Friday, October 09, 2009

Currencies and Confidence

In many ways the continuing financial crisis is quite literally all about money.

The repeated bubbles of the Greenspan years at the US Fed created a long term credit environment that was so relaxed that it was essentially uncontrolled. The US created credit conditions that promoted massive borrowing which increased the wealth held in possessions but reduced the wealth held in cash- indeed created a negative net cash position. Yet the side effect was also to reduce the value of saving so that the holders of cash were not able to gain sufficient reward for them to even want to hold their wealth in money. A twenty year long largely debt-fuelled, gigantic spending spree was the result. In the end, this super cycle of credit growth ended with the credit providers being forced to recognise that the quality of their assets (i.e. the loans they had made) were not what they were said to be.

This final recognition was the result not just of the dramatic expansion of lending to poor quality credit, but the way that this poor quality credit was distributed unexpectedly across the entire system through the use of credit accumulators such as collateralized debt obligations. As the financial system began to recognise their losses it quickly became clear that the scale of these losses could not be sustained without massive government intervention.

The conventional way of dealing with the crisis would have been the restructuring of bank balance sheets and for the short term at least, a significant contraction in the overall level of credit in the economy. However, Ben Bernanke, the Chairman of the Fed, and several other major policy makers believed that the scale of the credit contraction that they were looking at was so severe that it would have cause an economic crisis of an even bigger magnitude that the Great Depression of the 1930s. As historians of this period they thought that they had the answer, which was to reduce the impact of the contraction of the credit by increasing the monetary mass in the economy by a level that would, to a great extent, off-set the monetary contraction.

In a way, what these policy makers were doing made a certain amount of sense: they were trying to ease the impact of the credit crunch so that the credit system could have time to restructure itself without a massive fall in lending that would have caused the global economy to hit the wall and make the existing credit problems still worse. However, there is an increasingly significant side effect from the policy: holders of cash in the currencies were these policies are running are still facing negative interest rates and therefore the relative attractiveness of holding US Dollar or Sterling assets has fallen sharply. Other economies without such "Quantitative Easing" policies have therefore become more attractive. Furthermore, China which has become the primary manufacturing market on the planet, has found that their immense US Dollar surpluses have lost a significant percentage of their value, even though the Chinese have managed to avoid the giant appreciation in the Yuan that the current situation justifies. Using the Dollar as the base currency used to make sense, since the Greenback has been the global reserve currency for decades. Oil and most commodities are priced in Dollars, and it is the worlds largest economy.

Now, however the scale of the twenty year debt binge in the US has undermined the value of the Dollar, and many now believe that that American currency can no longer be seen as the ultimate store of value that its "reserve currency" status implies.

The counterpart to fall of the Dollar in the financial crisis has been the increase in the value of gold. Gold is often used as a store of value in a crisis, and there is a direct relationship between global instability and a higher price of gold. As the Dollar fell, allowing US to pay back its US Dollar debts in smaller amounts of Euros, Yuan or Yen, Investors have questioned the place of the Dollar as the reserve currency and the price of gold has continued its long term upwards trend.

More and more commentators suggest that the Dollar's days as the reserve currency are indeed essentially over, but though several secret discussions are said to be taking place about a global basket of currencies, including the Euro, Yen and Yuan as well as the Dollar (and potentially gold too) to replace the greenback, this has not yet taken place.

The value of a currency depends on investor returns and the confidence that those returns can be sustained. Yet the credit crisis has drained confidence and the policies of quantitative easing are so ruinously expensive that they can not be considered as long term solutions. Sterling in particular, as a medium sized currency, is vulnerable from every angle: a beneficiary from the global credit binge, the UK has a highly inflated housing market, and a diminishing productive capacity, not only in manufacturing, but in services as well. The UK economy has many of the most extreme problems of the US, but it does not have the size of the economy that can give it stability in the long term. Certainly many Chinese market players do not expect that Sterling can survive as an independent currency. As for the US itself, confidence remains elusive, and other concerns such as "peak oil"- i.e. the end of the hydrocarbon energy bonanza- and the fears about the impact of climate change are creating an atmosphere that suggests that the systemic upheavals of the past two years are not a passing crisis, but instead presage a far more unstable economic environment and, as an undemocratic China asserts itself more aggressively, an existential risk to the systems that we have known since 1945.

As the markets wax and wane under the tides of confidence, there is a growing fear that the policies that the US and the UK are following are not only unsustainable in the long term, which is not really a matter of debate, but that they will cause permanent damage to the economies of both countries. The impact is not just that we may see further considerable instability in the Anglo-Saxon markets, but that we are entering a long term crisis with dramatic and highly unpredictable consequences.

2 comments:

Newmania said...

That was really a superb post deserving of wider notice C.

Brian Barker said...

A recent CNN television broadcast gave the impression that Esperanto aims to be a single global language. The comparison was with a global reserve currency instead of the US dollar.

See http://jeffreyhill.typepad.com/english/2009/09/video-global-currency-global-language.html#tpe-action-posted-6a00d8341d417153ef0120a5a17e4b970b

May I put the record straight? Esperanto intends to be an auxiliary language, or a second language for all. Please see http://www.lernu.net for confirmation.