Crisis Begets Crisis

"If ever there was a crisis that could shake the global economy," Richard Russell told the audience at the New Orleans Investment Conference a few weeks back, "this is it." But in a fiat money world, explains Christopher Mayer, currency is always in crisis.

"The world is in permanent monetary crisis," Murray Rothbard once observed (in Making Economic Sense), "but once in a while, the crisis flares up acutely, and we noisily shift gears from one flawed monetary system to another." Monetary systems built on floating fiat currencies are fragile things. Most of the world currently operates under this arrangement.

The only thing worse, in Rothbard’s estimation, is fixed exchange rates based on fiat money and international coordination. Markets are fluid and changing. The government fixed exchange rate is bound to be either too high or too low – with problems in either case. The history of attempting to maintain certain fixed exchange rates by international agreement has a long, rich history of failure, once again illustrating that government power is no match for the relentless and merciless forces of the market. All of which does not bode well for China’s ability to maintain its own fixed exchange rate against the dollar.

Our own dollar has led the life of a tempestuous teenager, seemingly unable to stay within the bounds of the rules laid down for it by the powers that be. The Bretton Woods Agreement lasted from 1944 to 1971 and was a form of a fixed exchange rate system based on international coordination. The dollar was defined at 1/35 ounce of gold; all other currencies were fixed in terms of the dollar. Importantly, the dollar was only redeemable in gold for foreign governments.

Currency Crises: The Smithsonian Agreement

As expected, the U.S. government inflated the currency – as governments are prone to do. Dollars grew rapidly; the supply of gold did not. Inevitably, as foreign governments began to turn in their dollars for gold, Uncle Sam found out that his gold stash was getting light. And so he decided to break the agreement.

In 1971, Nixon closed the gold window. In its place came the Smithsonian Agreement, which called for an 8 percent devaluation of the dollar, among other things. But that could not stop the push of market forces, which, like the swollen Potomac River in the days before hurricane Isabel, simply ignored whatever man put in its way. In February 1973, the dollar was devalued again. By March, the Smithsonian agreement was no more.

Ever since, the dollar has been a fluctuating fiat currency with no ties to gold.

Europe, too, has been unable to build a durable system based on fiat currency. The European Economic Community established one of the better-known pegged rate exchange systems in April 1972. EEC members decided that their currencies were to be maintained within established limits of each other.

This initial arrangement became colorfully known as "the snake." But market pressures busted the snake, as governments were unable to keep their currencies within these bands.

Currency Crises: ECU

The next step was the European Monetary System, in March 1979. Here currencies were held together by the European Currency Unit (ECU) – a unit of account based on a weighted average of the exchange rates of member countries. That went bust in the fall of 1992, after experiencing severe problems and despite the attempts of numerous European Central Banks to maintain it by intervening directly in the foreign exchange markets. Again, government dictates held up like straw houses in gale force winds – which is to say, they didn’t.

The latest system created the euro, which began in 1999. The euro is relatively young even by monetary standards. There are not yet actuarial tables accurately devised for the life expectancy of paper money, but theory and history agree that it’s something less than permanent.

Pegged rate systems are great for fueling crises. Like oily combustibles lying around in a garage, a small flame can start a great fire and take down a house. Another instructive case is the peso meltdown in 1994-95, or the so-called Tequila Crisis.

Before the crisis, Mexico linked the peso to the dollar, but allowed for a band within which it could float. The Mexican government would frequently have to intervene in the market to enforce this band. Mexico experienced a large trade deficit in 1994, perhaps indicating that pegged to the dollar, the peso was stronger than it would have been without government intervention. Money supply growth was brisk in the years preceding the crisis, and 20% or more per annum throughout most of 1994.

As always seems to happen in these types of systems, the Mexican government could not control the growing supply of pesos, nor could it bolster the weakening demand for pesos. At the same time, it struggled to maintain the peso’s value in terms of the dollar.

In December, the endgame began for this arrangement. Mexico’s central bank finally devalued the peso by 13% on December 20. By the end of December, the peso floated freely and fell another 15%. In the four-month period beginning on December 20th, the peso lost 50% of its value.

Currency Crises: The Asian Crisis of 1997

Take another example – who can forget the Asian Crisis of 1997? Originating in Thailand, it spread throughout Southeast Asia – the Malaysian ringgit, Singapore dollar, Philippine peso, Taiwan dollar and Indonesian rupiah all declined. The Asian Crisis sent ripples across financial markets all over the world.

Prior to the Asian Crisis, Thailand had a pegged exchange rate tied to the dollar. Again, the Thai baht became weaker in the marketplace, and investors exchanged the baht for dollars. The Thai central bank spent more than $20 billion trying to maintain its pegged rate, but ultimately had to lift it. Quite simply, the supply of baht exceeded the market’s demand for it and the government’s intervention only delayed and exacerbated the crisis. Over a five-week period, the Thai baht lost more than 20% against the dollar. Other Southeast Asian countries also had to surrender their fixed exchange rates.

This brings us, in a roundabout way, to the current feud surrounding the yuan and dollar. As we have blazed through a selective short history of currency blow-ups, it should be clear that maintaining a peg in disharmony with market forces is a recipe for a costly disaster.

For ten years, the Chinese have maintained a fixed exchange rate of about 8.28 yuan to the dollar. As has been well documented, the U.S. has been a great importer of Chinese goods. We take their merchandise, and they take our dollars. According to James Grant, "the dollars pile up on the balance sheet of the People’s Republic of China at the rate of $10 billion per month." Such trends are unsustainable. At some point, the Chinese are going to have to stop acquiring dollars at the fixed rate. The yuan, it seems, is too cheap at this rate, and the Chinese money supply is booming. People are eagerly swapping their dollars for yuan.

Currency Crises: China Booms

Meanwhile, money and credit are booming in China. As Grant writes, "It is therefore no accident that the Shanghai real estate market is on fire, that Chinese loan growth is burgeoning or that frightened Chinese monetary authorities have been unable to keep the lid on Chinese money-supply growth. By making the yuan too cheap, they have also, necessarily, made it too plentiful."

The resulting artificial boom in China is no good for the Chinese. A bust follows every such boom. If allowed to float, the yuan would presumably get stronger, and some of the money flows would slow or even reverse. It may be too late for China, whose government seems just as intent on destroying the Chinese currency as American officials seem bent on destroying the dollar – whether knowingly or not.

Count the yuan dollar fiasco as just another chapter in the long saga of man’s futile struggle to master paper money. The unattainable dream is to be able to produce as much of it as possible at near zero cost, while still retaining its purchasing power in the real world of things.


Christopher Mayer
for The Daily Reckoning

November 18, 2003

P.S. Murray Rothbard wrote, "Governments don’t know, and don’t want to know, that the only successful fixing of exchange rates occurred, not coincidentally, in the era of the gold standard." The reason is easy enough to understand. It worked because monetary units, like the dollar, were fixed in terms of their weight in gold. Gold has to be extracted, manufactured within the market, and cannot be created out of thin air. But government planners don’t like gold. It ties their hand. They can’t spend so freely because they know they have to redeem their monetary issues in gold. It checks their inflating ways.

It’s easy to be depressed when you look around and see the state of monetary affairs. But, as Rothbard noted, and as the short historical vignettes above show, we have one great force in our favor. As Rothbard cheerfully remarked, "Free markets, not only [in] the long run but often in the short run, will triumph over government power." The inability of governments to maintain fixed exchange rates in the face of opposing market forces is only further proof of their impotency.

Christopher Mayer is a commercial lender for Provident Bank in the suburbs of Washington, D.C.

"What can be done?"

We were being interviewed on Bloomberg radio last night. We had outlined our view: that Americans were getting poorer, not richer, each year…that stocks would inevitably go down to more reasonable levels…that the dollar would collapse…that consumers would have to stop consuming so much and begin saving and investing.

"What should the Fed do…what should the administration do…how can these things be avoided?" came the question. In the America of 2003, every problem is believed to have a solution. Every crisis is avoidable. Every situation is win-win. And every knob on the Great Machine has a function; we just have to know how and when to turn it.

Nothing can be done, we explained. Alan Greenspan can do nothing but make the situation worse. Nature has to have Her way.

Here at the Daily Reckoning office, we keep a lonely candle burning for the Ought School of Economic Theory. What happens, we believe, is not what people want to happen – no matter how many knobs they turn – but what ought to happen. Of course, what Ought to happen doesn’t always happen at convenient moments. We are subject to deep depressions and frequent sulks when – as now – we have to wait. After all, we have staked our reputations on the arrival of the Ought event; thank God, we lost little when it failed to show up.

The structural problem, we continued, is that Americans spend more than they can afford. They make up the difference by mortgaging their houses and using credit cards. Debts mount up – to 32 trillion dollars, or three times GDP. Never before have they been so high. By any measure, never before have so many Americans owed so much to so many.

"We know your listeners would like to avoid any disagreeable outcomes," we went on in a surly tone of voice. "But people who spend too much ought to suffer somehow…don’t you think?"

There are some things that ought not be avoided…and shouldn’t be. If a man robs a liquor store or beats his wife, a night or two in the hoosegow might have salutary effects. Even if he is not caught, he ought to be. Recessions…and bear markets, too…are similarly useful and ought to happen from time to time. They are nature’s way of reminding us not to overdo it.

When the recession struck in 2001, it would have been a good time for reflection and readjustment. Faced with job losses and stacks of bills, the normal thing to do would have been to put the liquor away, cut back on spending, and pay down debts. Instead, the Fed dangled the keys to a new car…offered more E-Z credit…and practically stocked the liquor cabinet. In a matter of months, the music started up and the party continues to this day.

Will the music ever stop? Yes, it will. Will the bills be toted up? Yes, they will. Will there be headaches and regrets? You bet. Is there anything the Fed can do to avoid it? No, there isn’t.

Over to Eric Fry, with the market news:


Our man on the scene in New York City…

– The Empire State’s business activity is booming, but the Empires State’s stock market is "bumming." Manufacturing activity in New York State surged again in November, the Federal Reserve reported yesterday. But the stock market responded to the news with a sell-off. The Dow Jones Industrial Average fell 58 points to 9,711, while the Nasdaq dropped 1% to 1,910. Gold also skidded yesterday, falling $6.50 to $391.50 an ounce, after touching a new high of $399.90 earlier in the session.

– The "general business conditions" index of the New York Fed’s Empire State Manufacturing Survey surged to 41, a new record, from a revised 34.1 in October. The New York Fed also said three quarters of respondents expect better conditions in the future, compared with just 5 percent expecting conditions to worsen.

– But the Empire State’s surging optimism did not inspire much optimism in the stock market. Maybe that’s because the increasing terrorist activity in the Middle East is inspiring an offsetting dose of pessimism…

– Is the stock market’s disillusionment phase underway? Has Mr. Market become a glass-half-empty kind of guy?

– We like Mr. Market, but we trust him less than a country- club smile. For months, he pretended to see a recovering economy that no one else could see, while pretending not to see a geopolitical crisis that was brewing right under his nose.

– Maybe he was faking it all along. Maybe he never really did see a robust recovery after all…It’s true that GDP soared 7.2% in the third quarter. But the statistically booming economy is failing to add jobs, failing to generate sales growth from the private sector and failing to prevent insiders from dumping their overpriced shares.

– "As any economist will tell you, rapid productivity growth is the way to economic Eden," said Business Week’s Kathleen Madigan, while on the set of CNNfn with your New York editor last week. "Lately, though, the spectacular improvement in output per hour worked seems more like the ticket to a jobless Hell…About a million jobs have disappeared from U.S. payrolls since the recovery began nearly two years ago. Now comes word that even though the economy powered through the third quarter at a 7.2% annual rate of growth, the strongest in 19 years, productivity accounted for all of that gain as well. Are we caught in a kind of productivity trap that will continue to rob job growth and thus hold back the recovery in 2004?"

– When it comes to faith in the nation’s productivity miracle, the Daily Reckoning’s New York correspondent is an atheist. Even though we Americans type on laptops while driving and wear cell phones to bed, we have less "down time" than ever before. It’s true, we have become extremely productive…at the expense of destroying weekends and vacation time.

– "Productivity" always feels like a kind of statistical mirage – comforting from a distant macroeconomic perspective, but disappointing up close. Touchy-feely statistics like productivity don’t drive a great big economy; gritty data like industrial production and export growth do.

– Based on the gritty data, the U.S. economy seems to lack an engine of sustainable growth. Earlier this month, when Cisco Systems released its third-quarter earnings, CEO John Chambers wondered aloud about the strength of the U.S. economic recovery, "What sort of legs will it have? How strong will it be? And how long will it last?"

– Chambers had good reason to ask these questions. Cisco’s dazzling earnings report relied upon a very unspectacular – and unsustainable – foundation: sales to the government. "Over the past couple of weeks, I’ve listened to scores of tech company conference calls," says Fred Hickey, editor of The High Tech Strategist. "In nearly every case, from Cisco to Foundry to Motorola to CDW, the story was the same – their best customer was the U.S. government."

– Obviously, a tech-boom fueled by government spending is not exactly the sort of boom that powers sustainable revenue growth. "If, as Cisco and others suggest, Uncle Sam was doing a lot of the heavy lifting, where does that leave the economy?" wonders Terry Keenan of the New York Post. "You guessed it – back in the hands of the over-leveraged consumer."

– Cisco’s Chambers, for one, does not seem convinced that a long-term recovery is underway. We infer as much from the fact that he pocketed $38.3 million Thursday selling Cisco shares as they hovered near 52-week highs.

– "The move comes just days after the executive voiced his strongest prediction yet of an emerging tech-spending recovery," notes "Adding to the brilliant timing, the networking chief is selling at a time when his San Jose-based tech juggernaut just happens to be buying back shares at a record clip.

– "Cisco spent $2 billion last quarter on stock buybacks, doubling its $1 billion in cash flow for the period. And executives on the earnings call last week told analysts that ‘we intend to be active in the market,’ as the company has $10.2 billion in buyback funding remaining."

– Hmmm…the demand for Cisco shares may be as unsustainable as the demand for Cisco routers.


Bill Bonner, back in Paris…

*** A soothing message came to us from colleague Dan Ferris, editor of Extreme Value:

"Aren’t you the most idiotic investors, waiting for your buy price in gold. It’s a classic error.

"If you’re waiting for some kind of wonderful price before you buy gold, think of it this way. If you bought gold for $400, and it fell to $300, what action would you take, if any?

"If the answer is ‘buy more,’ then you are either being presented with the chance to buy gold before it really takes off, or you’ll be presented with the chance to lower your average cost sometime hence. Either possibility is attractive.

"You can’t expect dirt cheap prices for something like gold to prevail for long. (Everyone who hears that will say it was dirt cheap for the better part of 20 years, but nothing like that is the truth.) When it went to $370 or whatever it was a few weeks back, that was your chance. I don’t know that you’ll see it again for a while…like years.

"Investing is not a game whereby you pick the precise moment, after which the price will only go up.

"If it’s down-and-out bargains you want, then you need to either be extraordinarily patient and stick to your gold strategy (how did you arrive at your target buy price, anyway?), or go where the down-and-out bargains are, like Latin America, or someplace like that."

*** The price of gold fell $6.50 yesterday. But it remains above $390 an ounce. How high might it go? The price hit a bubble high of $850 an ounce back in 1980. It would have to rise over $2,000 to hit that level again, adjusted for inflation. Of course, the supply of dollars multiplied many times in the last 20 years too. What is a reasonable price for gold? Who knows.

*** All around us, a bullish tide continues to surge. But the music will stop, we believe; eventually, the illicit party will come to an end. Then, there will be plenty of hangovers, wish-I-hadn’ts and if-I’d-only’s…

We cannot foresee all that lies in wait for us. But we have a hunch: the U.S. dollar’s predicament is at the heart of the matter. As of yesterday, the greenback wallowed in misery at nearly 1.18 to the euro.

[Ed note: More on the problems facing the U.S. currency in a DR guest essay, below…discovered as we researched what’s in store for the dollar. Watch this space for a new special report – written expressly for you by your DR editors – on how you can profit from the dollar’s ineluctable decline.]

*** We met with Father Varengo yesterday. Henry is expected to go to the Vatican at Easter to do his Profession of Faith, the only class of 7th graders in all of Christendom so privileged. But his mother was worried: Henry was not baptized Catholic. What if church authorities noticed?

Your editor argued that high church Episcopalians were already Catholic. "At least, we are not really protestants," he continued, "since we never protested anything…and in fact, we seem willing to go along with just about anything…as recent events in New Hampshire prove."

His mother took a different line of argument. "He has done everything to become Catholic. He goes to a Catholic school. He is an altar boy in church. He goes to mass and has been confirmed in the church. And besides, we would like him to be Catholic. At least, the doctrines are clear. In fact, I was thinking about it myself."

"Don’t worry about it," said Father Varengo. Henry is a practicing Catholic, even if he is not, shall we say, ‘legally’ or ‘officially’ a Roman Catholic. He has been confirmed in our church, after all. There should be no problem."

"Henry," his father reported the news to the 13-year-old, "you’re all clear.All set. No problem. But if you get to St. Peter’s square and you see a stake with firewood around the base, run!"

The Daily Reckoning