A Stable Disequilibrium
By John Mauldin
May 7, 2005
A Stable Disequilibrium
Divorce, Disequilibrium Style
The Grim Arithmetic of the US Trade Deficit
Is There No End of Instability?
The Breakdown of Bretton Woods 2
Napa Valley and Chicago
This week we look at a speech
given by Paul McCulley (Managing Director at PIMCO funds) at
my recent Accredited Investor Conference in La Jolla. In it he
introduces to us the concept of a stable disequilibrium to describe
the state of affairs in world monetary matters. It made a great
deal of sense to me and I will try and give you the gist of his
thought. For the past few weeks I've been thinking about stable
disequilibrium's throughout history and throughout the world
of today and think the concept offers us an interesting paradigm
through which to view the world.
We look at China and Europe, General Motors and Ford and matters
both small and great through the prism of a stable disequilibrium.
I think it should make for interesting letter, so let's jump
right in.
A Stable Disequilibrium
In the past few months I have written at length about what is
loosely known as Bretton Woods 2. In order to understand the
problems facing the world you must understand Bretton Woods 2.
Let's do a quick review.
"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,
has 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.
I have described the instability in terms of a Nash equilibrium.
Again, in review: 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.")
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 they 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. The one thing
I can be certain of is that things will most definitely not stay
the same. This trend is unsustainable, and so therefore it will
end. 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 now enters McCulley, stage left, providing another way to
look at our "Nash equilibrium" model. Paul looks at
it from the other side of the coin, calling it a stable disequilibrium.
He readily admits that we do not often use those words together,
but it does describe the scenario in which we find ourselves
today.
Divorce, Disequilibrium Style
What is a stable disequilibrium? The easiest (and most colorful)
way to describe it is "that period of time in a marriage
prior to a divorce." As Paul pointed out, 50% of the people
in any given room (except perhaps your local church) understand
instinctively what he means.
With the possible exception of some Hollywood figures, everyone
enters into a marriage relationship with the full intent of it
being stable and long-lasting. Without getting into commentary
on the societal problems of divorce (this is an economics e-letter),
let's look at what happens in a marriage prior to the actual
divorce.
At first, things go along well. Then, one partner does something
that changes the nature of the relationship. Often it is quite
subtle, but something in the fabric of the rapport seems to unravel.
At first, nobody can put their finger on it. Often the man is
totally oblivious. This lack of touch with reality will soon
be pointed out. Probably several times. At this point, the counselor
enters and with a little work and love things work out.
But sometimes they don't. The outward relationship continues
in seeming stability, while the imbalance gets worse and worse.
While the participants may not realize it, close outside observers
can see that the relationship is headed for the divorce courts.
It is just a matter of time.
There are two sides to every story we are told. In divorce there
may be three sides: his story, her story, and the real story.
More often than not, the participants are good people. But over
time their respective agendas seem to change. Quite often they
work hard to keep the marriage together, for the sake of the
kids, religious beliefs or whatever. But deep in their hearts,
they can see things getting worse and recognize that the ultimate
break is coming.
I would add, Paul, that a lot of the disequilibrium is caused
by a codependent relationship. Rather than deal with the problem
upfront, the participants bicker over small issues, while avoiding
their real individual problems.
Such marriages can rightly be described as a stable disequilibrium.
Not yet in the divorce courts, but not entirely comfortable for
the participants and those around them, with tensions mounting
and a break-up ever closer.
Bretton Woods 2 is a stable disequilibrium. We have a number
of dysfunctional parties, all acting in their own self-interest,
participating in a process that must eventually break down. It
is a matter of when, not if.
And as if on cue (and from stage right), into my inbox pops this
latest missive from Martin Barnes (he has asked me not to use
the words frighteningly brilliant to describe him, so I won't)
of Bank Credit Analyst, giving me his own description of the
problem. Let me give you a small portion of his letter:
The Grim Arithmetic of the US
Trade Deficit
• "The escalating
U.S. trade deficit has been due more to strong import growth
than weak exports. Faster growth in exports alone will not significantly
reduce the deficit.
• "The pace of
import penetration should slow, but will not reverse given the
huge cost advantage of Asian producers relative to those in the
U.S.
• "The U.S. trade
surplus on services trade peaked in 1996 as a percent of GDP,
despite the U.S. comparative advantage in many service sectors.
There is scope for services trade to improve, but it will not
be enough to offset the deterioration in goods trade.
• "A reduction
in the U.S. trade deficit will require a much lower dollar and
a retrenchment in domestic demand, events that will be very deflationary
for the global economy.
• "An inevitable
adjustment will be delayed for as long as Asian central banks
are prepared to be the dollar buyers of last resort. When that
ends, markets will force a reduction in the U.S. external deficit.
That will be traumatic for the U.S. economy and markets, but
may not occur for many years.
"The supposedly 'unsustainable' U.S. trade deficit just
keeps getting bigger, reaching a record $730 billion annual rate
in February.1 Investors have not seemed overly concerned about
recent mind-numbingly large deficits, with the dollar's trade-weighted
index actually rising between end-December and end- April. Nevertheless,
trade trends remain extremely troubling because growing deficits
represent a huge drain on growth and will not always be so easy
to finance. An adjustment will be required eventually, and it
will likely be traumatic for the U.S. and global economies and
financial markets.
"Reducing the U.S. trade imbalance will require a combination
of increased U.S. competitiveness, and a marked slowdown in the
growth of U.S. demand relative to that overseas. A weaker dollar
alone cannot do all the work and there is negligible chance that
foreign activity will accelerate by enough to have a major impact.
This leaves the unpleasant conclusion that a retrenchment in
U.S. growth must play an important role.
"If the financial markets had been allowed to operate freely
in the past few years, they would have already forced a major
reduction in global trade imbalances. However, massive Asian
official purchases of dollars have interfered with the normal
market mechanism. In the absence of these purchases, the dollar
and the stock market would have been lower, U.S. interest rates
higher and domestic demand weaker. A new equilibrium would have
been established with the deficit shrinking to a level that private
investors would have been willing to finance. This would have
been hugely deflationary for the global economy and explains
why Asian central banks acted as they did. Nevertheless, although
the subversion of market forces has been good for U.S. and global
growth, the cost has been ever-larger imbalances and a more difficult
adjustment down the road."
" ... the escalating U.S. trade deficit has largely been
a by-product of the massively reflationary policies in the U.S.,
underwritten in recent years by the actions of Asian central
banks. Thus, reversing the imbalances is likely to be a deflationary
and highly destabilizing event for the global economy.
"A retrenchment by U.S. consumers will rob the world of
the major source of demand, and a weaker dollar will put downward
pressure on profits and prices in Europe and Asia. Thus, while
the U.S. receives widespread criticism from global leaders about
its trade deficit, this represents a classic example of being
careful what you wish for.
"There are many imbalances and excesses in the U.S. and
global economy and all are interlinked to some degree....While
a benign outcome is possible, it is not the most likely."
(The above paragraphs need to be read with the understanding
that Martin is basically an optimist. I highly recommend the
Bank Credit Analyst for investors and institutions interested
in a balanced and thoughtful (notice I did not say frighteningly
brilliant) analysis of the world economic scene. You can go to
www.bcaresearch.com
to find out more).
Let's go back to 1970. The United States was in a major confrontation
in Vietnam. The Cold War was at its height, and America's military
spending was creating problems and deficits as far as the eye
could see. France was grumbling about the power of the United
States (some things never change), and especially the dollar's
role as the world reserve currency. "It's our dollar,"
said John Connally (another former governor of Texas, but then
Secretary of the Treasury), "but it's your problem."
Charles de Gaulle decided that he wanted to trade his dollars
for the gold in Fort Knox, and Richard Nixon decided it was time
to renege on Bretton Woods 1. A year or so later the oil-producing
countries got together and formed an organization called OPEC
and raised oil prices. Inflation began to creep up. Commodity
prices began to rise. Interest rates started going up. Wages
were not keeping up with inflation. The stock market drifted
sideways and then wrenched violently down. It was certainly a
Muddle Through Decade that caused some severe adjustments throughout
the world. (Sound altogether too familiar?)
But prior to all that we were living in what we can now understand
as a stable disequilibrium. And that brings me to Paul's second
point: the breakdown of Bretton Woods 1 ushered in a period of
significant adjustments, which took almost a decade to unwind.
Should we expect anything less from a breakdown of the stable
disequilibrium of Bretton Woods 2? If anything, the imbalances
of today are even more pronounced.
The answer is: not if we are being realistic. It is just one
more reason that I believe we will see a return of the Muddle
Through Economy which will last for a decade or longer. "History
does not repeat," said Mark Twain, "but it does rhyme.
The 10 years following the breakdown of Bretton Woods 2 will
not look exactly like the 70s, but it will be a period of significant
instability for, and the mass rearrangement of, whole segments
of the worldwide economy.
In the 60s and 70s, the Western world saw the Soviet Union as
a powerful foe. Ronald Reagan and Margaret Thatcher saw the Soviet
Union as a stable disequilibrium, and worked to bring about its
collapse in divorce. The point is that a lot of things that we
take for granted as stable may ultimately be seen to be unstable.
A trend that cannot continue, even a trend that we like, is by
definition a stable disequilibrium.
European pension and health commitments are a stable disequilibrium.
Likewise, the pension and health benefits of General Motors are
a stable disequilibrium.
Sidebar: I find it interesting that that old corporate raider,
Kirk Kerkorian, is now on the prowl for General Motors. At first
glance it seems like this 87 year-old gentleman has finally lost
his marbles. The company is by definition a stable disequilibrium.
When the divorce begins between the shareholders, bondholders,
unions and retirees, it will make a Donald Trump divorce look
like child's play.
However, I don't think I would bet against Kerkorian just yet.
He's got all the money that he could possibly spend, but there's
a lot more than money riding on this deal. If he can somehow
pull something out of the fire that is General Motors, it will
be a deal for the ages. It will get him more than a few footnotes
in history, and that is the only thing he doesn't have now. I'm
not privy to his personal counsel, but I think I see a rhyme
in his actions. Basically, General Motors is an auto and mortgage
finance company that builds cars as a hobby. A hobby, I should
point out, that loses a lot of money.
If you could get rid of that money-losing hobby along with the
pension and health care commitments, General Motors is actually
worth quite a lot of money. Substantially more than Kerkorian
is now paying. Watch for him to start agitating for General Motors
to spin off their finance divisions. Then watch for the car division
to file bankruptcy. Those shareholders get screwed, but they
more than make up for it with the profits on the financial subsidiaries.
The pension and health benefits get renegotiated and General
Motors survives.
Perhaps more benignly Kerkorian may suggest that the board simply
give the auto manufacturing portion of the Company to the unions.
Kerkorian takes some of the debt in exchange for the finance
operations, throws in a few incentive clauses here and there,
and voila! Kerkorian walks away with another billion or so, along
with a few footnotes. And now back to our regular story.
Is There No End of Instability?
I look at Europe and I see a stable disequilibrium. Slow growth
in the West, major demographic problems, France looking like
it will vote no, significant cost of labor disparities between
the East and West, an unsustainable health care and pension system,
massive bureaucracy, a proposed constitution that no one has
read and no one is sure what it actually means, not to mention
multiple languages, old animosities and an increasingly uncomfortable
electorate.
Perhaps with a great deal of counseling, and a lot of give and
take on the partners, the marriage of Europe can be saved. Perhaps
a no vote here and there will force them to get realistic and
propose something that could actually work. A little reality
therapy. I hope so. A strong and united Europe is a major plus
for the world.
I should point out that there was a lot of give and take when
the United States was initially formed. It took us many years
after we won our independence to actually have a functioning
nation. It was not altogether clear or certain that the United
States would actually emerge from the disparate interests of
the various states, let alone survive. That it did was a blessing
to the world. I think that in 50 years we will see that a united
Europe, if one should come about, will also make the world a
better and more stable place. While Europe's problems are daunting
today, necessity (and the marketplace) will force them to solve
the problems in one fashion or another.
The Breakdown of Bretton Woods
2
What could be the trigger that would signal the end of Bretton
Woods 2? A US recession is the obvious answer, but problems in
Asia or an unwillingness on their part to finance our trade deficit
are also just as likely.
Over the past few days I've had a number of e-mails suggesting
that China is getting ready to revalue its currency within the
next few weeks or even days. Of course I get an equal number
of e-mails suggesting that there's no way in Hades that China
is going to do it this year. Let's leave aside the issue of when
for a moment, and speculate upon what revaluation might look
like and how it might affect the US.
I think it is unlikely in the extreme that China simply wakes
up one day and decides to float its currency. It is far more
likely that they allow for a wider trading band around the current
price. Credible sources suggest that that might be a 5% number.
If that works okay, then they would expand it slowly over time.
It won't be enough to make certain numbskull US senators happy,
but that's another story.
But let's assume for the moment that they allow the Renminbi
(RMB) to adjust by 10%. Would that help the US trade deficit?
The simple answer is probably not. In fact, it might make it
worse. It would allow China to buy oil and other imports at a
price that is 10% cheaper than it is today. The cost of labor
to build the products it exports would only rise by 10% in terms
of foreign currency. If labor is making a dollar an hour, what's
another dime?
In fact, the rise in labor might be offset by a decrease in other
costs. A 10% drop in the RMB by itself would do little to help
the US trade deficit. In fact a 20% or 30% drop in the RMB by
itself would not have that much of an effect. Now, if every Asian
currency dropped by 30%, along with that of our other trade partners,
that would begin to eat into the buying power of the US consumer.
It would also create instability within the US. That means consumers,
and especially boomers will become more uncomfortable, which
presumably would lead them to save more and buy less. That would
reduce the trade deficit. Be careful for what you wish.
If China could reduce the cost of its imports by 10%, and not
lose much of its market share in the United States, why does
it not go ahead and just revalue? Because China is its own stable
disequilibrium.
While it has not made the news in the United States, there is
a rise in the number, intensity and size of demonstrations in
China. China has 20 million people, moving from the country to
the cities every year. They must build the equivalent of a Dallas,
Texas every month and a half. They have to find jobs, housing,
services and infrastructure in a staggeringly short time. To
fail to meet those expectations will create problems and more
tensions.
Chinese banks are worse than bankrupt. The government banks have
been making massive loans to insolvent and unprofitable state
businesses for decades. They continue to do so because to allow
them to fail would create massive unemployment. Massive unemployment
would create unrest in the cities and surrounding areas. Above
all it would disappoint the rising expectations of a growing
Chinese middle class. That would create more tension.
While the government of China has done an impressive job in managing
the largest migration in the history of the world (some 200 million
people have moved the country to the cities in the last 20 years),
it has not been without cost. There is an increasingly unwieldy
top-down bureaucracy trying to keep things going along, while
a freewheeling market economy is emerging. Freewheeling economies
and top-down bureaucracies are not a prescription for stability.
Further, it is not altogether clear that allowing the RMB to
float will mean an immediate rise in the value of the RMB. We
have seen massive foreign direct investments in China for the
last 20 years. That investment has not had a chance to leave
the country. Do you think that investors might like to take a
little off the table when they get a chance?
I watch with increasing interest as a growing number of Chinese
entrepreneurs come to the United States capital markets and list
their companies on American exchanges through reverse mergers.
Do you think they might like to diversify their newfound wealth?
Do you think other Chinese entrepreneurs would also like to diversify?
While I think over time we will see the RMB rise significantly,
if the Chinese were allow the RMB to float today, it is not altogether
clear to me that the initial move of capital would be into China.
A radical readjustment of the currency in a country that is not
prepared for it, and is already rife with potential instability,
simply doesn't make sense.
What does make sense is for China to slowly and steadily allow
the RMB to trade with increasingly wider bands, and to let their
entrepreneurs and businesses adjust to the new realities. And
we in the United States should not wish for anything else. One
of the absolute worst things that could happen for global stability
is for China to become internally unstable. While in the grand
scheme of things this process does not have to take a long time,
it is certainly not going to happen in 6 or 12 months.
We are in for a long and difficult period as the world hits the
reset button, as Bretton Woods 2 collapses and as a new world
balance emerges. The worst thing that could happen is for this
process to happen in too short a time period. That is a prescription
for worldwide depression. No, we need our pain in small measured
doses. It took a long time to get in the current stable disequilibrium.
It has been fed by codependent relationship among all parties.
In an odd way, the United States is probably better positioned
than all the other parties to come through the Muddle Through
Decade. Our entrepreneurs and businessmen are used to having
to adjust to changing times. Our free market system is more resilient
than the mercantilist systems of Asia or the bureaucratic socialist
systems of Europe.
That doesn't mean it will be a picnic or that it will be particularly
enjoyable. It does mean that with proper planning, investors
and businessmen will be able to maintain and even grow their
portfolios and businesses. And proper planning means that you
have to understand that McCulley is right. We are in a stable
disequilibrium. It is going to end in divorce. It will be a period
of creative destruction. There will be plenty of opportunities,
but not for those that insist on trying to do business, or trying
to invest, in the old ways.
Napa Valley and Chicago
I will be going to Napa Valley for a small private gathering
hosted by Rob Arnott and Research Affiliates. He has assembled
quite a group of investment industry "players" to come
together to ponder "The Stealth Bubble." Financial
services now representing 30+% of Russell 1000 profits for 2004,
and 20+% of market capitalization, book values, dividends and
revenues for the economy, though it still represents less than
10% of the employment in the economy. Forty years ago, financial
services comprised less than 5% on all of these metrics. In our
industry, we sell risk management, risk reallocation, transaction
facilitation, comfort and hope. Question: is this a normal evolution
in a more services-oriented economy, or is it abnormal for an
industry that produces nothing tangible to be one-fourth of the
economy? I will take notes and report back.
It also looks like I will be in Chicago around June 7 for some
meetings, and may have some time to meet with clients and prospective
clients. And for those interested, I did pass the English Securities
exam. They did not tell me what my score was. They only have
three results: pass, fail and almost passed. I am not certain
how knowing you almost passed is supposed to help. I guess it's
like British humor - you're not quite sure but everyone around
you is laughing their heads off. One-third of those who took
the test failed, although they did not say how many "almost
passed."
I mentioned at the beginning of this letter the Accredited Investor
Conference we held last week. It is a conference that we are
forced to limit attendance to because of US regulatory requirements
as we not only have speakers like Paul McCulley, Richard Russell
and Rob Arnott, but we also talk about hedge funds and private
offerings. We will do one again next year.
If you would like to know more, you can go to www.accreditedinvestor.ws
and sign up for my free letters and reports on private offerings
and hedge funds. You must be an accredited investor (basically
$1,000,000 net worth or more, see the web sites for details).
I have just written a new letter which will go out to current
subscribers early next week. Basically, in conjunction with my
friends at Altegris Investments (and my European partners Absolute
Return Partners) we offer information and research on and access
to hedge funds and private offerings. You can read the web site
for details on how it works.
(In this regard, I am the owner and a registered representative
of Millennium Wave Securities, LLC, an NASD member firm. See
more disclosures on the web site and at the end of this letter.)
Time to go. My #2 daughter is waiting patiently for Dad to come
and have a late dinner. And the Rangers are getting beaten badly
(7 run first inning for Cleveland), so I think I will beat the
crowd and leave.
Enjoy your Mother's Day!
Your 'thinking about change' analyst,
May 6, 2005
John Mauldin
email:
John@frontlinethoughts.com
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