The end of September is here. We wish you a happy and healthy fall season in the northern hemisphere and spring in the southern hemisphere.
THE G-20 MEETING
Last Thursday and Friday, the G-20 meeting was held in Pittsburgh. At this meeting, it was decided that world economic power, which had been the bailiwick of the eight G-8 countries, should be broadened to give more voice to twelve additional countries. This gives the G-20 power to set world economic policies.
The Group of 20 includes Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Mexico, Netherlands, Russia, Saudi Arabia, South Africa, Spain, Turkey, the United Kingdom, and the United States. The most powerful of the twelve newcomers to the economic setting body are India, Brazil, Saudi Arabia, and China. It is interesting to note that both Saudi Arabia and China are big creditor nations to the U.S., and India and Brazil are among the world’s fastest growing nations.
The G-20 summit also included much political furor about the pay of bankers. Legislation will undoubtedly ensue as a result of the political outrage of the man in the street. Does anyone really think that this will stop high trader and banker pay? It is a big world. The companies who hire the high-priced traders and bankers are big global companies, and they can pay you anywhere and at any time. Our guess is that this will create some fees for international tax lawyers but very little change in income for bankers.
In an article last week, Martin Feldstein, professor of economics at Harvard, was Chairman of President Ronald Reagan’s Council of Economic Advisors and President of the National Bureau for Economic Research discussed his expectation for rhetoric, but little substance from the G-20 communiqué this past weekend.
Martin Feldstein: The G-20’s empty promises
Talk about “exit strategies” will be high on the agenda when the heads of the G-20 countries gather in Pittsburgh a few days from now. They will promise to reverse the explosive monetary and fiscal expansion of the past two years, to do it neither too soon nor too late, and to do it in a coordinated way.
These are the right things to promise. But what will such promises mean?
Consider first the goal of reversing the monetary expansion, which is necessary to avoid a surge of inflation when aggregate demand begins to pick up. But it is also important not to do it too soon, which might stifle today’s nascent and very fragile recovery.
But promises by heads of government mean little, given that central banks are explicitly independent of government control in every important country. The US Federal Reserve’s Ben Bernanke, the Bank of England’s Mervyn King, and the European Central Bank’s Jean-Claude Trichet will each decide when and how to reverse their expansionary monetary policies. Bernanke doesn’t take orders from the US president, and King doesn’t take orders from the British prime minister (and it’s not even clear who would claim to tell Trichet what to do).
So the political promises in Pittsburgh about monetary policy are really just statements of governments’ confidence that their countries’ respective monetary authorities will act in appropriate ways.
That will be particularly challenging for Bernanke. Although the Federal Reserve is technically independent and not accountable to the President, it is a creation of the US Congress and accountable to it. Because of the lagged effects of monetary policy and the need to manage expectations, early tightening by the Fed would be appropriate. But the unemployment rate could be over 9 per cent — and possibly even more than 10 — when it begins to act. If so, can we really expect Congress not to object?
In fact, Congress might tell the Fed that it should wait until there are clear signs of inflation and a much lower unemployment rate. Because Congress determines the Fed’s regulatory powers and approves the appointments of its seven governors, Bernanke will have to listen to it carefully — heightening the risk of delayed tightening and rising inflation.
Reversing the upsurge in fiscal deficits is also critical to the global economy’s health. While the fiscal stimulus packages enacted in the past two years have been helpful in achieving the current rise in economic activity, the path of future deficits can do substantial damage to long-run growth.
In the US, the Congressional Budget Office has estimated that President Barack Obama’s proposed policies would cause the federal government’s fiscal deficit to exceed 5 per cent of GDP in 2019, even after a decade of continuous economic growth. And the deficits run up during the intervening decade would cause the national debt to double, rising to more than 80 per cent of GDP.
Such large fiscal deficits would mean that the government must borrow funds that would otherwise be available for private businesses to finance investment in productivity-enhancing plant and equipment. Without that investment, economic growth will be slower and the standard of living lower than it would otherwise be. Moreover, the deficits would mean higher interest rates and continued international imbalances.
In contrast to monetary policy, the US president does have a powerful and direct impact on future fiscal deficits. If the presidential promise to reduce the fiscal deficit was really a commitment to cut spending and raise taxes, we could see today’s dangerous deficit trajectory be reversed.
Unfortunately, Obama shows no real interest in reducing deficits. The centrepiece of his domestic agenda is a healthcare plan that will cost more than a trillion dollars over the next decade, and that he proposes to finance by reducing waste in the existing government health programmes (Medicare and Medicaid) without reducing the quantity and quality of services.
A second major policy thrust is a cap-and-trade system to reduce carbon emissions. But, instead of raising revenue by auctioning the emission permits, Obama has agreed to distribute them without charge to favoured industries in order to attract enough congressional votes. Add to this the pledge not to raise taxes on anyone earning less than $250,000 and you have a recipe for large fiscal deficits as long as this president can serve. I hope that the other G-20 leaders do a better job of reining in their budgets.
Finally, there is the G-20’s promise to reduce monetary and fiscal excesses in an internationally coordinated way. While the meaning of “coordinated” has not been spelled out, it presumably implies that the national exit strategies should not lead to significant changes in exchange rates that would upset existing patterns of trade.
In fact, however, exchange rates will change — and need to change in order to shrink the existing trade imbalances. The dollar, in particular, is likely to continue falling on a trade-weighted basis if investors around the world continue to set aside the extreme risk-aversion that caused the dollar’s rise after 2007. Once the Chinese are confident about their domestic growth rate, they can allow the real value of the renminbi to rise. Other exchange rates will respond to these shifts.
In short, it would be wrong for investors or ordinary citizens around the world to have too much faith in G-20’s promises to rein in monetary and fiscal policies, much less to do so in a coordinated way.
Additional news which came out Friday is that while world trade is picking up, trade is still shrinking in the U.S. and Europe. World trade is rising in large part to Asia, Australia, Canada, Brazil, and European, and U.S. machinery and technology companies exporting to Asia. Although, we have been concerned about a possible trade war during this economic contraction, we are not as concerned now. We know that for political purposes, the U.S. and China are both behaving in a reactionary manner, but we do not see these as precursors to a larger trade war.
ECONOMICALLY, AS GOES CHINA…SO GOES THE WORLD
As the world economy continues to stumble ahead, we can see signs that the deflationary recession / depression that we have experienced is becoming less deflationary and that inventory restocking is causing some growth in the world. However, the world, excluding China, India, and some other parts of Asia remains very dependent upon Asian economic activity to provide the economic growth.
Much depends on what amount of economic growth China’s top officials determine is necessary to stimulate. This will determine how much the world can recover. China is moving to shift some of the huge build-up in liquidity caused by foreign direct investment and export income from China into neighboring economies. China is buying more supplies from their Asian neighbors, and the manufacturing of low-labor-cost articles is moving to other countries, such as Vietnam.
China is encouraging Chinese investors to buy gold and other investments which will mop up excess liquidity. China is also encouraging money to flow out of the country into neighbors like Hong Kong through administering special licenses for investing abroad.
THIS IS A BIG WEEK FOR THE U.S. DOLLAR. WE EXPECT IT TO FALL.
Fundamentally, there is no compelling reason to hold dollars over the long term. Last week, there was a Federal Reserve meeting in which the Fed said that they will leave interest rates unchanged for an extended period of time. They neither did nor said anything to buoy the falling dollar.
The G-20’s increased power diversifies global economic power away from the U.S. dominated G8. This can only be bad for the U.S. dollar, and bad for the U.S.’s unilateral influence over world economic and financial activity. This is yet another of the many steps that have been progressing for some time and will be needed to transfer world currency dominance from the U.S. dollar to another currency. The next major step may be to use a basket of currencies to replace the dollar. The basket approach has been shown to be ineffective in the past. The final solution, which could take over a decade or longer be agreed upon, will be for the Chinese Yuan to be the world reserve currency.
We see only one reason that people will flock to U.S. dollars in the future, and that is due to the dollar’s perceived value as a safe haven; for example if there were renewed fears of a collapsing global banking system.
We believe the next leg down in the global banking system may be some years away when the derivatives market once again comes around to bite the naïve and the greedy. Since we foresee no global banking collapse in the coming months, there is no reason to believe that the dollar can experience more than a temporary rally. However, we will use any rallies as an opportunity to further diversify out of the dollar.
We are considering and buying currencies such as the Brazilian real and the Indian rupee, in addition to the old standbys like the Euro, Canadian, Australian, and Norwegian currencies. Within the U.S. dollar sphere, we believe it is safe to own oil and gold stocks in this dollar-declining environment. Also within the dollar sphere, we feel comfortable owning export-oriented stocks with demand from abroad. Some examples are: manufacturers of semiconductors, machine tools, some other technology products, and farming related products. These benefit from a weaker dollar since their prices become more competitive as the dollar falls.
I am happy to report that the limited availability of rare earth metals has finally come to the attention of investors and businesspeople in the developed world. China has dominated the mining and trading of rare earth metals, and they have been hoarding rare earths for years as we have mentioned in our past commentaries. China now controls many of the rare earth minerals that are necessary to produce certain high tech and energy saving products, and they are threatening export restrictions of these minerals.
For years, the U.S. and European governments and the buyers of these raw materials who use them in critical military and security devices, have been doing nothing to prepare for the coming emergency. We can only assume that long-term planning is anathema to politicians who are only worried about collecting enough money to be re-elected, and who ignore the longer-term consequences of their selfish and shortsighted approach.
In any case, we are happy to see that rare earth mining is increasing outside of China and that substitute products for rare earths are being created when possible.
Many markets, including most world stock markets, oil and gold have been getting a correction in price as the end September has rolled around. We will use corrections in oil gold and foreign markets as opportunities to buy. The trader-oriented rumors that an oil glut is coming are patently absurd. China, India, and many other countries are increasing oil demand, and global oil supply is falling. New discoveries offshore in deep water which have recently been announced will take the better part of a decade to begin to flow.
Within the U.S. and Europe we will consider buying export-driven stocks. Last, but not least, foreign currencies are a must for all U.S. based investors to protect them from a current and expected decline in the value of the U.S. currency.
Thanks for listening. Please do not hesitate to contact us with your questions or comments.
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