Currencies | Sep 23 2009
By Greg Peel
The top ten countries in the world by population are, in descending order, China, India, US, Indonesia, Brazil, Pakistan, Bangladesh, Nigeria, Russia, Japan (Australia comes at 52 in case you’re wondering). If you combine the populations of the European Union as one entity, it would rank third ahead of the US.
Some interesting round numbers to note are that the US has a population of 307m, the EU 491m, Japan 127m, China 1333m, and the BRIC countries combined (Brazil, Russia, India, China) have a population of 2834m.
The equivalent 2008 GDP comparison in trillions of US dollars is US 14.2, EU 18.4, Japan 4.9, China 4.4, and combined BRIC 8.9.
Now note that the US consumer represents roughly 70% of the US economy, or about US$9.9trn in 2008, while BRIC consumer spending in 2008 reached only US$2.5trn, representing only 28%.
Looking at such numbers, one begins to see why the world is in economic imbalance. But while the US is undoubtedly the world’s biggest consumer, the BRICs are still only the fastest growing exporting group. The EU is the world’s biggest exporter, with Germany still number one all on its own, while China comes in second on its own and Japan fourth. The equation is then muddled by the US being the third biggest exporter, and by the EU being a pretty healthy consumer.
But amongst the mess we can see that the world is far from in any form of equilibrium, in which the most economically powerful and populous groups have balanced import and export economies. There is a big leaning towards the rest of the world producing goods for the US to consume.
The real problem arises when one considers the US dollar is the world’s reserve currency, with nothing but the US economy to back up its value. Since any requirement of gold-backing was dropped in 1972, the US has plunged deeper and deeper into debt to support its consumption binge. But because the export nations reinvest their US dollar receipts into US Treasury securities, the world is lending the US the money to fund its consumption. The more the US consumes, the more the export nations receive, the more they lend that back to the US, the more the US consumes, ad infinitum.
Well not quite ad infinitum.
Obviously this formula is one that can only lead to a bubble – a bubble that last year spectacularly burst. But there were two more factors which only served to accelerate the bubble in this century – uncontrolled US leverage and a Chinese currency pegged to the US dollar.
In the case of the former, leverage serves to multiply debt and allow even more spending of what is really “funny money”. The US Fed dropped its funds rate to an historical low 1% in 2004 in the wake of the post-9/11 recession in order to restart the US economy, while at the same time regulators allowed US investment banks to increase their leverage limits from 12 times to 40 times. Cheap money, multiplied to astronomical levels.
In the case of the latter, one dampening mechanism on global economic imbalance is free-floating exchange rates. The more indebted economy (US) should see its exchange rate drop in relation to the surplus (exporter) economy thus making those goods more expensive to buy and US exported goods more attractively priced. But because the fastest growing economy’s currency is pegged in a range to the US dollar, this mechanism is disabled. That, in itself, is one reason China is the fastest growing economy.
It’s not a perfect mechanism anyway. The Japanese yen floats, but because Japan has been stuck in deflation for over a decade its interest rate has remained near zero, offering an alternative funding mechanism for US consumption and keeping a lid on yen appreciation. The Japanese also have a longstanding mindset of saving money (and investing those savings offshore) in contrast to US spending lust. The Chinese are also dedicated savers.
The GFC provided an opportunity for the world economy to rebalance, or more realistically for the world economy to collapse and start again. But because this solution was rather unpalatable, world leaders adopted a plan to prevent collapse by replacing the excessive private debt imbalance in the system with public debt. And the greatest amount of public debt injection has been made by the US, which really is only a means of ensuring the American lifestyle is reinstated, being one of excess consumption backed by debt.
It would make perfect sense for the rest of the world to let Americans suffer as a result of a GFC many feel was American in origin, but the truth is the rest of the world needs the US to consume its exports such that its own economies do not collapse.
In other words, the Great GFC Rescue Plan, being enormous public-funded fiscal and monetary stimulus, is simply a means of returning the world to the imbalanced state that created the GFC in the first place. The only inevitable outcome can be another GFC at a later date.
Except that the G20 leaders see the GGFCRP as being a means of preventing collapse in the short term and thus allow breathing space in which to adopt measures to ease the world quietly out of debt and into a new, safer global economic framework. Thus this week’s G20 meeting, which begins in Pittsburgh on Thursday night, has three main agenda points – climate change, regulation and global imbalance.
Forget climate change – that’s a side issue. And forget regulation. Regulations may be put in place to avoid, for example, another subprime lending spree but regulations only plug holes behind financial disasters, they never pre-empt them. Addressing global imbalance is another issue entirely.
The problem is the world is in a reserve currency trap. The GFC proves that the reserve currency is overvalued, even despite its fall since 2001. Were the US dollar to collapse in value against other currencies (including the Chinese renminbi) then US consumption would be choked off, forcing the US to put more effort into producing exports and less into consuming imports, thus attempting to find a balance. On the flipside, economies such as China’s would be forced to put less effort into making fridges for Americans, who would now no longer be able to afford them, and more effort into making fridges for Chinese, which will now be cheaper locally (given a stronger renminbi).
In other words, were the US dollar to collapse (and assuming the renminbi was unpegged) then global imbalance would begin trending towards balance and another GFC would be less and less of a threat. The rest of the world could easily spark a US dollar collapse by refusing to buy any more US Treasuries – the funding needed to finance the US deficits.
But again, the problem is that such a collapse would not just hurt Americans. The rest of the world, and particularly the export nations, are the biggest holders of existing US Treasuries, so to allow the US dollar to collapse would be to see trillions wiped off the value of foreign US holdings. That is not a palatable solution either.
Yet a solution must be found, and the only real alternative is to find some sort of middle ground. The safest solution would be to allow the US dollar to devalue in an orderly fashion, over time, thus achieving the desired goal without a calamitous “short, sharp shock”. But given the world’s major currencies are supposed to float freely, then such a solution would required an orchestrated depreciation of the US dollar by the world’s central banks.
Central banks enter into currency markets to prevent excessive volatility often, although it’s seen as a bit of a last ditch effort. When the GFC hit in earnest, world central banks agreed to use their own currencies in coordination to prevent any major disasters. But if the G20 leaders decide the world needs orchestrated US dollar depreciation, it would mean the central banks moving in to overrule the free market.
And why not? It’s happened before.
In 1985, amidst the economic boom that followed the 1970s stagflation recession, the leaders of what was then the G5 (US, UK, West Germany, France and Japan) decided the reserve currency was so overvalued against the US current account deficit it was causing global economic imbalance. (And who said history never repeats). So they signed an agreement in the New York Plaza Hotel which came to be known as the Plaza Accord, which saw the G5 central banks intervening in currency markets to force a depreciation of the US dollar against the Deutschmark and the yen.
And it worked. By 1987 the dollar had depreciated by 50%. (Just don’t mention the Crash of ’87, or the Savings & Loans debacle of the early 1990s.)
Ahead of this week’s G20 meeting, a more emboldened International Monetary Fund is calling for the issue of global imbalance to be the major topic of discussion. Reuters reports the governor of the Bank of England (one of the developed world’s hardest hit economies) as suggesting that unless the issue is resolved, the world is “doomed to repetitions” of the GFC and accompanying “substantial recessions”.
And while it is beholden upon the President of the United States to be seen as always supporting a “strong dollar” policy, the announcement this week by Barack Obama that he would push G20 leaders for a new “global framework” has been taken as an implication by many that a coordinated dollar depreciation would be welcomed by the Obama Adminsitration as the best way to reduce America’s deficits and curb its profligacy.
Such a move would nevertheless act to stem China’s runaway economic boom (assuming the renminbi is allowed to also appreciate within the plan) but then that’s exactly what Chinese authorities want anyway – a more controlled boom. China also wants to ease away from excessive investment in US Treasuries, but can’t afford to do so given the huge amount it already holds.
Across the globe, world leaders are calling for either a move away from the US dollar as the global reserve currency or threatening to withdraw support for the US dollar over time. In other words, a coordinated and gradual depreciation of the US dollar would be in everyone’s interests, including America’s.
One presumes the topic will indeed be discussed in Pittsburgh. But as to whether a decision to go ahead with depreciation will ever be announced is another matter. Such an announcement would immediately lead to exactly the rapid collapse the G20 doesn’t want, given global currency markets would simply spring into action. Although an announcement of sorts did follow the Plaza Accord.
What could happen is a bit of a hint might be dropped, sparking further falls in the dollar, but then rather than coordinating US dollar-selling the major central banks could coordinate US dollar-buying against the market, and thus let the greenback down gracefully.
Whatever the outcome, the currencies markets have been jostling for position this week, ahead of the G20 meeting. The fact the euro went back through US$1.48 last night for the first time in 2009 may be a hint as to which way the dollar might go.
(Note that a depreciated US dollar would mean an appreciated Aussie dollar, which would mean Aussie exports to the US would suffer while US imports would be cheap. In terms of trade with China, Japan or anyone else, a depreciated dollar should be irrelevant given all other currencies will appreciate together. But Australia will thus be reliant upon the domestic economies of China, Japan et al to pick up end-consumption levels – ie consumption of finished goods, not just raw materials – lost from the US.)
