Peter T Treadway, PhD
Historical Analytics LLC
October 31, 2010


The International Monetary System is Broken

Deficiencies in the international monetary system are a root cause – if not the root cause – of the volatility and bubbles that have afflicted the post-Bretton Woods global economy. Political decisions often dominate what should be an economic process. Unlike under the classic gold standard, there seems to be no automatic market force that can eliminate the American trade deficit or the phenomenon of East Asian countries piling up American dollars.

In a recent Dismal Optimist, I argued because the dollar was the center of the current international monetary system, that unlike China or Japan the United States could not intervene in the currency markets to lower the value of its currency. Were the United States to do so, it would unleash total chaos on the international monetary system. In fact, in an Oct 4 article in the Financial Times, respected Brookings economist Fred Bergsten advocated that indeed the United States do just that type of intervention. Bergsten gave this hypothetical US action the grandiloquent appellation “countervailing currency intervention.”

I believe Bergsten’s recommendation is reckless and fraught with danger. But on second thought maybe it doesn’t matter. For the United States, there is more than one way to skin a monetary cat. QE2 to be precise will do just fine. QE2 is a grandiloquent abbreviation for the Fed recklessly printing money. There is no finer way for a country to depreciate its currency than by printing an endless supply of it. No need for countervailing currency intervention and completely consistent with the US policy of advocating a stronger dollar while acting to weaken the dollar. Quantitative easing by the US is equally reckless and fraught with danger.

The recent G 20 meeting exposed one of the weaknesses of the current system. Major international monetary decisions are usually political in nature. Governments have many weapons at their disposal. Markets either do not always succeed in forcing rational solutions to imbalances or they take time to do so. Governments set exchange rates maybe not forever but they last for periods that can be long enough. Adjustments by surplus and deficit countries often do not happen automatically and remain uncorrected for long periods of time. Countries will pursue their own self interest and “argue their own book”. Adjustments generally aren’t made voluntarily. The result of the G 20 meetings was a vague unenforceable resolution about excessive trade imbalances and competitive devaluations. A complete waste of time.

The East Asian Miracle /Train Wreck?

The biggest question mark for the global economy is what will happen with the Chinese economy in the next year. Forecasting the US and European economies is child’s play compared with forecasting that of China. For the optimists, China is the world economy’s growth engine since not much can be expected from the US or Europe. According to the pessimists, China and therefore the world economy are headed for trouble.

I frequently travel between Hong Kong and New York. Fifteen hour plane trips have some advantages. On my last trip I had time to read In the Jaws of the Dragon by Eamon Fingleton. Fingleton is not a consensus thinker. He puts forth (disapprovingly) what he terms the East Asian Economic Model, first followed by Japan in its WW II puppet state in Manchuria, then in post-War Japan itself, then Taiwan and Korea and now China. The East Asian model is according to Fingleton responsible for the success of the East Asian economies. The East Asian Model is at its core an ultra-mercantalist , statist strategy that is hollowing out the American manufacturing industry. Americans, seduced in part by low interest rates and cheap imports and imbued with the belief that the market will conquer all, have happily allowed this to happen.

Fingleton exaggerates from time to time and holds some debatable political views. But I believe his East Asian model – which is really a synthesis of ideas put forth by many others — describes economic reality well enough. The Model is an economic strategy that has the following key points:

1. A labyrinthine system of trade barriers.

2. An artificially undervalued currency.

3. An industrial policy that focuses on developing so-called pillar industries and uses export subsidies and other unfair tactics to give them an unfair advantage in world markets.

4. Systematic pressure on foreign companies to transfer their most advanced production technologies.

5. A systematic bias in favor of savings and against consumption.

An interesting conclusion can be derived this model. If China has erected significant tariff and non-tariff barriers, then it will also be true that a revaluation of the renminbi will have a limited effect on Chinese imports. It won’t matter what the price is of US exports to China if they are not allowed in at any price. The giant trade imbalances with the US will persist. The international monetary system will remain in disequilibrium. And Chinese consumers will get a raw deal. This is a world in which market signals are ignored.

Spending time in Hong Kong as I do, I have come to regard the city as a special mirror on what is happening in China. As I have written before, I have been struck by the ever-increasing numbers of Mainlanders who descend on the city to buy all kinds of luxury goods. Hong Kong is rapidly turning into a giant upscale mall. (Similarly Mainlanders head for Macau as gambling is flat out prohibited in China.) Why can’t the Mainlanders load up on Louis Vuittons and Pradas in China? One reason might be the gradual appreciation of the renminbi against the US dollar-pegged Hong Kong dollar. That makes everything in renminbi cheap in Hong Kong (including stocks and condos.) But a second reason might be that unlike in China there are no barriers – - tariff or non-tariff- – on consumer imports into Hong Kong.

Short seller Jim Chanos continues to hold to his view that the Chinese economy is about to suffer a serious slowdown. His argument is that China has poured excess funds into useless capital projects and real estate construction at the expense of its consumers. His presentations are peppered with tales of grandiose white elephants such as the new city of Ordos in Inner Mongolia and the New South China Mall in Guangdong. Both are apparently empty of people. Chanos and company are really predicting that the East Asian Model as far as it is practiced by China will hit the wall. According to this viewpoint, China has deviated too much from what a market directed economy would dictate. Stagnant Japan could be China’s future.

In my opinion, too much pessimism may not be warranted. Historically, China over thousands of years has fluctuated between periods of weakness and disorder and periods of external strength and internal prosperity. China at the moment is in the upswing part of its historical cycle. Western pessimists overlook one thing: the strong work habits and discipline of the East Asian populations and their national obsession to achieve material prosperity. These qualities continue to make East Asia an important long term investment destination. These qualities may overcome a plethora of economic policy sins. Or postpone the day of reckoning long enough to keep the shorts from making much money. We’ll see. As Lord Keynes famously said, “markets can remain irrational longer than you can remain solvent.”

Inasmuch as the East Asian Economic Model describes reality, the countries that have employed it need to ask whether it will work for them in the future. Don’t expect East Asian leaders to nobly act on behalf of the United States. But more consumer spending, more imports, and revalued exchange rates are what their future prosperity requires. They certainly don’t need a protectionist trade war with the United States, a continued pile up of dollar reserves or more domestic inflation. Unlike the paralyzed political class in Japan, the ever pragmatic Chinese leadership may yet make the necessary adjustments. Unfortunately the situation is complicated by the fact that, whereas Japan, South Korea and Taiwan have been allies of the United States, China is a geopolitical rival.

Investing in an Unstable World Economy

“It’s not easy” is the short answer. Markets can turn on a dime. A “buy stocks now” approach because the Fed is embarking on QE2 may be too simplistic and frankly is a little scary. Today’s smart investment can become tomorrow’s disaster when the value of a currency changes dramatically. If the US flips from quasi-deflation to significant inflation investors had better be prepared to do a quick rebalancing of their portfolios. If China exhibits a major slowdown in 2011 and the US and Europe limp along in near or renewed recession, investors face grim choices.

One investment that should be considered is gold. Currencies have lost their ability to be a reliable store of value. Gold is an alternative currency. It is a currency whose supply is not threatened by Bernanke-directed massive sudden increases.

OK gold doesn’t go up in a straight line. So-called experts have been forecasting a correction as gold has risen. And gold is subject to confiscatory actions by governments who do not relish giving up their monopoly to issue and debase their own currency. No doubt the coming US elections will have a major effect on the gold price. Unfortunately I don’t know what that effect will be and neither does anybody else.

I have argued in past Dismal Optimists that while the US may appear to be tottering on the brink of a debt deflation, the surplus countries of the world notably in Asia and the Middle East have inflation problems. All those reserves created in buying dollars are one factor. They aren’t all sterilized. Non US money supplies are rising. Add to this are pressures on natural resources and agricultural products coming from all those new emerging market consumers. This is a second area where investors should put their money while keeping their fingers crossed that any China slowdown will be a gradual one. Bernanke’s Quantitative Easing may not do much near term for US internal demand and real estate prices but they are adding to inflation around the world.

Longer term investors have to assume the gradual abandonment of the East Asian Model, i.e, stronger Asian currencies, more imports, more consumer spending. The big global export oriented US companies—especially those in the technology area– should be well positioned as this happens. So will consumer oriented companies in East Asia. Hopefully significant abandonment will occur in the next two years and not ten years from now.


Peter T Treadway also serves as Chief Economist, CT RISKS, Hong Kong
pttreadway -at-
305 761 4718
852 9409 1186

Category: Think Tank

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