The system of quasi-fixed exchange rates that dates back to the Nixon era, and which itself was an evolution of the gold standard Bretton Woods regime agreed in 1944 (which couldn't survive the 1960's spike in Vietnam war inspired US inflation), has become unsustainable. In the original gold standard regime (fixed exchange at $35 for an ounce), the capacity of the US to issue dollars to the world was strictly limited, as was the capacity to run up deficits. A key factor driving financial crises is extreme trade imbalances between nations; debt gets accumulated partly as a result of financing a trade deficit. For smaller countries, a vicious spiral can ensue which ends in recourse to the IMF. In 1944, the US was the world's biggest creditor, and imposed a system that placed the whole burden of maintaining the balance of trade on deficit nations; there would be no limits on the trade surplus that exporters could accumulate. The entire post-war economic infrastructure, including the World Bank and the IMF dates from this conference, and is now crumbling in the face of a sudden reversal of historic trade and savings imbalances.
The US would long ago have had to make dramatic economic adjustments had it not been for the dollar's special status as the world's reserve currency, in which commodities are priced and in which foreign countries have to hold currency balances at the IMF. China, which for all the media hype barely makes it into the top 100 countries by GDP per capita, has been hugely subsidizing US borrowing and consumption. The trade surplus countries have had to buy over $5 trillion dollars in US bonds in recent years to stop their currencies (China, the Gulf States and 40 other countries have dollar linked currencies) rising. This had the effect of inflating the recent US credit bubble by artificially forcing down bond yields; this whole mess has at its root an excess of savings and mercantilist growth policies in Asia. China is now in economic meltdown, as a growth model based on chronically unproductive over-investment and marginally profitable manufactured exports begins to unravel, as I warned it would back in March and repeatedly since. The World Bank's latest China Quarterly makes sobering reading, and can be downloaded here. The near collapse of the global banking system this year is the culmination of a series of dangerous imbalances that have build up over many years, notably consumer leverage levels reaching 350% of GDP in the US.
Goldman estimates that the US private sector’s financial balances (private borrowing net of private investment) will reverse from a deficit of 4% of GDP in 2005 to a surplus of around 10% of GDP at the end of 2009 ie the US private sector will go from being a net borrower to a big net saver. At the same time the current account deficit will swing from a 5-6% deficit to balance or even small surplus. I've long argued that US consumer demand will tumble by 6-7% points of GDP and revert to long term averages after the boom of recent years; the best policy can achieve is to make the process orderly. The implications for trade surplus countries in Asia are grim. The global liquidity engine, whereby China and the oil-exporters provide (subsidized) financing to the US to sustain its trade deficit and their exports, will come shuddering to a halt in coming months. The chart below indicates how a boycott by foreign central banks of US Agency Debt (Fannie and Freddie) this Summer precipitated the crisis at those institutions and forced the Treasury to nationalize them. If that boycott were repeated for US bonds in general, this crisis would enter a new and destructive phase; quantitative easing (or essentially money printing ie liquidity creation unsterilized by matching T-bill or bond issuance) has begun in the US already. This is exactly what I predicted a couple of months ago in Deflation: Those Fed Helicopters are Hovering.
Total credit extended by the Fed has surged from an average of $885 billion in the week ending August 27 to $2.2 trillion in the week ending November 12. The volume of reserve balances with the Fed, which had jumped from $8 billion at end Aug to $280 billion by mid Oct, has now surged again to a stunning $592 billion in the week ending Nov 12. The Fed, fearing Japanese style debt deflation, is now frantically increasing the quantity of money in the US economy to stimulate growth and inflation, via injecting excess liquidity into the banking system. This is an understandable but dangerous strategy; the only other country to attempt it was Japan from 2001-6, but in a very different domestic savings/funding and global growth context. I suspect that we get deflation as the predominant concern through the beginning of a cyclical recovery in 2010/11, but then inflation surges, driven not only by wanton money supply growth but also demographic decline hitting the labour market and a structural resource crunch exacerbated by the credit crisis. So what new currency regime might emerge? The Europeans are pushing for a managed currency system with capital controls to replace the current largely floating, market based, regime (and a tax on forex transactions), but any new architecture will realistically be designed by China and the US, and would squeeze Europe out of institutions like the IMF.
In return for giving up its dollar peg, China would want serious economic influence at international institutions as a quid pro quo. Some economists, including several recent Fed governors, argue for a currency regime linked explicitly to commodity prices. Paul Volcker, who has a key role in the new administration, recently stated:
'Once we moved off gold, we entered a world of so-called fiat currencies. In that world, there’s nothing behind money except the credibility of the government and of the central banks...you shouldn’t set up full employment in opposition to stable currency, but the stable currency domestically is important to building a base for prosperity over the long run.'
Wise words, but politics trumps sensible long term economics every time. Perhaps the most likely outcome of a looming instability crisis is that smaller countries will huddle together for safety in a series of regional currency blocs, from the Middle East to Asia, including an expanded Eurozone comprising countries like Denmark and even the UK (which economically and politically is now closer to meeting 'convergence criteria' than ever before). This would further diminish the relative importance of the dollar, and increase the difficulty of funding US structural fiscal deficits running at 8-10% of GDP without hugely higher yields (despite rising domestic private savings). On this view, current US bond yields look unsustainably low.
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