The Dollar as the Old Maid
John Mauldin
February 26, 2005
Bretton Woods 2, Redux
The Heavy Lifting of Global Rebalancing
The Dollar as the Old Maid
European Sado-Monetarism
Tampa, a Hedge Fund Idea and Golf
This week we continue to look
at the imbalance in global trade and the US trade deficit. What
are the ramifications for the dollar? I am going to weave together
several different lines of thoughts from analysts all over the
world and see if we can see a pattern emerge. While I give a
brief synopsis of last week's letter below, for those interested
you can read the full letter here.
Bretton Woods 2, Redux
As I wrote last week, 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.
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 placed upon each country and especially the US. 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.
The competitive devaluation game that this has spawned is even
more unstable than the original Bretton Woods. Asian countries
are now taking US dollars that are going to be worth less at
some future point than they are today. As I showed last week,
the losses they will experience are not some paper transaction,
costless central bank game. These will be real losses of buying
power and in some countries can mean significant (I mean quite
large in terms of GDP) loss of cash reserves, especially for
some of the smaller Asian economies.
At some point, the game will end. But at what point, and when,
are the key questions? I quoted a paper by Nouriel Roubini and
Brad Setser that suggest the time is close:
"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 [that is, Roubini and Setser] argue that there is
a meaningful risk the Bretton Woods 2 system will unravel before
the end of 2006."
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.
How can we get an understanding of how and why the system might
unravel? I think the best model is to look at game theory. 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.
After showing that the international devaluation game and the
accumulation of massive amounts of US dollar reserves in Asia
is a significant factor in holding down long term US rates, I
go on to the following conclusion:
"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."
The Heavy Lifting of Global Rebalancing
Let's again start with a quote from Stephen Roach (Chief Economist,
Morgan Stanley):
"Global rebalancing does not occur spontaneously. It takes
adjustments in economic policies and asset prices to spark a
meaningful realignment in the mix of global growth. Shifts in
currencies and real interest rates are the two major instruments
of rebalancing. The ideal prescription for today's lopsided US-centric
world would be a combination of dollar weakness and a rise in
US real interest rates. However, there is serious risk that the
Fed will not execute the full-blown normalization of real interest
rates that the US economy requires. If that's the case, then
there will be even greater pressure on currency adjustments to
correct today's imbalances - a development that could take world
financial markets by great surprise."
Next week's Outside the Box (which should come to you Monday
evening) will be a report by GaveKal Research on the meaning
of the announcement by Korea that they intend to diversify their
reserves. The announcement roiled the currency markets and was
accompanied by the usual article in the Korea Times blaming hedge
funds for the rising Korean won [the won - with
the "o" making the same sound as in bond- is the name
of the Korean currency]. Let's take a side trip and look at a
few paragraphs from today's Korea Times:
"The local currency market is turning into one of the most
popular playgrounds for hedge funds, with the won becoming the
main target by the international speculative funds aimed at short-term
gains, analysts said.
"Hedge funds are viewed as the main force behind the won's
steep gains recently, they said. It is concerned that they will
continue to bet on a stronger won, a major negative for the country's
economic recovery.
"Hedge funds were one of the main forces behind the 1997-1998
financial crisis. They usually grow on volatile currency markets."
Notice how hedge funds were one of the main forces behind the
97-98 crisis? Not that Asian countries like Thailand, Indonesia
and Malaysia borrowed more in dollars than they could ever repay
or that massive government fraud and corruption allowed billions
to flow into the private hands of friends of the government or
that the general incompetence of the government and central banks
might have been a problem or that Russia defaulted on its debt.
No, the bad guys are investors in the form of hedge funds that
recognized that there was an investment opportunity top shorting
bad governments.
Back then, hedge funds shorted the local currencies. Now, they
are shorting the dollar and buying the Korean won. They are saying
that the won is a stronger currency than the dollar. This of
course has Korean authorities upset as they want to keep their
currency weak while they sell their dollar holdings.
In essence, the Korean government would like to sell all the
dollars they intend to sell before the dollar goes down. Ever
had a stock go down before you could sell it? The Korean complaint
is somewhat like blaming your losses on all the others who sold
the stock you wanted to sell before you could get your own sell
order in.
The Dollar as the Old Maid
Remember the card game we played as a kid called Old Maid? You
can take a standard deck of cards and remove one queen. The dealer
then deals out all the cards to the players. The players all
look at their cards and discard any pairs they have (a pair is
two cards of equal rank, such as two sevens or two kings).
Then the fun begins. At your turn you must offer your cards spread
face down to the player to your left. That player selects a card
from your hand without seeing it, and adds it to her hand. If
it makes a pair in her hand she discards the pair. The player
who just took a card then offers her hand to the next player
to her left, and so on.
If you get rid of all your cards you are safe - the turn passes
to the next player and you take no further part. Eventually all
the cards will have been discarded except one queen (the Old
Maid) and the holder of this queen loses.
Korea wants to diversify its holding of dollars in its reserves.
How does it do this? It sells the dollar and buys Japanese yen
or Taiwanese yuan or Thai baht or euros or any of a number of
currencies. Now, of course, someone else has those dollars. If
other countries also want to diversify, they start selling their
dollars and buying other currencies.
The dollar could get traded from Korea to Taiwan to Singapore
to Malaysia. Now, as long as these countries want to keep their
currencies weak against the dollar, and are willing to take the
loss as the dollar drops, this process works just fine. But what
happens when two or three or four countries start to diversify
out of dollars? Who gets the Old Maid?
Now I don't think the Korean central bank is completely inept.
They made the "announcement" because their books would
show that is what they are doing in any event. And you can bet
they are watching other countries buy the won in an effort to
diversify their holdings.
Hedge funds are convenient scapegoats for a process that is going
to happen. Korea is acting just like a hedge fund when they start
selling dollars which they think are going down and buy baht
or yen or euros. Its just that hedge funds are so convenient
when governments want to whine and try to avoid people looking
at what they are doing.
If they wanted to weaken their currency, they could do what the
Japanese do. The Japanese simply print more yen. Or they could
do what the Chinese or do - they could fix their currency to
the dollar. Of course, this would hurt the Korean consumer and
make their imports more expensive.
Not to pick on the Koreans, but this dilemma is facing all of
Asia. When do you start the diversification process? How much
of a loss do you take? This interesting note came in today from
my friend Dennis Gartman in his daily letter:
"Finally, while discussing the US dollar, we thought it
interesting to note comments from Mr. Pierre Lassonde, the President
of Newmont Mining. Mr. Lassonde has been steadfastly bearish
of the US dollar for quite some long while and has been correct,
so we give his views some larger credence than we might otherwise
give that past performance. He believes strongly that the dollar
has much further to fall. With private capital flows insufficient
to fund the US' current account deficit, and now with the additional
loss of foreign central banks as suggested by the statements
much earlier this week by the S. Korean central bank, Mr. Lassonde
speaks now of a literal run on the dollar.
"Following S. Korea's 'lead,' he expects countries like
Malaysia, Thailand and Singapore 'to be the next defectors...
[for] the appetite of foreign central banks for US dollars is
starting to wane.' Interestingly, Mr. Lassonde said that Japan
and China shall be the last countries to continue to support
the dollar, for they have such enormous positions already established
that they've no choice but to hold to their present course of
action and try to defend their positions. If we had to bet, we'd
bet that Malaysia will be next on the list to join S. Korea."
European Sado-Monetarism
But there are other reasons that Japan and China might have to
avoid letting their currencies rise. Anatole Kaletsky of GaveKal
research writes:
"But a generalised Asian revaluation, led by Japan and China,
looks even less likely after this weekend's G7 meeting than it
did before. The Japanese have parried criticisms of their currency
intervention in three ways. Firstly, they have argued that the
Japanese economy is still in a delicate convalescence and has
to be supported with the cheapest real exchange-rate Japan has
enjoyed for 20 years. Secondly, Japan's private investors are
buying dollars and euros so that Japan's efforts to hold down
the yen do not show up as official intervention. Finally, the
absence of Japanese official intervention and the recent weakness
of Japan's economy have deflected attention to China, where the
economy is booming and the control of currency markets is undeniable.
"But China has three arguments of its own for avoiding revaluation.
Firstly, China's economic figures offer no support to the claim
that its currency is undervalued. China's current account surplus
this year will be only $20 billion or 2% of GDP, according to
Zhou Xiaochuan, the Chinese central bank governor, who spoke
alongside Mr Greenspan at last Friday's London conference. This
trivial number suggests that China is not a significant factor
in global trade imbalances. Secondly, China sees no case for
a one-off revaluation. If there is to be a change in regime,
it should be a move towards floating rates. But a floating rate
requires a market-based banking reform and this is still far
from complete.
"Thirdly, a Chinese revaluation would have no perceptible
impact on the US trade imbalance because Chinese wages are so
far below America's that even a 30% or 50% revaluation of the
RMB (Renminbi), would not be enough to send labour intensive
industries back to the US. A stronger RMB would be hugely beneficial
to Vietnam, Indonesia, Thailand and other poor Asian countries
which compete directly with Chinese costs. And it is to help
these smaller Asian economies that China may be persuaded to
shift its currency one day. But while a Chinese revaluation might
justify dancing in the streets of Jakarta or Saigon, it would
be as little help to Europe as to the US.
"What, then, could Europe do to protect itself in the face
of a narrowing US deficit, especially with both Japan and China
refusing to budge from their present currency regimes? The obvious
answer would be to stimulate domestic demand by cutting interest
rates and taxes. But the sado-monetarism of the ECB rules this
out.
"A second-best approach, if Europe refuses to compensate
for lower exports to America by stimulating domestic expansion,
would be to try to share the burden of adjustment with another
part of the world. China and Japan may refuse to oblige, but
there is another place where Europe and America could direct
attention and political pressure. Asia's middle-income economies
- Korea, Taiwan, Malaysia, Hong Kong and Singapore - have total
current account surpluses of around $120 billion. On average
these surpluses amount to 7% of GDP, ranging from 3% in Korea
to 7% in Taiwan, 12% in Malaysia and a staggering 22% in Singapore.
These are much bigger surpluses in relation to the size of the
national economies than we see in Japan or China. And, unlike
Japan, (and Singapore) these are still relatively poor countries,
with fairly young populations and large needs for infrastructure
and housing. It makes no sense at all for them to be lending
large parts of their incomes to the richest country in the world.
It would thus be appropriate for these countries' large current
account surpluses to be turned into deficits. Moreover, the economic
and technological advances in Korea, Taiwan and even Malaysia
in recent years, have made these countries direct competitors
to American and European exporters."
China is simply not listening to the US or Europe about the value
of their currency. They will revalue when they are ready and
not one minute before. But expect a lot of pressure on the rest
of Asia, from especially Europe and the US, to gradually allow
their currencies to rise.
Such a move is inevitable, in my opinion. But I am not as persuaded
or as confident as Alan Greenspan. Earlier this month, while
speaking at a conference in Europe, he told the audience that
a flexible economic system could "facilitate adjustment
to a smaller US deficit without significant costs."
Maybe, but I think that Roubini and Setser have more of the sense
of the problem when they write:
"If the US does not take policy steps to reduce its need
for external financing before it exhausts the world's central
banks willingness to keep adding to their dollar reserves - and
if the rest of the world does not take steps to reduce its dependence
on an unsustainable expansion in US domestic demand to support
its own growth -- the risk of a hard landing for the US and global
economy will grow. The basic outlines of a hard landing are easy
to envision: a sharp fall in the value of the US dollar, a rapid
increase in US long-term interest rates and a sharp fall in the
price of a range of risk assets including equities and housing.
The asset price adjustment would lead to a severe slowdown in
the US, and the fall in US imports associated with the US slowdown
and the dollar's fall would lead to a global severe economic
slowdown, if not an outright recession."
The IMF's Managing Director Rodrigo Rata highlighted the problem
last night in a speech to the Foreign Policy Association. It
does not sound like he sees "a smaller US deficit without
significant costs." Quoting from the speech: "Record
levels of debt are now financed by foreign investors and it is
highly unlikely that such easy credit will continue to be available
to the U.S. on the basis of the existing policy path...There
can be little doubt that the pattern of persistent and growing
US current account deficits, and the increase in dollar indebtedness
that they entail, have contributed to the recent renewed depreciation
of the dollar." (Chuck Butler's Pfennig)
Asian countries are going to start to play a new game. Instead
of the competitive devaluation of the last decade, it is now
a game of Old Maid. They all want to remain competitive, but
they do not want to lose money. There is a Nash equilibrium out
there, and they will whine and moan and blame hedge funds along
the way to finding it.
Frankly, I hope Roubini and Setser are wrong in their prediction
that the Bretton Woods 2 accord will collapse within two years.
I hope it takes much longer. I want my pain in slow, moderate
(dare we say measured?) amounts. There is a recession at the
end or maybe even the middle of the process, and we all want
it to be as mild as possible. But that is not the way I would
bet it unfolds.
That is enough for this week. Next week, we will talk about why
I think the trade deficit and currency problems guarantee that
US short term and long term interest rates are going to rise
much more than most observers think today. There are two ways
to reduce the trade deficit. One is to lower the value of the
dollar and thus increase the potential for export. The other
is to reduce the volume of imports. That is partly done by raising
the price of imported products, but it is also done by raising
the costs of borrowing.
The world is going to rebalance, one way or another. You do not
want to be on the wrong end of that process.
Tampa, a Hedge Fund Idea and Golf
I should point out that this all ties in with my view that we
are in a secular bear market for US stocks. The dollar problems
will initially be part of the catalyst for the next bear cycle,
but at the end things will look so cheap in the US that the cycle
will reverse.
You should have an understanding of secular market cycles. One
of the better ways (at least the critics think so) of getting
a handle on these cycles is to read my book, Bull's Eye Investing.
It is even more pertinent now. You can get it at Amazon.
I love Anatole Kaletsky's description of European monetary policy
as sado- monetarism. As he correctly pointed out, the proper
way to deal with their problems would be to cut taxes and government
spending in "Old Europe," but you are not going to
see that. Except in many countries in Europe, you have seen exactly
that. One country after another in "New Europe" is
going to a rather low flat tax. You watch how that is going to
boost their economies over the next decade. I offer this idea
freely, and if someone does it, let me
know. Someone should start a hedge fund that only invests in
the stocks of countries that have a flat tax. You can hedge it
by shorting the stocks of countries with high taxes. Now, of
course you need to be a good stock picker and know the local
markets and all that, but it would certainly offer an excellent
starting point.
We are off to Tampa and Orlando tomorrow, for some client meetings
and a speech. I am going to swing a golf club for the first time
in a long time, although only a wedge and only on a driving range.
My back is slowly improving and it is time to see how much progress
I am making. The hope is that by the middle of April I can actually
play. And since my friend and London partner Niels Jensen of
ARP is going to "force" me to go to meetings in Majorca
at his vacation home for the weekend, it would be a nice time
and place to pick up the sticks again. We'll see.
I am looking forward to be home for the month of March. I am
way behind on a number of projects, and my email inbox (and my
reading) is stacking up. The goal is to get everything back to
"caught up" by the Ides of March.
Your 'running so fast his shadow is way behind' analyst,
John Mauldin
email: John@frontlinethoughts.com
Mauldin Archives
Copyright ©2005
John Mauldin. All Rights Reserved.
Note: 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 their investment counselors
before making any investment decisions. Opinions expressed in
these reports may change without prior notice. John Mauldin and/or
the staff at Thoughts from the Frontline may or may not have investments
in any funds cited above. Mauldin can be reached at 800-829-7273.
MWA is also a Commodity Pool Operator (CPO) and a Commodity Trading
Advisor (CTA) registered with the CFTC, as well as an Introducing
Broker (IB). John Mauldin is a registered representative of Millennium
Wave Securities, LLC, (MWS) an NASD registered broker-dealer.
Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Funds
recommended by Mauldin may pay a portion of their fees to Altegris
Investments who will share 1/3 of those fees with MWS and thus
to Mauldin. For more information please see "How does it
work" at www.accreditedinvestor.ws. This website and any
views expressed herein are provided for information purposes only
and should not be construed in any way as an offer, an endorsement
or inducement to invest with any CTA, fund or program mentioned.
Before seeking any advisor's services or making an investment
in a fund, investors must read and examine thoroughly the respective
disclosure document or offering memorandum. Please read the information
under the tab "Hedge Funds:
Risks"
for further risks associated with hedge funds.
Recent Gold/Silver/$$$ essays at 321gold:
Nov 24 Gold: New Highs Or A Lows Retest? captainewave 321gold
Nov 22 Gold Mid-Tiers' Q3'24 Fundamentals Adam Hamilton 321gold
Nov 22 Gold Stocks: Rocket Launches In Play Morris Hubbartt 321gold
Nov 22 Sequential 9 Buy Setups in GLD and SLV Ross Clark 321gold
Nov 20 This past week in gold Jack Chan 321gold
Nov 19 Stk Mkt Concerns & Key Tactics For Gold Stewart Thomson 321gold
|
_______________
321gold Inc
|
