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

"Currency Chaos: Where Do We Go From Here?"

I would strongly recommend you read the “Weekend Interview” published in the Wall Street Journal on Saturday. The interview is with Robert Mundell, 1999 Nobel prize-winning economist who teaches at Columbia University. Mundell has been referred to as the “father of the euro.” (http://online.wsj.com/article/SB10001424052748704361504575552481963474898.html?mod=WSJ_Opinion_LEADTop)

Let me just summarize some of the points Mundell makes in the interview because, I believe, that more people should be aware of them.

First, Mundell reflects a bit on history and states that the major event of the post-World War II period was the United States going off the gold standard in 1971 and letting the value of the dollar float. “The price of gold was fixed at $35 an ounce in 1934, but by the time the U. S. got through the Korean War, the Vietnam war, with all the associated secular inflation, the price level had gone up nearly three times.” The U. S. lost more than half its gold stock and had to get off the gold standard.

No one has suggested any system, gold or whatever, to stabilize prices since. And, the “secular inflation” has continued into the 21st century.

Second, the dominance of the United States and the dollar in the world economy, which began in the 1930s, has declined. “”To be fair, America’s position (in the international community) is not nearly as strong now.” But, Mundell doesn’t “think the U. S. has any ideas, they don’t have strong leadership on the international side. There hasn’t been anyone in the administration for a long time who really knows much about the international monetary system.”

Third, it is wrong to think that the world situation revolves around the United States versus China faceoff. “It’s a multilateral issue because the U. S. deficit is a multilateral issue that is connected with the international role of the dollar.” Mundell supports the suggestion of French President Nicolas Sarkozy that discussions should begin on reforming the world monetary system. But, he argues that the Europeans must play a very important part in any discussions because the dollar-euro relationship is so important in world financial markets. “The dollar and the euro together represent about 40% of the world economy.”

Fourth, the world currency system needs to be based on fixed exchange rates and not flexible ones. Mundell believes that almost all of the volatility in foreign exchange markets is “noise, unnecessary uncertainty.” World trade will be better off without having to deal with this “noise” because “it just confuses the ability to evaluate market prices.”

The argument against fixed exchange rates is that, in a world where capital flows freely between nations, a country cannot run an independent economic policy aimed at achieving things like full employment and price stability and still maintain a stable exchange rate. This argument is called “the Trilemma problem” of international economics: you can only achieve two of these goals; capital mobility; fixed exchange rates; and an independent governmental economic policy. (For more on this see my post, http://seekingalpha.com/article/227990-monetary-warfare-can-nations-have-independent-economic-policies.)

What about a country losing the ability to run an independent economic policy?

Mundell is asked the following question: “I suppose the Fed officials would argue that their mandate is to try to achieve stable prices and maximum levels of employments.”

The answer: “Well, it’s stupid. It’s just stupid.”

“The Fed is making a big mistake by ignoring movements in the price of the dollar, movements in the price of gold, in favor of inflation-targeting, which is a bad idea. The Fed has always had the wrong view about the dollar exchange rate; they think the exchange rate doesn’t matter. They don’t say that publically, but that is their view.”

Hence, the fifth point is that monetary and fiscal policy should not be conducted independently of what is going on in the rest of the world. A country, even the United States, cannot continue to inflate its currency without repercussions. The government cannot continuously ignore what is happening to the value of its currency. If a country does ignore what is happening to its exchange rate there will be consequences to pay down the road.

Sixth, “the price of gold is an index of inflationary expectations.” What is it reflecting? Mundell argues that a rise in the price of gold might indicate “that people see huge amounts of debt being accumulated and they expect more money to be pumped out.”

“Look what happened a couple weeks ago: The Fed started to say, we’ve got to print more money, inflate the economy a little bit. The dollar plummeted! (The price of gold rose!) You won’t get a change in the inflation index for months.” But, the decline in the exchange rate and the rise in the price of gold is a “first signal.”

Read the article.

Returning to the Real World

Over the past two weeks, I have done the best I can to help re-stimulate the economy. I got married, I closed on a new house, I hired contractors, and I spent as much as I could. Well maybe I could have spent more.

This morning I returned to the real world. And, what did I see? Gold is right around $1,000 an ounce. The dollar sank to its lowest level in nearly a year. The Chinese, through their sovereign-wealth fund, are looking at investing big bucks in United States real estate, a better longer term investment than putting them in United States Treasury securities.

In this vein, the Wall Street Journal contains a “tongue-in-cheek” letter from the Ministry of Finance in Beijing to “Dear Esteemed Chairman and Savior of the World Economy” in its editorial “Dear Chairman Bernanke” congratulating Chairman Bernanke on his re-appointment at the Chairman of the Board of Governors of the Federal Reserve System (http://online.wsj.com/article/SB10001424052970203440104574401212809493056.html#mod=todays_us_opinion).
And, what about the quantity of United States Treasury securities?

Martin Feldstein has presented a sobering opinion about the future of federal deficits resulting from the proposed health care proposals. (See his “ObamaCare’s Crippling Deficits” in the Wall Street Journal, http://online.wsj.com/article/SB20001424052970203585004574393110640864526.html#mod=todays_us_opinion.) Feldstein quotes the Congressional Budget Office report of March 2009 which estimates that federal deficits “will average 5.2% of GDP over the next decade and will be 5.5% of GDP in 2019.” He adds that “Without the president’s proposals, the budget office forecasts a 2019 deficit of only 2% of GDP.” However, Feldstein argues, “More realistic assumptions would imply a 2019 deficit of more than 8% of GDP and a government debt of more than 100% of GDP.”

And what news do I see about economic activity?

I guess my stimulus efforts are not having much of an effect. Consumers aren’t borrowing, banks aren’t lending, commercial real estate is showing higher and higher levels of vacancies and unemployment has reached 9.7% of Americans looking for a job. Of course, this does not include the discouraged workers that are not seeking a job which indicates that the people without jobs is above 15%. And, today, there was an article in the New York Times about all the fancy mortgage loans granted over the past four or five years that are going to be re-pricing in the next 12 to 36 months, re-pricing at substantially higher payments that individuals and families will not be able to cover given their current income levels.

Americans seem to be de-leveraging. However, the net worth of American households is declining. But, America, the nation, seems to be leveraging up. The dollar is declining and this makes American physical assets cheaper and cheaper to those in the world that possess wealth, that hold United States Treasury securities.

As the dramatic events of the financial crisis recede we return to the story that was developing in 2007 and early 2008. This story evolved out of the massive federal deficits created by the Bush 43 administration and the more than 40% decline in the value of the United States dollar. Earlier in this decade, before the financial collapse, the wealth of the world was being shifted to China, India, and the Middle East. These countries and their sovereign wealth funds were buying more and more physical assets in the United States as their wealth increased and the value of the dollar declined.

On returning to the real world, it seems as if this latent story is still alive and well and will continue into the future as more and more wealth is transferred out of the United States and into the rest of the world.