The global financial crisis is playing out like a slow-moving, highly predicable stage play. In the current scene, Western governments are caught between the demands of entitled welfare beneficiaries and the anxiety of bondholders who fear they will be stuck with the bill. As the crisis reaches an apex, prime ministers and presidents are forced into a Sophie’s choice between social unrest and bankruptcy. But with the "Club Med" economies set to fall like dominoes, the US Treasury market is not yet acting the role we would have anticipated.
Our argument has always been that the US benefits from its reserve-currency status, allowing it to accumulate unsustainable debts for an unusually long period without the immediate repercussions of inflation or higher borrowing costs. But this false sense of security may be setting us up for a truly monumental crash.
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There is fresh evidence that time is running out for the dollar-centric global monetary order. In fact, central banks outside the US are already making swift and discrete preparation for a post-dollar era.
To begin, the People’s Bank of China has just this week decided to permit a wider trading range between the yuan and the dollar. This is the first step toward ending the infernal yuan-dollar peg. While the impetus behind this abrupt change remains a mystery, I have a sneaking suspicion that, as my colleague Neeraj Chaudhary explained in his commentary last week, the nationwide labor strikes were a prime motivator.
In response to the 2008 credit crunch, the Fed printed so many dollars that the People’s Bank of China was forced to drive Chinese inflation into double digits to maintain the peg. The pain has fallen on China’s workers, who have seen their wages stagnate while prices for everything from milk to apartments have skyrocketed. This week’s move indicates that, regardless of its own policy motives, the Communist Party can no longer afford to keep pace with the dollar’s devaluation. The result will be a shift in wealth from America to China, which may trigger a long-anticipated run on the dollar, while creating investment opportunities in China.
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Just days before China’s announcement, Russian President Dmitry Medvedev rattled his monetary sabre by telling the press of his intention to lead the world toward a new monetary order based on a broad basket of currencies. Giving strength to his claim, the Central Bank of Russia announced that it would be adding Canadian and Australian dollars to its reserves for the first time. Analysts suggest that the IMF may follow suit. While Russia floats in the limbo between hopeless kleptocracy and emerging economy, it does possess vast natural resources and a toe-hold in both Europe and Asia. In other words, it will be a strategically important partner for China as it tries to cast off dollar hegemony.
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Speaking of Europe, the major powers there are moving toward a post-dollar world by rejecting President Obama’s calls to jump on America’s debt grenade. The prescriptions coming from Washington translate loosely to: our airship is on fire, so why don’t you light a candle under yours so that we may crash and burn together. Given that dollar strength is largely seen as a function of euro weakness (as Andrew Schiff discussed in our most recent newsletter), debt troubles in the eurozone’s fringe economies have created a distorted confidence in the greenback. However, as you might imagine, Europe has higher priorities than being America’s fall guy. Led by an ever-bolder Germany, the European states are wisely choosing not to throw themselves on our funeral pyre, but to wisely clean house in anticipation of China’s rise.
In another ominous sign for the dollar, the Financial Times reported Wednesday that after two decades as net sellers of gold, foreign central banks have now become net buyers. What’s more, more than half of central bank officials surveyed by UBS didn’t think the dollar would be the world’s reserve in 2035. Among the predicted replacements were Asian currencies and the euro, but by far the favorite was gold. This is supported by Monday’s revelation by the Saudi central bank that it had covertly doubled its gold reserves, just about a year after China made a similar admission. There is no reason to assume these are isolated incidents, or that the covert trade of dollars for gold doesn’t continue. To the contrary, this is compelling evidence that foreign governments are outwardly supporting the status quo while quietly preparing for the dollar’s almost-inevitable devaluation. What people like Paul Krugman believe to be a return to medieval economics may, in fact, be the wave of the future.
In peacetime, hardened troops will likely tolerate a blowhard general for an extended period; but when the artillery opens up with live ordnance, an ineffectual leader risks rapid demotion. The newspapers are now riddled with hints that foreign governments have lost faith in Washington and the dollar reserve system. It seems to me only natural that after a century of war, inflation, and socialism, the next hundred years would belong to those people who hold the timeless values of hard money and fiscal prudence. Unfortunately, our policymakers are not those people.
June 26, 2010
John Browne is senior market strategist for Euro Pacific Capital.