CURRENCY REVOLUTION by James Grant from Grant's Interest Rate Observer, January 15, 1999
The arrival of the euro last week provoked an isolated and unexpected outpouring of nostalgia. "Our glorious lira," Carlo Azeglio Ciampi, the Italian treasurer, declared - "somewhat improbably," as the Financial Times noted.
Such is the way with currencies: Even the worst of them can get under your skin. The dollar is, by many criteria, the best of them. In branded conSumer-product terms, it is one part Coca-Cola, another part Tide and a third part Jell-O. As a medium of exchange and a store of value, it has had most of the late 20th century to itself. Some 60% of the world's monetary reserves are denominated in dollars, and one side or the other of 80% of the world's foreign exchange transactions involves the dollar. For perspective the U.S. generates only 25% of the world's production and just 20% of the world's trade,
The beginning of the end of the imperial dollar is the subject of this essay. Our conclusion, to leapfrog over about 3,000 words, is that the pieces arc in place for a new dollar crisis. The external financial position of the United States is worsening just as a new competitor currency is rising. Whether the euro will prove to be hard, soft or of an intermediate, chewy consistency is unknown. What is undeniable is that turmoil is the way of the monetary world, currency crises are becoming more frequent and the dollar is the currency with which the vaults of the world's central banks are already papered. Insofar as the dollar has already saturated the store-of-value sector of the monetary market, 'it therefore follows that it may begin to relinquish market share. The Currency outlook we categorically rule Out is the serene, low-volatility one.
Since the Bretton Woods conference in a New Hampshire locale of the same name in the cold summer of 1944, the dollar has enjoyed a privileged place among currencies. It was, to start, as good as gold. Since 1980, it has been better. Probably, not even Procter & Gamble itself could have created the global triumph that the Federal Reserve and the Bureau of Engraving and Printing (in cooperation with the Army, Navy, Air Force, Marine Corps and Coast Guard) have achieved with the legal tender of the United States. No less than two-thirds of the $472 billion of greenbacks outstanding circulate abroad, by Fed estimates. In fact, if not in name, Alan Greenspan is central banker to the world.
However, no monetary monopoly, or monetary system, lasts forever. This year marks the 20th anniversary of the European Monetary System, progenitor of the euro and the European Central Bank, and the 21st anniversary of the dollar crisis of 1978. The two anniversaries are joined at the hip. It was the collapse of the dollar in 1978 that crystallized an already formed spirit of European monetary cooperation. How long such comity might last is a great unknown (one among dozens in the currency markets, needless to say). Since about 1880, no monetary system has survived for more than a generation. The classical gold standard, suspended at the outbreak of World War 1, gave way to the gold exchange standard in the early 1920s, which gave way to the Bretton Woods system in the mid-1940s, which gave way to the current system in the early 1970s. Curiously, the existing dollar-centered monetary system, which features paper currencies without par values, goes without a name. We would call it, comprehensively, the Inconvertible-dollar-and-Improvisational-Semi-Floating-Rate-Free-Market-IMF-Bail out Mechanism. Now, starting with the January I launch of the euro, a new system is in operation.
Customarily, the transition from one international monetary system to another is solemnized by official meetings and declarations. No such ceremony has attended the present-day revolution, although the debut of the euro did not go unnoticed in the press or in the Old World (at a zoo on the banks of the Loire, a baby gorilla, born over the New Year's weekend, was duly named "Euro"). There has been no official acknowledgement of the dollar's demotion from monopoly money to oligopoly money. At the least, it seems to us, another systemic page is about to be turned in the Book of Currencies. Great change is upon us. The dollar was, and remains, the top choice among the world's reserve portfolio managers. The true significance of the euro is that it offers an alternative.
Grant's Interest Rate Observer has forever been skeptical of managed currencies the dollar no less than the dong, the won or the rupiah, and toward the central banks and governments that administer them. Our reasons are straightforward: Over time, the value of paper money tends to depreciate, so that the definition of a hard currency is one that loses value more slowly than the softer brands. The state of affairs in which a currency actually gains value against goods and services, namely, deflation, is condemned as a fatal disease, and central banks are expected to resist it. The means by which they combat deflation is to promote the expansion of credit.
Our prejudice against the institution of managed currencies is one that was hugely popular in the early 1980s, when it shouldn't have been. Then, if you will remember, 13%, 14% or 15% yields were deemed to be inadequate protection against the risks of hyperinflation. Today, the market believes that 5% yields are more than adequate protection against the improbable risk that even trace amounts of inflation will reappear. Possibly, the market may be right in this calculation: Great speculative bubbles of the kind now being blown in the United States have typically ended in deflationary collapse, not inflationary overheating. On the other hand, there is nothing historically typical about a pure paper monetary standard. With gold in the 19th year of a putative million-year bear market, creditors have come to trust in currencies that have rarely held their purchasing power over the life of an intermediate-term note. All the world loves paper, despite a succession of managed-currency disasters, including a European monetary crisis (1991-93), an emerging-market monetary crisis (1994-95) and an Asian monetary crisis (1997 to date). Since 1994, the dollar has traded for as many as 147 yen and as few as 80 yen. Yet, to judge by the gold price or by the coronation of Alan Greenspan as the Financial Times' Man of the Year for 1998, the institution of managed currencies is none the worse for wear. The sheer peasant fatalism of the professional investment world in monetary matters is, to us, a wonder.
Grant's, which is bearish on the dollar, is only relatively bullish on the yen and the euro, the major reciprocal monetary units. This posture may seem mulish. How can a serious, even a learned, financial periodical be bearish on the dollar without being correspondingly bullish on the currencies that compete with the dollar? Because we lack faith in the competition's management. What is the appeal of a 3%-yielding euro when (a) the biggest economy in the euro zone is apparently sinking and (b) European politics are shifting steadily to the left? (We know: The appeal lies in speculating that the administered euro rate will fall to 2 3/4% from 3%.) What is the appeal of the yen at a 112 exchange rate when the Japanese economy is in recession and Japanese interest rates are still remarkably close to zero?
We are bearish on the dollar, first and foremost, because the external financial position of the United States is deteriorating. America's excess of merchandise imports over exports is running at the rate of some $20 billion a month. By definition, these billions of dollars must be invested in something American, by someone: Treasury bills, corporate bonds, factories, equities. The piling up of trade deficits must therefore make its mark on the national balance sheet. So great is the cumulation of deficits that the nation became a net debtor to the world in the early 1980s.
So what? you may ask. In the decade and a half since that accounting event, the dollar exchange rate has been up, and it has been down. However, there is a more recent accounting event to reckon with. In the third quarter of 1997, U.S. aggregate net 'income on foreign assets turned negative for the first time in decades. What this means is that more income was paid to foreign investors in U.S. assets than was earned by American investors in foreign assets. "That will compound the problem," says Gert von der Linde, a Wall Street economist who has retired from Wall Street but not from economics. "Because for all those years we had that net positive income to offset some of our trade and service deficits."
As for the merchandise deficit, it has been worse, relatively speaking. Measured as a percentage of U.S. GDP, the overall payments deficit (the "deficit on current account") made its peak, at 3.6%, in the eventful year of 1987. In the third quarter of 1998, it was 2.9%.
However, we think, not-quite-3% is cold comfort in a world with not one reserve currency to choose from, but two (or, perhaps, more than two if Japan is intent on thrusting the yen into the competition, or if an Asian currency movement gets legs). The euro, for now, is the complicating factor.
There is no certain statistical point beyond which a current-account deficit becomes unfinanceable. There was a dollar crisis in the late 1970s when the U.S. current-account deficit was only slightly greater than 1% of GDP. The crucial variable is not the deficit's size in relation to the U.S. economy, but rather its size in relation to the demand for the dollar by foreign investors, or official institutions, at prevailing dollar exchange rates. Unfortunately, this handy piece of information is not available before it is too late. However, we may surmise that the foreign demand for dollars, whatever it might have been before the euro, has not expanded posteuro. Whether or not the demand for dollars has diminished, the range of possible choice has expanded.
The U.S. has had a chronic current account deficit since the late 1950s. The shortfall has always been financed, but not without occasional drama. Thus, in the early 1960s, in an attempt to mollify worried foreign creditors (was the dollar as good as gold? they wondered), the Kennedy administration imposed an interest-equalization tax, and lined up a standby line of credit from the IMF. By the late 1960s, with the Vietnam War raging, the creditors became unmollified all over again, and the Johnson administration took additional steps to restrict the flow of dollars outside the United States (this was the administration of the Johnson who was not impeached). When, in 1978, Roman hotel clerks chafed at the receipt of American traveler's checks, the Carter administration was actually reduced to borrowing in currencies that it was unable to print in Washington, D.C. Fresher in mind is the dollar bear market of 1987, which helped to precipitate a bond bear market and a notunrelated stock-market panic.
The salient feature of the evolution of the international monetary system over the past 85 years is that It has become easier for privileged countries to run a deficit. The graph on page 5 begins to suggest the extent to which the United States has availed itself of this opportunity. The case for a new dollar crisis rests on the possibility of a change in the tolerance of dollar holders for these deepening shortfalls. Possibly, a standard cyclical mishap (bear market or business recession) will occur as the dollar begins to lose market share to a competing brand of money. German economist Kurt Richebächer succinctly describes the established cyclical risks attending the dollar exchange rate: "In times of strong U.S. economic growth and higher U.S. interest rates in relation to Europe," says the January edition of The Richebächer Letter, "the dollar always tends to soar on the back of accelerating capital inflows. But in this respect, time is running out fast for the dollar. Conversely, it just as certainly becomes winter for the dollar when the U.S. economy slows down and U.S. interest rates fall in relation to those in Europe. Under those conditions, U.S. capital inflows regularly decelerate faster than the trade deficit. With his three rate cuts in the face of an exploding trade deficit and a weakening dollar, Mr. Greenspan gave the clearest possible confirmation that he cares more about the stability of the U.S. financial markets than about the external stability of the U.S. currency."
When the dollar was the only real reserve currency, the financing of the U.S. current-account deficit at a reasonable exchange rate could almostrepeat, almost-be considered a foregone conclusion. The euro has made the conclusion more problematical. At the five-year point of the yield curve, euro-denominated government securities yield 137 basis points less than U.S. Treasurys. Yet, income-starved Japanese financial life insurance companies are said to be weighing a substantial shift into euros by the end of the current fiscal year.
There are also the politics of the situation to consider. Just possibly, in the short run, they could be bullish, not bearish, for the dollar. If the Clinton impeachment trial ends without a conviction or a military coup, some portion of the international currency market will, undoubtedly, heave a sigh of relief. However, it seems to us, the world is opening its arms to an alternative to the American currency. Last week, for example, it was reported that Shozaburo Nakamura, the Japanese justice minister, assailed the United States in a New Year's message for its alleged free-market hypocrisy and bomb-dropping diplomacy. The Japanese people, Nakamura was supposed to have said, are "writhing because they cannot revise a constitution imposed by Allied forces so that the country would not be allowed to wage war, defend itself or have an army."
Nakamura apologized, but no newspaper definitively reported that the minister's fingers were uncrossed when he did so. Meanwhile, Keizo Obuchi, Japan's prime minister, traveled to Paris where he launched an appeal for international currency cooperation. "A tripartite cooperation between Japan, Europe and the U.S. would allow the creation of a stable and developed international monetary system," said the premier. Joseph Yam, head of the Hong Kong Monetary Authority, simultaneously issued a similar call in Hong Kong. "At present," said Yam, "Asia's central banks invest massive amounts in foreign securities, particularly U.S. dollar assets, only to see volatile funds flow back to the region from overseas markets. By investing reserves directly in Asian financial assets, this type of costly and unstable recycling through developed markets could be reduced."
In general, because no managed monetary system has ever succeeded for very long, the basic ideas of fixed- and flexible-rate regimes are continually being recycled. After a flexible-rate system comes a cropper, the cry for stability invariably goes up; and after a fixed-rate system collapses, statesmen pant after flexible rates. Sometimes, in the hands of an artful drafting committee, a single statement can come down on both sides of the fixed- and floating-rate issue. A masterpiece of such systemic diplomacy was produced by the Committee of 20 in the wake of the failure of the Bretton Woods system in the early 1970s. Said this body, judiciously, "Members of the Committee recognized that exchange rates must be a matter for international concern and consultation and that in the reformed system the exchange rate regime should remain based on stable but adjustable par values. It was also recognized that floating rates could provide a useful technique in particular situations. There was also general agreement on the need for exchange market stability and on the importance of Fund surveillance of exchange rate policies."
Sometimes, we suspect, momentous policy proposals are purposely couched in a soporific prose to lull the unwary. Thus, the Tripartite Agreement of 1936 among the U.S., Britain and France - a seemingly bland undertaking to work for currency cooperation and stability-actually wound up foreshadowing the landmark Bretton Woods arrangements eight years later. Possibly, the Obuchi balloon will float after all, and an Asian currency bloc will be created to vie with European and American ones.
What, exactly, might touch off the millennial dollar crisis? You know what, of course. However, a U.S. stockmarket break, which would likely cause the flow of foreign speculative capital into the United States to stream back out, Is perhaps too obvious a candidate. Maybe, the cause will be something out of the blue. Indeed, it isn't easy to identify the proximate cause of a currency crisis even after the event. Thus, in its postmortem of the 1991-93 European breakdown, the Bank for International Settlements could find no one cause, nor even a persuasive set of causes, to explain the debacle. It cited political reasons - e.g., doubts about whether the euro would actually come to passas well as economic and financial ones. It mentioned the subversive roles played by leveraged hedge funds and the unreliable dollar exchange rate.
This "most severe and widespread foreign exchange market crisis since the breakdown of the Bretton Woods system 20 years ago," as the BIS called it, was followed by a crisis that was arguably just as severe and even more widespread, and that has perhaps not ended yet. In its most recent annual report, the BIS considered this latest blot on the monetary record in phrases that do not buttress one's confidence in the prospects for meaningful nearterm monetary reform: -The fact that financial and exchange rate crises have continued to occur, and indeed have become more frequent in the 1990s," said the bank, recalling the hypnotic style of the Committee of 20 a generation before, "clearly indicates that preventive measures to date have been inadequate. Nevertheless, a great deal of work has been undertaken in recent years and considerable progress has been made in some areas. The Group of Seven summit communiques from Halifax, Lyon and Denver gave significant impetus to such work, as have the documents issued after the Birmingham Summit."
How will the BIS explain the dollar crisis of 1999, or (we would like to give ourselves some latitude as to timing) 2000 or thereabouts? It will cite, of course, the multi-decade buildup of dollar balances as the consequence of the persistent U.S. current account deficit. It will mention the speculative bubble that foreign capital helped to finance and the marginal shift of international reserve portfolios out of the dollar and into the euro, or an Asian alternative. It might choose to draw attention to the intervention of June 17, 1998, in which the United States government, in cooperation with the Japanese government, sold dollars for yen (thereby sowing doubts about the durability of the commitment by the great debtor nation to a strong currency). The irony of the dollar's fall from grace, the bank could observe, is that it was the dollar's alarming weakness that galvanized the Europeans into action in 1979 to establish the European Monetary System. Finally, the bank might adapt a paragraph from a January 9 Financial Times editorial: "U.S. oil imports, which had been running at 10 million barrels per day," it would say, "made the country much more vulnerable than a decade ago to any world price increase. The return to $20 per barrel oil in mid-1999 added $30 billion to the United States' already over-stretched external deficit."
All good things come to an end, the dollar's charmed life in the world currency markets not excepted. It ended temporarily some 21 years ago, during the inflationary crisis of the Carter term. On Nov. 1, 1978, the U.S. administration, its back to the monetary wall, announced a drastic plan to restore confidence. It would borrow from the IMF, sell SDRs, increase the Federal Reserve's swap lines with the Bank of Japan, the Bundesbank and the Swiss National Bank, issue up to $10 billion of U.S. government securities denominated in marks, Swiss francs and yen, and - a rarity in U.S. monetary policy - boost the Federal Reserve discount rate by one full percentage point, to 9 1/2% exclusively for foreignexchange reasons. Such was the humble pie served tip to the reserve-currency country when the dollar (financial bastion of the Free World against the Soviet Union) was the only liquid reserve currency available.
Even before the coming of the euro, and before the talk of a globally competitive yen, the dollar was an accident waiting to happen. Now that monetary competition is surfacing, the wait has been measurably shortened. Economist Von der Linde says that his prediction for the surprise of the millennium is that the United States once more is forced to borrow in a currency not of its own creation. What could be more unthinkable? Yet, it has happened before.