Sunday, August 28, 2011

Modern Global Economy - Wither currencies?

Very few realize the depth of the changes Nixon brought about in 1971 when he depegged dollar from gold thus creating the modern currency markets as we know them. One of the most profound change was the paperization of currencies. This one move made all currencies into paper currencies - delinking them from any hard/real asset and thus allowing central banks everywhere to choose to print money at will!
In theory this was a good thing. (and no, I am far from an enthusiast of gold standard, this is not about that anyway). This allowed countries much higher degree of flexibility in managing their fiscal, monetary and economic  policies. In practice though, the world very quickly witnesses several cases of hyperinflation including Poland, Russia, Zimbabwe, Brazil and so on. Part of this was because the central banks of these countries sort of ignored the linkage of inflation with printing money (and thus money supply).

Till date though, it was thought that the currency systems after the abovementioned demise of Bretton-Woods-II was largely a positive thing - especially for the governments whose central banks were more responsible about printing money. The recent fall-out of the 2008 crisis however raises serious doubts about this.

There are three major contributions of the present currency system to the development, deepening and furtherance of the crisis.
1. Status of Dollar as a global currency - despite the freedom that the US central bank has in printing money
2. Manipulation of Yuan by China and their respective currencies by the East Asian governments to promote exports at the cost of domestic demand - thus creating long lasting global economic imbalances
3. Emergence of Euro - a monetary union which works in good times but complicates life significantly during bad ones.

I have detailed the first two in my book. The funny thing about the present currency system is that the fiscal and monetary policy independence enjoyed by individual countries is not entirely reflected in the interlinkages of their respective currencies with each other. The presence of central banks of all the leading governments - as active players in bond and currency markets globally - makes the matters even more complex. These are no more simply rational economic agents trying to maximize their risk adjusted returns - their behavior is far more complex and hence lends itself to rounds of second, third and higher order guessing by other market participants! (Imagine the recent anticipation ahead of Ben Bernanke's address at Jackson Hole!)

For a moment if we were allowed the "flight of rationalistic fancy", what would we wish for as regards global monetary system?

Tough question. I would think of a global currency backed by reserves held by all major economies with a central authority - in the form of guarantees or claims on hard assets. This currency to have tooth will also need some compulsory use in global trade - almost like a quote each country has to finish before starting to use any other currency for trade. This is half-return to gold standard. Half in the sense that there is no gold backing any one currency. However, the relative values of different currencies are not entirely in the hands of the respective central banks! That might solve the problem of uncoordinated monetary policy pushing the world into worse state every day. This needs more work! 

Thursday, August 18, 2011

The Anomaly of US Credit Rating Downgrade!

The credit rating downgrade of US Govt. seemed like an exercise in signalling alone. In fact funnily enough the flight of safety that will ensue thus will push up the prices of US treasuries thus reducing the yields on them. Hence the US treasuries would probably become the first security ever to increase in value after a credit rating downgrade!!
That of course is only half the story. The price of a security is mostly about its economic value. However, there are some overlays such as liquidity, special currency status and home country bias that may produce a fundamentally opposite outcome to that on account of inherent economic value alone. This is indeed the case with US Govt debt. Owing to the special status of dollar as the global currency, the unmatched depth and liquidity of the US Treasury bond market and the fact that US in indeed the home to a large proportion of global investors, the treasuries can indeed rally despite (and in fact because of) the credit rating downgrade!

Where do we go from here? Will the US go into long-lasting recession (or even depression)? Will the Euro survive? Will China slow down? Will India slow down? Will global inflation lead to continued tight money policy in emerging economies thus leading to a period of anaemic growth even amongst the BRIICS?

Whatever be the ultimate diagnosis and the result thereof, I often think that the worries as well as enthusiasm get played up significantly in our times - thanks largely to media, social networking and the presence of highly liquid markets for assets. While that may sound like a nuisance to some, it also smells like an opportunity - if only one can keep one's head when everyone around is losing theirs!