Bretton Woods, Part Two
John Mauldin
February 19, 2005
A Beautiful Equilibrium
Staying Vigilant Against Complacency
Things Fall Apart; the Center Cannot Hold
Stability Breeds Instability
Why Long Term Rates Are So Low
Connecticut, Florida and Guacamole
"Another G-7 meeting has
come and gone. And what has been accomplished? Next to nothing,
in my view. The club of the world's wealthiest nations has punted
on the big issues facing the global economy - namely, unprecedented
current-account imbalances, currency misalignments, mounting
trade tensions, and the liquidity- prone biases of central banks.
The G-7's latest communique is emblematic of the increasingly
vacuous rhetoric of globalization. This is a perilous course
of inaction for a global economy beset with record imbalances."
(Stephen Roach, Chief Economist, Morgan Stanley).
In his talks to Congress this week, Chairman Greenspan dropped
in these words, which did not make the highlight reels, but nonetheless
should be listened to: "People experiencing long periods
of relative stability are prone to excess. We must thus remain
vigilant against complacency."
The record imbalances which Roach alluded to are inherently unstable.
They are the proverbial unsustainable trend. Yet things seem
to be rocking along just fine. One of America's finest theoretical
economists, Hyman Minsky, gave us this great quote, "Stability
is unstable." What he meant by that is that the longer things
remain the same, the more we expect them to remain the same and
the more complacent we get. Thus, when things actually do change,
the shock is much greater. Few have "remained vigilant."
The long-term stability of trends is the seedbed for asset and
credit bubbles of all types.
This week, we begin a multi-part series on that most unsustainable
of all trends, the US trade balance. While the game can go on
for much longer than reason would dictate, there will be an end
to it. Will it be the soft landing with nations agreeing to work
together to find a sort of Nash equilibrium; or, the hard landing
where the "vacuous rhetoric of globalization" masks
the reality of each nation going its own way, in a kind of "devil
take the hindmost" world?
A Beautiful Equilibrium
In game theory, the Nash equilibrium (named after
John Nash) is a kind of optimal strategy for games involving
two or more players, whereby the players reach an outcome to
mutual advantage. If there is a set of strategies for a game
with the property that no player can benefit by changing his
strategy while (if) the other players keep their strategies unchanged,
then that set of strategies and the corresponding payoffs constitute
a Nash equilibrium. John Nash, the Nobel laureate in mathematics
was featured in the movie "A Beautiful Mind." (Highly
recommended, by the way.)
The US is living, many say, on the kindness of strangers. If
it were not for the willingness of Chinese and Japanese central
banks, along with their smaller Asian counterparts, to finance
our trade deficit, we would be in perilous circumstances. If
Asian currencies saw the dollar fall by 33%, they stand to lose
over $600 billion in buying power due to their massive $1.8 trillion
US dollar reserves. That is a massive amount of confidence.
Yet it works both ways. Exports to the US alone accounted for
about 12% of China's GDP, and that was up from 9% in 2000. At
current growth rates, US imports could be responsible for 20%
of China's GDP by 2008. It may be that China is depending upon
the kindness of strangers, in this case US consumers. Other Asian
countries have similar, if not as dramatic, dependence upon US
consumers. And many of them ship materials to China which eventually
find their way to the US.
The elephant in the world economic room is the now $660 billion
US current account deficit. At least $465 billion of that comes
from foreign central banks. It is an odd Nash equilibrium. They
take our paper, which they know will one day be worth less than
it is today, in order to be able to sell us products which keeps
factories growing. How long can the game continue? In the case
of China, it may continue until the have established their own
internal equilibrium of jobs for the hundreds of millions of
peasants moving from the farms looking for a better life.
It is not a matter of things staying the same. There is in fact
no Nash equilibrium into which the world has settled. We are
still "playing the game" and some players may be opting
to take advantage of others. The system itself is inherently
unstable, as we will see. And if you have trouble understanding
how the game is played, then take comfort in the fact that a
US Senator, whose staff at least should know better, clearly
does not understand the basics of how the economy works. I quote
this from good friend Dennis Gartman:
"Secondly, we are now firmly convinced that Sen. 'Debbie'
Stabenow (D-Michigan) is an utter and complete idiot. Why mince
words, for clarity is what we are after here, and in her questioning
of Mr. Greenspan yesterday Sen. Stabenow removed any and all
possibilities that she is not an idiot. Taking a page from the
manners of H. Ross Perot and waving a piece of paper upon which
one of her staff had obviously listed the foreign buyers of US
treasury securities, Sen. Stabenow roared before the television
audience and wondered aloud what Mr. Greenspan was going to do
about this problem!
"Sen. Stabenow was indignant that so many 'foreigners' owned
US treasury securities, and she hoped that Mr. Greenspan would
somehow come to his sense and prohibit them from doing so in
the future... or at least expose this as a problem that must
needs be addressed immediately.
"Mr. Greenspan, visibly torn between laughing aloud at the
Senator's idiocy and between disdain, but summoning up all of
the will power necessary to answer her properly, said that he
knew of no laws that these 'foreigners' had broken; that he knew
of nothing he could do to stop them from making investments that
they thought were well advised and reasonable; that without their
purchases US interest rates might well have been a good deal
higher than they are, and that there seems to be no movement
on their part to create an untoward market circumstance by selling
those securities presently. The only comment he missed making
and one we wish he had made is that their purchases are a huge
'vote of confidence' in the US economy, not an indictment of
same. Sen. Stabenow proved the wisdom of the old aphorism that
it is far better to remain silent and thought of as an idiot
than to say something and remove all doubts. In her case, there
were few doubts before her appearance; now there are none."
As a prelude to a paper we are going to examine in detail in
the next few weeks, there is reason to believe that long term
interest rates might be at least 1% higher and perhaps as much
as 2% without foreign buying of US government debt. 10 year treasuries
at 6% would mean that 30-year mortgages would be well over 7%.
That would create quite a slowdown in housing construction and
at least put a lid on the rise in home values, if not reverse
the trend. That would certainly slow the economy down.
While it is doubtful the Senator would wish for such an economic
slowdown, this illustrates that there are consequences for individual
investors to the "international trade game" that we
will be discussing. It is not played in a vacuum.
Staying Vigilant Against Complacency
What I want to do over the next few weeks is to show you
why Greenspan is right. You must remain vigilant against complacency.
The last "Big Thing" to come upon the world was the
bursting of the stock market bubble in 2000-2002. There was a
new paradigm. The next Big Thing is likely to be the fallout
from the rebalancing of global trade. You do NOT want to be on
the wrong side of that trade. The good news is that we will muddle
through. It is not the end of the world. However, the transition
will not be fun. It will affect your bonds, your stocks, your
home values and maybe your job. Assuming that tomorrow will be
like today is a complacency that you cannot afford.
To start us off, I want to quote a few paragraphs about what
Hyman Minsky wrote about financial balance.
"...Minsky characterized the financial balance along a scale
of running from 'fragile' to robust.' 'Fragile finance' refers
to states in which cash commitments are relatively heavy compared
to cash flows, so that there is some danger of widespread failure
to meet commitments, failure that might cause general breakdown
in coherence. 'Robust finance' refers to states in which commitments
are relatively light compared to cash flows, so that the danger
of incoherence is relatively remote. The emphasis on the threat
of incoherence is one way of reading the scale.
"Viewed more positively, what is so appealing about a
state of 'robust finance' is that it leaves open many different
possible future paths for subsequent social freedom. What is
so tragic about a state of 'fragile finance' is that previous
commitments leave open only very few possibilities for the future,
and maybe no possibilities at all that are consistent with existing
commitments. Fragile finance is a state of social constraint.
The degree of fragility or robustness in the economy as a whole
ultimately depends on the fragility or robustness of financing
arrangements at the level of the constituent economic units."
(Perry Mehrling, The Vision of Hyman P. Minsky, 1998)
Or put more simply, if you have cash, you have more options.
It would seem that the United States has fewer options, as we
are the borrower, not the lender. But that is not entirely the
case. While Europe does not feel the need to build up dollar
reserves, thus lowering the values of their currency and financing
our trade deficit, clearly Asia does. While they may have "cash."
They also have "existing commitments," as Minsky put
it, to support export growth as a way to increase employment
and improve their national well-being.
What would happen, do you think, if China were to see their exports
to the US decrease? What about all the spare capacity and who
would use it? What about the bank loans made that are predicated
on the kindness of US consumers being willing to forego savings
and purchase Chinese goods? What about the expectations of the
masses of poor who are looking for jobs, not to mention the loss
of jobs from those currently employed? The Chinese must feel
an existing commitment to be willing to take dollars that they
surely must know will not be worth as much in the future.
Things Fall Apart; the Center Cannot Hold
"Things fall apart; the center cannot hold; mere anarchy
is loosed upon the world, the blood-dimmed tide is loosed, and
everywhere the ceremony of innocence is drowned." -William
Butler Yeats
Yeats was
not describing what has come to be called Bretton Woods 2, but
it seems apropos to start with that quote. The first Bretton
Woods system came about when representatives of most of the world's
leading nations met at Bretton Woods, New Hampshire, in 1944
to create a new international monetary system. Because the US
at the time accounted for over half of the world's manufacturing
capacity and held most of the world's gold, the leaders decided
to tie world currencies to the dollar, which, in turn, they agreed
should be convertible into gold at $35 per ounce.
Under the Bretton Woods system, central banks of countries other
than the US were given the task of maintaining fixed exchange
rates between their currencies and the dollar. They did this
by intervening in foreign exchange markets. If a country's currency
was too high relative to the dollar, its central bank would sell
its currency in exchange for dollars, driving down the value
of its currency. Conversely, if the value of a country's money
was too low, the country would buy its own currency, thereby
driving up the price.
The dollar became the world's reserve currency. Yet there were
limits. Each country had to police its own reserves and currency
or be forced to revalue. And the US was constrained because the
dollar was fully convertible into gold. This changed in 1971
when Nixon closed the gold window.
Now we have what many are coming to call a Bretton Woods 2 system.
That is where much of the world, but primarily the Asian countries,
have more or less informally agreed to peg their currencies to
the dollar. They do this in order to maintain their relative
competitive ability to sell their products to the world and specifically
to the US.
But this system is inherently more unstable than the first Bretton
Woods. There is no gold conversion constraint upon the reserve
currency. The US has few reasons to protect the value of the
currency, and many reasons why they should want it to drop. And
there is no formal agreement among the nations. Any nation at
any time could begin to act unilaterally to change. Russia has
specifically said they would start to have a larger euro component
to their growing national reserves. Thailand has said the same,
and indications are that they are putting actions behind their
words.
For the rest of today's letter, and probably much of next week's,
we are going to look at a rather remarkable paper called: "Will
the Bretton Woods 2 Regime Unravel Soon? The Risk of a Hard Landing
in 2005-2006" It is by Nouriel Roubini of the Stern School
of Business at New York University and Brad Setser, Research
Associate Global Economic Governance Programme at University
College, Oxford University. It was done for a symposium held
this month in San Francisco sponsored by the Federal Reserve
Bank of San Francisco and University of California - Berkley.
The symposium was called "Revived Bretton Woods System:
A New Paradigm for Asian Development?"
Let's look at a few paragraphs from the introduction that helps
us get our bearings to the problems that Roubini and Setser want
to point out:
"The defining feature of the global economy right now is
the $660 billion US current account deficit. The world's largest
economy - and the world's preeminent military and geo-strategic
power - is also the world's largest debtor. The current account
surpluses of most other regions of the world are the mirror image
of the US deficit. The US absorbs at least 80% of the savings
that the rest of the world does not invest at home. Barring an
economic slump in the US or a major fall in the dollar, the US
current account deficit looks set to expand significantly in
2005 and 2006.
"The defining feature of the current international financial
and monetary system is that it finances the United States' enormous
external deficit - and the associated fiscal deficit -- at low
interest rates. The world's central banks, not private investors,
provide the bulk of the financing the United States needs to
sustain its deficits.
"...Michael Dooley, David Folkerts-Landau and Peter Garber,
in a series of influential papers, have argued that the nations
of the Pacific have constituted a new Bretton Woods system. In
the original Bretton Woods system, Europe and Japan tied their
currencies to the dollar; today the industrialized - and rapidly
industrializing - Asian economies formally or informally tie
their currencies to the dollar. Dooley, Folkerts-Landau and Garber,
argue that this system of fixed and heavily managed exchange
rates is fundamentally stable, and the intervention required
to prevent Asian currencies from appreciating will continue to
provide the bulk of the financing the US needs to run ongoing
current account deficits.
"For countries on the periphery, the benefits of stable,
weak exchange rates exceed the costs of reserve accumulation.
China relies on rapid export-led growth to absorb surplus labor
of hundreds of millions of low-skill poor workers from its vast
agricultural sector into the modern, industrial and traded sector.
Continued reserve accumulation by Asian - and other - central
banks, in turn, allows the US to continue to rely on domestic
demand to drive its growth, and to run the resulting large current
account deficits. Indeed, the external deficits financed through
a new renminbi-dollar standard are far larger than any deficits
associated with the original gold-dollar
standard or the original Bretton Woods system.
"Initially, Garber, Dooley and Folkerts-Landau suggested
the new system of fixed and quasi-fixed exchange rates would
last a generation, until China's agricultural labor surplus was
absorbed in a new urban industrial sector. More recently, Peter
Garber backed off a bit, but he still maintained that the new
Bretton Woods system would last another eight years. Michael
Mussa has suggested it will not last another four years. We believe
it may have difficulty lasting for another two years.
"...we argue that there is a meaningful risk the Bretton
Woods 2 system will unravel before the end of 2006."
Stability Breeds Instability
They find several sources of instability. Let's look at a
few of them briefly. (I will try to find a web link for the paper
by next week.)
First, as alluded to above, they see a tension between the growing
need for financing by the US and the "large losses that
those lending to the US in dollars are almost certain to incur
as part of the adjustment needed to reduce the US trade deficit."
The world's central banks hold roughly $2.5 trillion of the $3.8
trillion worth of reserves in dollars. Asian central banks have
roughly $1.8 trillion in dollars. If Asian currencies were to
depreciate by 33%, that means Asian central banks would lose
$600 billion, which is not a small sum. And it cannot be dismissed
as merely a paper loss.
Most of the countries "sterilize" their dollar holdings
in order to maintain the relative value of their currency and
maintain control of their money supply and thus inflation. "To
the extent that central banks have to sterilize their reserve
accumulation, their dollar assets are offset by local currency
liabilities that have to be paid. Central banks can always be
recapitalized by taxpayers, but the new government bonds given
to the central bank to make up for exchange rate losses have
to be serviced out of the government's budget. That is a real
cost."
Let's see if I can explain this. A business sells $ billion dollars
worth of widgets to the US. When it comes back to the country,
the business needs local currency to pay suppliers and employees,
so they convert it to the local currency. This increases the
money supply. At some point, that is inflationary, so the local
central banks issues government debt to soak up the excess cash
and try and maintain a stable money supply. That local debt has
to eventually be paid. It is a real cost. If the dollar goes
down, so does the value of its reserves, yet its debt in local
currency has stayed the same. Someone (read taxpayer) has to
make up the local currency losses.
For some smaller economies, these losses can be significant.
As they point out in a footnote: "As Higgins and Klitgaard
(2004) note, reserve holdings of some Asian economies are so
large that the losses for some central banks from even small
moves in their exchange rate as significant: a 10% appreciation
of the Singapore dollar might reduce the local currency value
of Singapore's reserves by 10% of GDP; a 10% move in the Taiwanese
dollar would generate local currency losses of 8% of Taiwan's
GDP." This is just one more reason why central banks would
be reluctant to see the dollar drop.
Of course, that could change. What if Singapore started to move
it reserves out of the dollar and into yen and euros? At some
point, it makes sense to do so. But when? And if one country
starts, do others follow? Is there some new Nash equilibrium
out there?
Why Long Term Rates Are So Low
"Developing a clean test of the impact of central bank
demand on interest rates is hard, and estimates of the impact
vary substantially. Goldman Sachs (2004) has presented an analysis
suggesting that central banks intervention is narrowing Treasury
yields by only 40bps; Sack (2004) provides a similar estimate.13
Truman (2005) notes that sustained intervention from central
banks is similar to a sustained reduction in the fiscal deficit:
his ballpark estimate suggests a $300 billion in central bank
intervention might have a 75 bp impact. Research from Federal
Reserve suggests a 50 to 100 bps impact (see Bernanke, Reinhart
and Sack (2004)); PIMCO's Bill Gross puts it at closer to 100
bps, and Morgan Stanley's Stephen Roach puts it at between 100
and 150 bps."
Since 2000, Roubini and Setser tell us that all of the net new
supply of Treasuries has been bought by non-residents, and that
between 80-90% has been by central banks. One last quote and
then I will wrap up for this week:
"Central bank demand made it easier for the US Treasury
to shorten the maturity of the US debt stock, and thus to reduce
relative supply of long term US Treasuries. By eliminating the
30 year bond and supplying very little of the 10 year bond, the
US reduced the share of ten year and longer Treasuries in the
overall marketable stock from 40% in 2001 to 31% at the end of
fiscal 2004. The overall stock of marketable treasuries went
up by $931 billion in FY 2002-04, but the stock of ten-year notes
and longer-term bonds went up only by $35 billion. Had the share
of longer term Treasuries in stock stayed constant, the increase
would have been closer to $365 billion. Central banks clearly
are not just buying short-dated bills and two and three year
Treasury notes: US data indicates that they have been important
participants in the five and ten year note auctions. Consequently,
the stock of ten-year notes in private US hands has presumably
gone down over the past few years despite the large increase
in the overall Treasury stock. Treasuries of different maturities
are a close substitutes, but the relative scarcity of the ten-year
note and other longer dated Treasuries could nonetheless have
had an impact on its yield.
"Consequently, the 40bp [basis point] Goldman
estimate seriously understates the effects of the Asian intervention
on the market. Considering the size of recent central bank purchases,
the indirect impact of central bank intervention on private demand
for Treasuries, the interaction between central bank reserve
accumulation and Treasury debt management policy and the effects
of Asian reserve accumulation on inflation and growth (general
equilibrium effects), we would bet the overall impact would be
closer to 200bps."
Part of the reason they think the affect is higher is that such
large purchases by foreign central banks distorts the value of
the dollar and inflation, as well as US GDP and trade. These
all have an impact on interest rates, and are usually not taken
into account by those who look at the impact of foreign currency
buying upon US interest rates.
Yes, with a much lower dollar, the trade deficit would be lower.
We would be investing in industry which would make things for
trade, as we would be more competitive. Fewer jobs would go offshore.
But we would also be paying much higher prices for nearly everything.
Inflation would be a problem, or the Fed would be fighting it
with higher interest rates. That means a much slower economy,
and the increase in value in your house? Forget about it.
There are no economic free lunches. There is a trade-off for
everything. I prefer the market to make those decisions, but
we do not have a free market in currencies. It is manipulated
by Asian central banks, and that distortion is going to cause
pain down the road.
The interesting exercise for us is to try and understand how
all the "players" in the game will act. What kind of
odd Nash equilibrium will they settle into? Will they all share
some pain so as to lessen the total amount of pain, or will they
seek to avoid as much personal pain as possible thereby causing
more pain for everyone else? I am not entirely optimistic, given
the current level of the "vacuous rhetoric of globalization."
But one can always hope. It will take more than a few beautiful
minds to work this equilibrium equation out.
But that's enough for this week. There is a lot more to come
the next few weeks on this topic.
And just for fun and a little surprise, next week I will tell
you why the Bush administration and Congressional Republicans
are making the problem worse. It is not a pretty picture.
Connecticut, Florida and Guacamole
Puerto Vallarta was just what the doctor ordered. What a
beautiful place. Sun, margaritas and guacamole. Normally, I come
back a few pounds heavier from eating massive quantities of guacamole
and chips. This trip, we told them to bring us lettuce leaves
instead of chips with the guac. Combined with a lot of fresh
fish, I somehow came back the same weight, but got to eat a lot
of guacamole.
I live in Texas, where there is no shortage of Mexican restaurants
and guacamole. But there is simply no comparison. The Mexican
version is far superior. Perhaps it is the avocado and fresher
ingredients. Yet I can't get Mexican avocadoes, which cost a
fraction of the California version. I wonder why the US government
needs to protect me from Mexican avocadoes? Perhaps, as Gary
North suggested, to help me enjoy paying twice the world price
to protect Florida sugar growers.
I am in Connecticut and New York for the first part of next week,
and then I go to Tampa and Orlando for a series of meetings and
a private speaking engagement. Then I come back home where right
now it looks like I will be home for the entire month of March.
April is looking ugly, because I have to go to London for a course
on English security law and then take a test 8 days later, so
that means the first 13 days I will be in Europe. My partners
there are already planning to move me through a few countries,
but all in all it should be fun. Except for that test. I hate
regulatory exams. I have taken over half a dozen, and always
done quite well, but they do put stress into one's life. And
if I fail this one, I have to go back the next month and try
it again.
Enjoy your week. I will be having brunch with my new daughter-in-law
and some of the kids for her birthday tomorrow morning. Being
with family is always a good way to spend a weekend. Even if
there is no guacamole.
Your 'wishing his mind was more beautiful' analyst,
February 18, 2005
John Mauldin
John@frontlinethoughts.com
 Copyright ©2005 John Mauldin.
All Rights Reserved.
John
Mauldin is president of Millennium Wave Advisors, LLC, a registered
investment advisor. All material presented herein is believed
to be reliable but we cannot attest to its accuracy. Investment
recommendations may change and readers are urged to check with
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Opinions expressed in these reports may change without prior
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