Currencies After the Crash: The Uncertain Future of the Global Paper-Based Currency System

CURRENCIES AFTER THE CRASH

THE UNCERTAIN FUTURE OF THE GLOBAL PAPER-BASED CURRENCY SYSTEM

The McGraw-Hill Companies, Inc.

Excerpt

CHAPTER 1

THE DOLLAR WILL REMAIN ON FIRST

Gary Shilling

"I just don't see at this point there is a major shift away from the dollar."

—Ben Bernanke, Federal Reserve Chairman, March 2011

"Who's on first, What's on second, I Don't Know is on third," and so it goes in Abbott and Costello's marvelous routine that deliberately confuses baseball players' names with questions. In the game of global reserve currencies in future decades, we need to ask, Who's on first, Is Anyone on second, and Who Cares What's on third? By its nature, the currency roster always requires a batting order, since no currency operates independently in the international ballpark. The dollar doesn't stand alone, but against the euro, the yen, and even gold.

Reserve Currency Advantages

Of course, being the primary global reserve currency, the position enjoyed by the dollar since World War II, has tremendous advantages and creates a huge demand for greenbacks. Most of the world's trade is carried out in dollars, including trade and capital transactions that have no involvement with the United States. When Brazil sells iron ore to China, the transaction is probably in U.S. dollars. When Indians make a direct investment in Thailand, dollars are the likely medium of exchange.

Demand for bucks is supplied by foreign exchange reserves, which are mostly in dollars. Recently, foreigners' willingness, even zeal, to hold greenbacks has allowed and perhaps encouraged America to run chronic trade and current account deficits (Figure 1-1) because foreigners are happy to recycle the surplus dollars that result back into Treasuries and other U.S. investments.

Washington wizards figured out decades ago that if they're running a big budget deficit, they should also run a huge current account deficit in order to get foreigners to pay for the federal red ink with dollars that are recycled into Treasuries. This game became more crucial as U.S. households slashed their saving rate for 25 years (Figure 1-2) and supplied less and less money to fund federal deficits and business investments, while hyping household borrowing (Figure 1-3).

$1 Trillion-Plus Deficits

Contrary to Congressional Budget Office projections, federal deficits in the $1 trillion-plus range are likely to persist if my forecast of chronic slow economic growth and chronic high unemployment is valid, and the resulting pressure on Washington to create jobs only increases. A key reason for the low 2 percent annual real GDP growth I forecast is my expectation that U.S. consumers will continue to deleverage, paying off the debts that they owe on their homes, credit cards, and other loans and pushing their saving rate back into double digits and the ratio of debt to disposable (after-tax) income back to its 65 percent norm.

This will compress the trade and current account deficits and reduce the amount of foreign-earned dollars that are recycled into federal deficit financing (assuming that foreigners continue to buy U.S. exports, since every 1 percent shortfall in consumer spending reduces our imports—the rest of the world's exports—by 2.8 percent). At the same time, however, more consumer saving will fund much more of the chronic high federal deficits. In the third quarter of 2011, disposable personal income was $11.6 trillion, so if the household saving rate were 10 percent, $1.16 trillion in consumer saving would be available to fund federal deficits and business investments.

Down Memory Lane

Let's take a stroll down memory lane to see what factors elevated various currencies to primary global trading and reserve status in the past. Not surprisingly, these currencies were linked to strong and sizable economies. The silver drachma issued in Athens in the fifth century BC was probably the first currency that circulated widely outside its issuer's borders, and it followed Alexander the Great (356–323 BC) as he conquered the then-known world from Egypt to Persia. Then, as Greece faded and Rome rose to global dominance, its gold aureus and silver denarius coins dominated, even though Athenian and Roman money circulated simultaneously for years.

But as the Roman Empire faded and the related inflation galloped, continually devalued Roman coins became less and less acceptable outside the empire. This and Rome's being overrun by Goths, Vandals, and Huns paved the way for the Byzantine Empire's gold solidus coin to become the standard for international trade in the sixth century.

In the seventh century, when the Arabs, flush with Muslim zeal, burst out of the Arabian Peninsula and charged across North Africa, the Arabian dinar partially replaced the solidus. The solidus was being debased to cover Byzantine deficits and was no longer solid, but it still circulated internationally into the eleventh century. Nevertheless, the Arabs also had government deficit problems and gradually devalued the dinar, starting at the end of the tenth century.

Florence and Venice

The merchants and bankers of Florence—the same guys who financed the Renaissance—began to flourish in the thirteenth century, and their currency, the fiorino, was used throughout the Mediterranean in commercial transactions. However, the Venetian ducato took over in the fifteenth century after Marco Polo (1253–1324) and others opened up the land route to China, and Venice became the western terminus of the Silk Road. Alas, the Portuguese then discovered the much easier water route to China around the southern tip of Africa, and Venice became the tourist trap it's been ever since while the ducato atrophied in international trade.

Global trade by water was the new technology of the seventeenth and eighteenth centuries, with the Dutch as the financial and commercial leaders, so the guilder reigned as the international currency. And paper money began to replace coins, even though it was not backed by the Dutch government. Spain, of course, controlled much of the New World after 1492, but the real de a ocho, or Spanish dollar, never really made the cut, since most of Spain's New World gold was dissipated in financing the Spanish Armada and other military disasters. In the nineteenth century, national central banks and treasuries began to hold gold as reserves, and bills and interest-bearing deposit claims that were gold substitutes also began to be held as reserves.

At the same time, the Industrial Revolution, which began in both England and New England in the late eighteenth century, made the United Kingdom the leading exporter of manufactured goods and services, and the biggest importer of food and industrial raw materials. As a result, sterling dominated as the international reserve and trading currency, and between the 1860s and the start of World War I in 1914, 60 percent of global trade was in pounds. With the advent of the telegraph and other communications advances, sterling was increasingly used in commercial transactions between non-U.K. residents. This role was also enhanced by London's emergence as the global leader in shipping and insurance and the center for both organized commodity markets and growing British foreign investments, usually denominated in sterling.

U.K. Sunset

Sterling's dominance in world trade started to slip before World War I, with the shares of the French franc, the German mark, and the U.S. dollar all increasing. Then World War I pretty much ended Britain's leading role in the international economy as economic interdependence broke down. Britain suspended the conversion of sterling into gold during the Great War, then reestablished it in 1925 at about prewar levels; this greatly overvalued sterling because of massive inflation in the meanwhile. With the Great Depression, the United Kingdom, the United States, and most other developed countries abandoned public conversion of paper currencies into gold.

With the rising power of the U.S. economy in global trade and finance, the dollar became the international currency starting in the 1920s, and it was crowned as the world's primary reserve currency by the Bretton Woods Agreement in 1944. The dollar was linked to gold, and all other currencies were linked to the dollar; this gave other countries access to the U.S. gold hoard, which had leaped during World War II, while fixing international exchange rates. But a foreign government rush for U.S. gold in the inflationary early 1970s forced President Nixon to sever the link to gold, and floating exchange rates for major economies followed.

The euro, introduced at the beginning of 1999, was heralded as a rival to the dollar as a reserve currency, reflecting the combined strength and size of the eurozone countries, which, together, had a GDP close to that of the United States. In the following decade, some countries moved a portion of their reserves to euros, and after an initial 30 percent drop from 1.18 euros per dollar to 0.83, the euro climbed steadily—until recent years (Figure 1-4).

The 2007–2009 Great Recession, however, revealed that joining the Teutonic north with the Club Med south under one currency but with no common fiscal policy was inherently flawed. It worked in the early to mid-2000s, when global economic growth covered up a multitude of sins, but not when tough times set in.

Eurozone Crisis

Germany and other strong countries in the Teutonic north have two unattractive options for dealing with the current crisis. They can continue, directly or through the European Central Bank, to bail out Greece and other weak countries, including potentially Spain and Italy. This strategy has no end in sight and is accompanied by rising resentment from their own voters. Or they can do nothing and wait for Greece to default on its sovereign debt, withdraw from the European Union (EU) and the eurozone, and devalue massively as it returns to drachmas, draculas, or whatever. Then there'd be a run on other Club Med country banks as investors yelled, "Who's next?," and contagion would force a disintegration of the eurozone as it is presently constituted.

That would bring big troubles for German, Dutch, and other strong country banks that have considerable exposure to the weak economies. So those countries' governments would have to bail out their own banks. As long as the crisis was confined to Greece, Ireland, and Portugal, it appeared manageable. Those three small countries combined account for less than 6 percent of eurozone GDP.

But if the woes spread to the other two PIIGS (PIIGS 5 Portugal, Ireland, Italy, Greece, and Spain), Spain and Italy, the problems will become huge whether the strong countries bail out the weak countries or their own banks. Spain accounted for 11.5 percent of eurozone GDP in the first quarter of 2012, and Italy accounted for 16.7 percent. All five of the PIIGS have high government deficits and debts. All except Ireland, which has given itself some very stringent fiscal medicine, have more and more risky sovereign debt issues, according to credit default swap prices. European banks that hold weak sovereign bonds are in trouble, and the woes of French banks and the French economy resulted in the January 2012 downgrade of French sovereign debt; Standard & Poor's also stripped Austria of its triple-A rating and reduced the ratings of Spain, Italy, and five other eurozone countries.

So the strong eurozone members need to bail out someone, and I think that they will continue to aid the weak countries directly. Otherwise, the eurozone will disintegrate, ending the noble post–World War II experiment in Europe. After the war, the German and French leaders decided that they had to find a different way of interacting from their method that had been used since Napoleon 150 years earlier—all-out war. They reasoned that integrating their economies more closely would reduce the likelihood of military conflict. That set them on the path that moved from the founding of the European Economic Community in 1958 to the eurozone in 1999. Complete political or even economic integration in such diverse countries was not feasible, but a common currency was believed to be an important step.

Sources of Strength

This review of history shows that primary reserve currencies are those that dominate international trade and are issued by robust economies. But how did these economies become robust? Alexander the Great knocked off every nation in sight by military conquest, including much, much larger Persia. Rome was notorious for conquering foreign lands and then carting the loot back to Rome. Egypt became the source of grain to provide the Roman multitudes with bread while Egyptian obelisks were moved to Rome as parts of the circuses.

Productivity Growth

In recent centuries, another element has superseded the grabbing of land and loot as a source of economic strength—productivity growth. In their 1988 book American Business: A Two-Minute Warning (New York: Free Press) C. Jackson Grayson, Jr., and Carla O'Dell make a very convincing case for superior productivity growth as the key to global economic leadership and, therefore, to principal reserve currency status. They explain that rapid productivity growth is necessary for raising living standards and achieving and maintaining global economic leadership.

They also note that earlier, the lack of productivity growth wasn't caused by a lack of technology. Ancient China, for example, was very technologically advanced, having invented gunpowder, umbrellas, movable type, paper making, and the magnetic compass. The strength of the Roman Empire, some argue, was the result of its advanced military technology. But ancient societies didn't apply their technologies to economic growth because they didn't want to upset the balance of power, vested interests, and stable societies.

No Growth

As a result, for millennia, world economic growth only kept up with population growth, and GDP per capita was static (Figure 1-5). According to Grayson and O'Dell, from 1500 to 1700, annual income rose from $215 per capita in current dollars to $265, a mere 0.1 percent per year. So it was a zero-sum world. Whatever Alexander or Rome gained, someone else lost.

But the Crusaders introduced Western Europeans to the East and its different cultures and products. Marco Polo and others developed the Silk Road to obtain spices, silks, and other things that were unknown in the West, and the desire to get to China by water led to the discovery of the New World. That not only shook up the old order but also gradually, very gradually, introduced conditions that promoted productivity and competition, not through arms but via commerce. And productivity became the means of raising living standards.

Now, let's be clear: productivity enhancement was not any nation's policy during the Age of Discovery or even in 1700, when it began to grow. Columbus got the backing of King Ferdinand and Queen Isabella to sail west to obtain gold and other riches, not to raise Spanish living standards. But the rise of towns in the Middle Ages and the circumnavigation of the globe worked to break down rigid controls and allowed Adam Smith's invisible hand, or the self-regulating nature of the free market, to get through the resulting crack in the door. With free markets, he argued, the pursuit of individuals' best interests increased the welfare and living standards of the whole community.

The Dutch

By 1700, global trading was the hot new technology, as mentioned earlier, and the Dutch were its masters from then until about 1785. They controlled not only the mouth of the Rhine, the water gateway to Europe, but also most of the trading routes to Southeast Asia. Grayson and O'Dell point out that in 1700, Dutch GDP per capita was about $440, or around 50 percent greater than England's $288. The Dutch had considerable expertise in producing woolens and linens, beer, ceramics, soap, and ships. Their fleet was bigger than England's, and, on a per capita basis, so was their international banking and insurance industry. Their low-cost textiles killed competitors in Genoa, Venice, and Milan.

The guilder was the international trading currency of the seventeenth and eighteenth centuries, as noted earlier. By the late 1700s, however, the Dutch got fat and happy and spent lots of time enjoying life and having their portraits painted by the successors to Rembrandt, van der Meer, and the boys. And they weren't carefully watching the ascendancy of the Brits.

Up until then, Dutch productivity exceeded that of England, but Holland's productivity growth slowed and even fell 0.1 percent annually during the latter part of the eighteenth century, according to Grayson and O'Dell. Meanwhile, English productivity growth accelerated to about 0.4 percent per year. The English gained on the Dutch in both agriculture and trade, and by 1760 they had overtaken the Netherlands to become the world's biggest trading nation.

U.K. Dominance

The United Kingdom's dominance really picked up steam with the unfolding there of the Industrial Revolution in the late 1700s. Among early inventions, the spinning jenny and the steam engine hyped productivity manyfold compared to hand spinning and weaving, and human and animal power. The Industrial Revolution, like any new technology, grew rapidly but started from zero, so it took decades before the effects on British productivity were appreciable. Productivity in England rose only about 0.5 percent annually in the last several decades of the eighteenth century, but combined with stagnation in the Netherlands, British productivity surpassed that of the Dutch by about 1785.

The Industrial Revolution also had a profound effect on society. Think of the transformation from the days of Jane Austen's Pride and Prejudice, when jobs were beneath the dignity of the country gentry and prospective husbands were measured by their annual pensions from their families, to the wealth and power attained by the nineteenth-century industrialists and financiers, as exhibited by their "cottages" (mega-mansions) in Newport, Rhode Island.

The Middle Class

I've long believed that the greatest effect of the Industrial Revolution was to create vast middle classes. Earlier, European economies were two-class societies. Those on top owned almost everything and controlled most of the income. They spent lavishly on their palaces, entertainment, armies, and so forth, but they still had large saving rates. Those on the bottom spent all their income to subsist, but they had very little. Therefore, potential output was far in excess of domestic demand, and those countries tried to export it in return for gold. This, of course, was the strategy of the mercantilists, who held sway before the Industrial Revolution. But with the Industrial Revolution came the middle class, all those people who wanted a better life, conspicuous consumption, and education for their children. And they now had the money to pay for these desires. Hence the advent of domestic spending–led economies in developed countries—except in Japan, which clings to its feudalistic "export or die" mentality.

(Continues...)

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Excerpted from CURRENCIES AFTER THE CRASH by SARA EISEN. Copyright © 2013 by The McGraw-Hill Companies, Inc.. Excerpted by permission of The McGraw-Hill Companies, Inc..
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