’”

The agenda is bigger than forming a G-3, a group of the United States, China and Europe. The world of the future cannot be organized by just these three territorial giants. The world of the future is either going to be integrated in a way that many might conceive of as inconceivable, or, the world is going to collapse into separate blocks with limited international trade and cooperation.

The model for this last scenario is the world at the start of the 20th century. World integration was discussed then for the world was open in the early 1900s in a way that has not been equaled since. Yet, the world conflict taking place in the 1910s split the nations apart leading up to conflicts of the 1920s and 1930s and the second world war that followed.

For the G-20 to help the evolution of the world into something approaching the first scenario the United States is going to have to adjust its attitude. Yes, the United States is still going to be the most powerful nation in the world, both economically and militarily, but it is going to have to change its belief that it can act, either economically or militarily, independently of the rest of the world.

If Rachman is even close to being correct on his view of how the G-20 might evolve, the United States is not going to be able to get away with continually allowing the value of the dollar to decline. The United States cannot have it all! Other countries must adjust their behavior as well (for example, the savings rate in China must fall), but the day is coming when the United States is going to have to accept the consequences of the irresponsible fiscal and monetary policy of the last eight years. And, the current administration cannot continue to add to these policy blunders going forward as they now seem to be doing.

Something new is happening. And, Nicolas Sarkozy and Angela Merkel, and other leaders in Europe are not going to let this opportunity pass them by. They will talk about cooperation with the United States, internationally, but they want the United States to get its shop in order. France, and Germany, and Britain, all went through the economic wringer in the last half of the 20th century as international financial markets took their governments to task for irresponsible fiscal policy and extremely loose monetary policy. They certainly are going to ask for the American government to exhibit a little more discipline going forward.

For people interested in the value of the United States dollar, my view is that the value of the dollar will continue to decline until the United States government stops talking about achieving a strong dollar while running up trillions and trillions of dollars in deficits and actually begins to act to achieve a strong dollar. How long this will take depends upon how much pressure is exerted in organizations like the G-20, the World Bank, the IMF, and elsewhere. This pressure will only continue to grow as the G-20 achieves more influence and these other international organizations are given more and more responsibility to oversee international financial markets. This is not going to happen, however, overnight.

The Changing World Financial Order

The economic and financial order of the world is changing. The Group of 20 met in Pittsburgh last week and clearly showed that it was the international body to contend with rather than the G-7. This past weekend there was the annual meetings of the World Bank and the International Monetary Fund. On Friday, Dominique Strauss-Kahn, who leads the IMF, referred to G-7 as the “late G-7”.

The organizations that deal with world financial and economic issues are broadening their base and becoming more inclusive of nations that are playing a larger and larger role in the world. What is clear, implicitly, if not explicitly, is that the United States is being challenged, not only in terms of its leadership of the world, but also financially in terms of the role that the United States Dollar plays in the world.

The economic leadership of the United States, in pre-conference statements, defended the position of the dollar in the world by “mouthing” their commitment to a strong United States Dollar. Before the weekend meeting, both Mr. Geithner and Mr. Bernanke spoke in support of the dollar: “Top U. S. officials threw their weight behind the dollar Thursday, with the Treasury chief stressing the importance of a strong dollar and the Federal Reserve chief addressing concern about the greenback’s future as a reserve currency.” (Wall Street Journal: http://online.wsj.com/article/SB125440283756156107.html.)

The problem with this is that their assurances were exactly the same as those issued by Treasury Secretaries O’Neill, Snow, and Paulson and that of a Federal Reserve chief with the name of Greenspan. For eight years the Bush (43) administration voiced its support of a strong dollar and the value of the dollar dropped more than 40% against other major currencies!

Geithner, Bernanke, and the Obama administration continue on the defensive as the value of the U. S. Dollar is down both against the Euro by about 11% and against major currencies by about 10% since January 20, 2009.

Given the stance of both the Bush (43) administration and the Obama administration over the past nine years the credibility of U. S. leadership in international circles is not very high.

Although the world community speaks very softly on the issue of the changing nature of international financial and economic cooperation, the talk “off-the-record” is expanding with more call for change surfacing from time-to-time. And, the position of the United States continues to weaken as the government continues to pile up huge deficits which ultimately lead to the further decline in the value of the dollar.

The United States cannot have it both ways. It cannot continue to be fiscally irresponsible and financially powerful.

Another piece of evidence supporting this conclusion is the continuing sale of physical assets in the United States to foreign interests. As the value of the dollar has declined over the past eight years, Sovereign Wealth funds as well as private interests have continued to acquire all or parts of U. S. companies. This move to foreign ownership is not going to cease given the fiscal path the United States is following.

And, it is going to be very difficult and take a good piece of time for the government to change the direction it is heading in. First, the mindset of Washington has to change and there is no evidence that anything of that kind is in the works.

We are in the midst of a major change in how the world is organized. It is not going to happen overnight, but, it is going to happen. The United States will continue to be the most powerful nation in the world, but, its relative position is changing and will continue to change. Furthermore, given these shifts, the United States cannot “get away” with the behavior that it has exhibited in the past. It is going to have to cooperate with others and this includes acting responsibly in terms of its fiscal and monetary policy. Until this happens continue to expect a weak dollar.