G7 - Between the Devil and the Deep Blue Sea
Daan Joubert
The "G-7" is the acronym for finance ministers of the seven richest countries in the world and the regular meetings they hold. These meetings have a long history - although earlier they were known as the G-5. They have achieved some notable successes, such as the Plaza accord in 1985 where they decided the dollar was too weak and had to be supported. The results were so good that in 1987 at the Louvre meeting they had to put the brakes on the US currency - also with success.
These examples show that when the powerful men are in agreement, they achieve results with no qualms about ‘letting free markets determine the relative levels of currencies.’ They probably arrange a lot more besides - that would not fit well with the concept of free markets. The ideal of ‘free markets’ only gets hauled out when one or other of the G-7 members disagree with the nature of the intervention engaged in by one or more of the other members.
So the first lesson to remember about members of the G-7 is that when one or more of the members place the ideal of a free market on a public pedestal, one should immediately wonder what parochial interest lies behind the sudden change of heart. Recently we have had Mr Snow, Secretary of the Treasury, calling for currencies to find their own levels in the free market system. He calls for currencies to reflect economic fundamentals and not to be managed according to the wishes of government or any pressure groups.
Just to make sure that matters did not progress too hastily and cause unwanted volatility, the pronouncements in favour of ‘free markets’ were at first interspersed with statements that the US still favoured a ‘strong dollar policy’, without, of course, ever having given the slightest clue as to how such an official policy is implemented. In the run-up to this past weekend’s G-7 meeting in Boca Raton, Florida’ the strong dollar policy was quietly forgotten and everything was focused on ‘let the free markets rule’.
What does Mr. Snow want to achieve with this rhetoric?
First of all Snow wants China to unpeg the yuan from the dollar so that China's growing economic muscle can be reflected in a stronger currency. That would make US imports from China more expensive and would hopefully begin to assist to reduce the escalating trade deficit. If this can be achieved, at the same time as boosting US exports, an important voting block would look more positively on the Bush re-election. Japan has similar issues to solve. The Bank of Japan does not wnat to continue to have to spend trillions of Yen buying dollars in order to remain competitive with China.
The currency affair seems to be a high priority issue. However, in today’s complex world where all manner of derivatives have strengthened the ties between different aspects of the global economy - a weaker dollar is not something that can be achieved in isolation. Other developments are bound to be triggered by a weaker dollar - and with immediate ramifications. So let us list a few - just a few!
Of the factors that the Bush administration surely had to weigh very carefully before they let Snow loose on the free market topic:
It seems quite certain that tax cuts and various freebies - and in particular the funds released by the mortgage refinance business - were major contributors to the good growth in the US economy last year
Low interest rates are essential if the housing and refinance boom are to continue
American households are using a wide range of credit, including the mortage market, to finance their purchases of all manner of durable goods and services
US corporations are gearing up to meet the increased demand of the past few quarters; they have started to hire new employees and some are even beginning to make capital investments to expand or renew production capacity
With so much US industrial production moving off-shore, prices of manufactured goods in the US are becoming more sensitive to the value of the dollar.
The Federal Reserve has indicated that it will keep interest rates low until growth in the economy has shown itself to be self-sustaining
There is a saying that one should be careful - one’s wishes might be granted.
So what is the kind of scenario one could expect should Snow's wishes come true -- for instance if China decides to cut the peg to the dollar and let the yuan revalue.
Two of the critical effects of such a development would be the following:
The Bank of Japan - and some other central banks - would no longer have to purchase dollars in such extraordinary quantitites to devalue their own currencies
Imports into the US of a very wide range of consumer goods would rise in price as the dollar weakens further against nearly all currencies
With their surplus of dollar reserves and the US$ weakening further, China, Japan, Taiwan and a good number of other (predominantly Asian) countries will reduce the growing drain on their reserves by selling US securities, probably switching into the Euro.
US households will face rapidly rising prices for consumer goods - something against which they have been well protected because of the peg of the yuan to the dollar. This is likely to trigger a credit funded buying spree to be followed by a steep decline in purchases of all manner of consumer goods - with a negative effect on GDP and perhaps disastrous effects on US manufacturers -- who have recently been gearing up for the new boom in the economy.
Rising inflation can no longer be hidden by hedonistic statistics. Foreign holders of US$ assets would get frightened by the (initial) lack of a suitable response from the Fed; they would begin to sell dollars in earnest
When foreign central banks stop buying US securities - Treasuries in particular - the yields would begin to rise, placing upward pressure on mortgage rates. The end of the boom in house prices and also the refinance bubble.
If these scenarios escalate, determine for yourself the consequences of a weaker dollar. Look again at the above lists and the implications for the US and global economy.
It does not take long to realise that the global economy that has been running only on half cylinders - an economy propped up effectively by US debt - cannot hold up against the devastating effects that would almost inevitably follow from a sustained decline in the US currency.
Obviously, the strategists in the Bush administration are aware of the risks of a weaker dollar, but they would not have advised Snow to embark on the path he took unless they believed that they can manage the situation, however it develops. They believe they can steer the US into a new and sustained growth phase.
One alternative is that they accept that they cannot accomplish this, but believe they have enough power through the Fed to be able to put sufficient spin on it all to convince the masses that all is well and getting better. To ensure a Bush re-election as well! Let whatever problems cannot be solved, delayed or spun out of sight -- stand over until 2005 and a new inaugural speech.
A cynical view?
Just think of the WMD fiasco and ask yourself how much less chutzpa it will require to bluff the American people into a resurrected economy until November this year.
What does this have to do with the gold price - which is the main theme of these essays?
Very much indeed. A weaker dollar, as now seems most likely, is good for gold. The turmoil that one can expect to erupt once these dominoes fall, will accelerate the gold price.
Don’t sell your gold shares yet!
10 February 2004
© February 2004 Daan Joubert
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