"There is no means of avoiding a final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion or later as a final and total catastrophe of the currency system involved."
- Ludwig von Mises

Sunday, October 31, 2010

Rebalancing Global Trade Before The Whole Thing Topples Into Currency Collapse and War

In a prior post I described the developments that ocurred in the latest G20 Meeting of the Finance Ministers.  The final topic covered by the G20 was the suggestion put forth by US Treasury Secretary Timothy Geithner that nations adopt "caps" on severe trade imbalances, i.e. to limit extreme trade surpluses and deficits.

The suggestion went somewhat like this:  Consistent trade imbalances are unsustainable and need to be adressed.  A 4% amount of GDP should be used as a ceiling (or floor) for judging trade imblances.  Sounds novel, I have to agree.  However, who exactly measures GDP?  Why is GDP always revised?  Does anyone really believe most nations' GDP figures?  What I'm getting at is the obvious opportunity that exists to game the system.  Nonetheless, this suggestion has been debated extensivley since last weekend.  Even China is no longer ruling it out.

But before we continue, shouldn't we examine WHY trade imblances have gotten so lopsided?   Policymakers all too often accept the current monetary system as a given of sorts in their analysis, and look elsewhere for the "design flaws" of the current system.  They never question the fiat system we have, they just address what they deem as design flaws and unsuccessfully try to add more layers of global regulation, money printing, and taxes to a system that can never act like historical money.  What is historical money?  Gold.

Here is an excellent description by economist Michael Hudson of how trade used to be conducted prior to 1971, and why the system collapsed, emphasis mine:

This crisis provides an opportunity – indeed, a need – to step back and review the longue durée of international financial evolution to see where past trends are leading and what paths need to be re-tracked. For many centuries prior to 1971, nations settled their balance of payments in gold or silver. This “money of the world,” as Sir James Steuart called gold in 1767, formed the basis of domestic currency as well. Until 1971 each U.S. Federal Reserve note was backed 25 per cent by gold, valued at $35 an ounce. Countries had to obtain gold by running trade and payments surpluses in order to increase their money supply to facilitate general economic expansion. And when they ran trade deficits or undertook military campaigns, central banks restricted the supply of domestic credit to raise interest rates and attract foreign financial inflows.

As long as this behavioral condition remained in place, the international financial system operated fairly smoothly under checks and balances, albeit under “stop-go” policies when business expansions led to trade and payments deficits. Countries running such deficits raised their interest rates to attract foreign capital, while slashing government spending, raising taxes on consumers and slowing the domestic economy so as to reduce the purchase of imports.

What destabilized this system was war spending. War-related transactions spanning World Wars I and II enabled the United States to accumulate some 80 per cent of the world’s monetary gold by 1950. This made the dollar a virtual proxy for gold. But after the Korean War broke out, U.S. overseas military spending accounted for the entire payments deficit during the 1950s and ‘60s and early ‘70s. Private-sector trade and investment was exactly in balance.

By August 1971, war spending in Vietnam and other foreign countries forced the United States to suspend gold convertibility of the dollar through sales via the London Gold Pool. But largely by inertia, central banks continued to settle their payments balances in U.S. Treasury securities. After all, there was no other asset in sufficient supply to form the basis for central bank monetary reserves. But replacing gold – a pure asset – with dollar-denominated U.S. Treasury debt transformed the global financial system. It became debt-based, not asset-based. And geopolitically, the Treasury-bill standard made the United States immune from the traditional balance-of-payments and financial constraints, enabling its capital markets to become more highly debt-leveraged and “innovative.” It also enabled the U.S. Government to wage foreign policy and military campaigns without much regard for the balance of payments.

The problem is that the supply of dollar credit has become potentially infinite. The “dollar glut” has grown in proportion to the U.S. payments deficit. Growth in central bank reserves and sovereign-country funds has taken the form of recycling of dollar inflows into new purchases of U.S. Treasury securities – thereby making foreign central banks (and taxpayers) responsible for financing most of the U.S. federal budget deficit. The fact that this deficit is largely military in nature – for purposes that many foreign voters oppose – makes this lock-in particularly galling. So it hardly is surprising that foreign countries are seeking an alternative.

Misthos here.  I'm not saying that we should immediately go to a gold standard and all the world's economic woes will be instantly cured as some Austrian economists suggest.  What I have been saying is that ultimately, a gold standard of sorts will naturally evolve to replace the current system.  Capping trade surpluses and deficits in a debt based fiat world will never be a solution to the current unsustainable system.  There's just too much room for Enron/Wall Street style accounting tricks that are available to nations to game the system.  And they will game it.

To me, Hudson makes two extremely important observations that are often overlooked:

1) "What destabilized this system was war spending."

2) "But replacing gold – a pure asset – with dollar-denominated U.S. Treasury debt transformed the global financial system. It became debt-based, not asset-based."

What makes these two observations so important?  In a world of limited resources and potential unlimited demand, a debt based system naturally favors the nations or economic areas that benefit the most by having reserve currencies that the rest of the world uses.  These nations can export inflation, easily finance resource wars, and disproportionately consume the economic output of other nations without creating a similar amount of economic output.

But this current system we have is unsustainable as well.  There are extreme global wage imbalances that are not "correcting" anytime soon.  Same with cost of  living imbalances.  And  when nations replaced an asset (gold) with someone else's liability (government bonds) as a means to store their trade surplus, they also put at risk the future value of that "wealth storage."  Germany is an EU success, right?  But the periphery countries such as Greece and Italy and Portugal have been consuming Germany's economic output without creating the same amount of wealth.  And in a fiat debt-based world, who really is the success?  

And let's not forget what happened in the 1920s-1930s.  In that time period, the USA was the world's largest manufacturing nation, it was the world's biggest creditor (not debtor) nation, and it was the largest exporter of oil.  Basically, the US was both at the same time the world's China and Saudi Arabia of the 1920s and 1930s, while still having the largest GDP.  And guess what?  With the onset of the Great Depression, it too, was on its knees.  My point is that when global imbalances are severe, when the banking system is essentially insolvent, and when nations address these issues with trade and currency wars, even the "winners" are not immune to economic collapse.

War and Economic policy are political tools that nations use to exert power to disproportionately consume the world's resources.  This will never change.  We now find ourselves at an historic moment where trade and debt imbalances can no longer continue.  When a system is no longer sustainable, it must end, or at least change.  This happened in 1971, when debt-based fiat replaced gold.  And it will happen again soon.

No one wants to face this fact, so the West and Japan will continue to print money and delay addressing their banking systems' issues and their sovereign debt and currency issues until the system can no longer function.  What the G20 is trying to do is to create a "soft landing" of the current system by instituting novel policies and possibly preparing the IMF, along with its currency, the SDR, to become a global bank.

But again, with such disproportionate wage disparities, global trade imbalances, sovereign debt imbalances, and limited resources, will every nation play along to create the circumstances for a "soft landing?"  Is a "peaceful" transition possible? 

If the system breaks apart on its own, all sovereign debts will be suspect.  And by default, not design, gold will once again figure prominently on the balance sheets of sovereigns.  The question is, at what price?

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