"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

Monday, November 1, 2010

Simon Johnson Questions the G20's Influence

Simon Johnson, a Professor of Economics at MIT and former Chief Economist at the IMF has written a rather critical article of the G20 at his his blog The Baseline Scenario

It has always been my view that international cooperation is needed now, just as it was needed, and unfortunately lacking during the 1930s leading to World War II.  I believe that a new global monetary system can only be created in three situations:

1) Global Cooperation: the largest, most economically powerful nations peacefully agree on a new system.  Obviously there will be winners and losers in such a scenario, but the costs of not peacefully agreeing on a new system are much greater, and thus, international cooperation is seen as the best, worthwhile scenario.  However, I can't think think of any historical precedent.  The current IMF/G20 developments in the SDR's greater use and expansion is the closest thing I can come up with.  Yet even this is untested and still in its infancy.

2) A System dictated by a hegemon:  The best modern example here is the Bretton Woods system created in 1944 as WWII drew to a close.  Obviously the USA was the largest, almost unscathed nation to emerge after the war, and so had the greatest say in how the new system would develop.  However, this gold-backed system was once again unilaterally replaced in 1971.  The US's allies were not happy about it, but the cold war was still raging so the USSR, India, and China, for various reasons, were pretty much irrelevant in that transition. 

3) By chaotic default:  What I mean by this is that the existing system deteriorates in such a short period of time, that a system by default emerges - not by cooperation.  The only reserve asset in such a scenario that could possibly emerge, in my opinion, is gold.  In such a breakdown event, the value of sovereign debt becomes suspect and gold "absorbs" whatever value sovereign debts and currencies had under "normal" circumstances.  That is, currencies and debts are denominated in gold, and not gold denominated by currencies.  Basically, a gold standard of sorts emerges.  This is when gold no longer trades as a normal commodity, it's value exceeds all prior traded prices.  For many holders of gold, this is an extremely fortunate scenario.   I don't often share that view.  In such a scenario, if history is any guide, gold confiscation by sovereigns can not be ruled out.  I'm not saying it is unavoidable, I'm just being humble in the face of history.

But enough of my view on how it could play out.  Let's look at what Simon Johnson has to say about the current global institutional body that is handling the global financial system, the G20.  The link to the full post is HERE and it is well worth a read.

A portion of Simon Johnson's article:

Who’s In Charge Here? Not The G20

They [emerging markets] even begin to think about forming the basis for a new monetary arrangement that is less dependent on the dollar – since the 2008 financial crisis, both the Russians and Chinese have spoken in public about this objective, and it is shared in private by most policy-makers outside Europe and the United States.

The “reserve currency” status of the dollar means just that – private and public sector investors around the world hold their rainy-day funds in dollars. Traditionally, at least, this arrangement has been seen as a major economic advantage and source of political power for the United States.

Emerging markets want to discuss moving reserves into a basket of currencies, presumably involving some Chinese renminbi, Indian rupees, Russian rubles and Brazilian reals (the four Rs), among other currencies.

But this is where tension with the second goal enters the picture. Most emerging markets – including those with the four Rs – do not want to allow their currencies to appreciate, and they are also unwilling to take other measures (like cutting fiscal spending) that would be likely to hold back appreciation in some instances (Brazil, in particular, takes this stance). Instead they are imposing capital controls to prevent inflows.

The controls are unlikely to prove fully effective, but they do slow the appreciation for now – and they also send a very clear signal: Foreign investors will be treated at a differential disadvantage when the chips are down.

Ask an Indian executive whether she is thinking about investing in Brazil and the answer is an unequivocal yes. But ask whether she or her policy-making colleague would like to hold reserves in reals and the answer is also quite frank: no, thank you.

Emerging markets will continue to save for a very rainy day (or a bright unspecified future) – in dollars. They intervene to keep their exchange rates relatively depreciated and will try to run current-account surpluses for as long as they can. This behavior pushes down long-term interest rates in the United States, relative to what those would be otherwise.

And – here’s the kicker – very low interest rates in the United States contrast sharply in the minds of yield- and risk-seeking investors with the situation in Brazil, where you are now offered 11 percent interest rates.
In other words, the global credit machine in this part of its cycle takes savings from emerging markets, runs them through the United States, and – at the margin — plows them back into emerging markets. Dollars are bought up through central bank intervention and – you guessed it – funneled back into the United States. The Institute for International Finance, which represents global banks, just revised upward its estimate of capital flows into emerging markets this year.

This is exactly the kind of issue – inherently cross-border and very political – for which a structure like the G-20 is needed. But it will do nothing about these flows for three reasons:

1. The emerging markets want to save in this fashion, thinking they can dodge the consequences.

2. The United States needs to borrow, big time. Our politicians refuse even to think about the first-order causes of our recent fiscal disaster; they would rather just continue to borrow (at least as long as interest rates remain low).

3. The big banks like this approach. Their influence is in no way diminishing, and there is nothing about their recent track record that has diminished their appeal in the eyes of policy-makers (just this week, for example, the I.M.F. appointed a senior Goldman Sachs executive to head its high-profile European Department).

Accommodating emerging markets in global governance structures is appealing; their aspirations are legitimate, and the G7 looks outmoded. The profound instability of global financial structures and the broader “doom cycle” today is not the fault of emerging markets – the blame lies squarely with the United States and Western Europe, which have consistently failed to rein in their global megabanks.  (For an 8-minute primer on the “doom cycle,” if you are not familiar with the concept, try this video.)

The argument that the global savings glut, largely from emerging markets, was a major driver of the 2008-9 crisis is tenuous at best. But there is no question of a dissonance within the current policy goals of emerging markets – and this is not helpful to financial stability moving forward.   Most likely it helps feed – or otherwise becomes central to – the next financial frenzy.  And there is nothing the G-20 can or will do about it.

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