US's turn to face a currency crisis
As the world turns, its the US's turn to face a currency crisis
Capuchinomics Weekly eLetter
April 2, 2006
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In 1994, Mexico came within a hairs breadth of a complete financial meltdown. The Mexican crisis was replicated in 1997 in Malaysia, Thailand, Indonesia, the Philippines and South Korea, referred to then as the "Asian tiger" economies because of their rapid growth. The Asian tiger economies, unlike Mexico, experienced meltdowns. Nearly all these economies saw their economies devastated, currencies devalued, asset price deflation and sudden impoverishment for a wide swathe of their populations. In 1998, Russia experienced the same fate as the Asian tigers with one additional feature, sovereign debt default. In 2002, Argentina, following a familiar script experienced a crisis that catapulted it from an emerging first world nation to third world nation overnight and featured the now familiar actors of a collapsed economy: devalued currency, asset price deflation, sudden impoverishment and sovereign debt default.
It's an astonishing and tragic catalogue of failure. Only South Korea and to a lesser extent Mexico have recovered from the devastation of these crises. In physics, Newton's third law of motion states that "For every action, there is an equal and opposite reaction." The financial variation goes "for every loser there's a winner." This set of global crises had many losers i.e. the populations of these countries that suffered sudden impoverishment and decline in living standards. The biggest beneficiary of these crises was and still is the US.
To understand how this came about, one must understand the political and economic backdrop to the crises we listed in the first paragraph. 1989 marked the biggest upheaval in post World War II human history as communism collapsed as an organizing principle for politics, economies and societies. The immediate aftermath of this collapse caused an immense void that the West and capitalist societies were wholly unprepared for. Few had anticipated the fall of communism and fewer had prepared to rebuild the shattered societies and economies of the ex-communist countries. The void was filled by the World Bank and the International Monetary Fund that advocated a neo-classicist capitalist model irrespective of the condition of the state of these economies. To ensure compliance to their recommendations financial aid and economic assistance was doled out based on the country's compliance and adherence to this model. The goal of the IMF was to remake these countries into capitalist economies and societies instantaneously.
Such advice was in demand, and not just from ex-communist countries but also from reforming Asian countries and South American countries. The end of the cold war had caused mini-revolutions in all these areas and politicians were eager to abandon statist models and to adopt new capitalist ones. One of the key recommendations of the IMF and World Bank that played a critical role in every crisis was the recommendation that a country's currency should be set at some fixed value to the dollar. In almost every crisis, speculators attacked these fixed values, called pegs by shorting these currencies. The central banks of these countries were advised to defend the value of their currency by purchasing it in open markets even as it declined precipitously. Ultimately, these central banks did not have sufficient reserves to defend the fixed values (pegs) that had been set. In every case, currencies succumbed to these speculative attacks, catalyzing economic depredations for its populations.
With this background, we can now look back at the last 15 years of global finance, and see an arc of cause and effect that provides a simplified narrative for what occurred during these years. In the first phase, liberalizing economies around the world fix the value of their currency to the dollar. Next, the inflated value of these currencies lead to fiscal crises as governments and businesses take on too much debt too soon. Consequently, speculators seeing an arbitrage opportunity, launch speculative attacks on these currencies. Currency crises erupt in the countries that followed the neoclassical model without adequately comprehending its risks. Next, currency devaluations and debt defaults catalyze disastrous economic consequences for these countries. These crises decimate local economies but provide one unintended benefit: they become highly competitive in their the cost of labor.
That brings us to the present day. Now, American companies routinely manufacture overseas to tap into these low labor costs and have shipped their production of goods to these areas. The affected countries after suffering through the devastation of the crises have learned and put into practice two important lessons. First, don't take the IMF's handouts and its accompanying advice. Second, one can never have enough reserves. As a result world central banks have accumulated reserves far beyond than what is needed to maintain liquidity and solvency for their economies and currencies.
The US emerged out of these various crises as the financial hegemon. The dollar became the de facto currency of the world. Around the world, dollars were preferred over local currencies. These developments coincided with the internet bubble and a budget surplus, a combination that caused capital flows to move even more rapidly to the US. Even after the internet bubble burst this fund flow continued unabated. It's human nature to take all manner of precautions to address the crisis that's just passed. As a result, central banks around the world are still accumulating treasury bonds even though the US's fiscal condition now matches that of Argentina or Mexico or the Asian tigers at the point of their financial crises.
The US by dint of the fact that it issues the world's reserve currency believes that its position cannot be challenged. However, by any reckoning, the dollar today is an emperor with no clothes. The currency features low yields, deteriorating fiscal conditions and a deteriorating investment income position. And now political forces are combining, to overthrow the arrangements that made possible the extraordinary prosperity and wealth of the last two decades catalyzed by the fall of communism and the victory of capitalism.
What lies in store next for the global financial system? In 1989, the dollar began its road back to preeminence. This preeminence has been lost after Nixon took it off the gold standard in 1971. Thirty years later (since the Dollar peaked in 2001), the dollar came full circle, traveling from global currency villain in 1971 to hero and savior status through the various crises listed in the first paragraph. By our reckoning, the dollar is headed for another stint as global villain. Ahead then is the a period of resolution of imbalances caused by the events described above. Will these imbalance be resolved by a series of small, incremental and painless adjustments? Or are we about to see a wholesale rearrangement of the dollar oriented global financial system? Sharp moves in financial markets are suggesting that some investors have made their decision and have begun to act.