Sunday, July 08, 2007

Can the death sentence of Bretton Woods II be commuted?

God, give us grace to accept with serenity the things that cannot be changed, courage to change the things that should be changed, and the wisdom to distinguish the one from the other. Reinhold Niebuhr

One of the perils of self-righteousness is the increasing inability to distinguish the things that can be changed from those that can't. The more self-righteous one becomes the more malleable the world seems.

The above thought popped into my head upon reading the news of Mr. Libby's commuted sentence for perjury and obstruction of justice. This isn't to argue that President Bush acted outside his authority in this matter, rather it was the ham-handed manner of the commutation, announced hours after Mr. Libby's request to remain free on bail while his appeals were heard, was denied.

Who knew Monopoly "Get out of Jail Free" cards weren't fictitious?

More people than your author thought this reeked of a deal struck months before- that Mr. Libby need fear no jail time.

Again, I'm not arguing against the President's Constitutionally guaranteed pardon power, but the manner of its use- suggestive of a mindset which thinks laws are for others.

There are, however, as the legend of King Canute relates, some laws even an absolute monarch cannot change. The tides will rise and fall as they will, regardless of who orders them to stop. The earth will rotate on its axis, giving us night and day as it does, regardless of what any person on this planet orders. And economic resources must be allocated reasonably efficiently to produce the necessities of life from the current context or human life will become increasingly difficult.

Governments can certainly ensure that stock indices, whose presence has become ubiquitous on most news channels, will keep rising month after month and year after year, but only at the cost of making those indices useless as measures of national economic well-being (if such were ever the case).

These days I wonder more and more if the primary function of capital markets- to allocate scarce capital amongst competing needs- has been forgotten.

VP Cheney's quip that "Reagan proved that deficits don't matter" comes to mind.

He's wrong. They do, as he and many others are, I believe, soon to learn.

More and more often I read of the need for economic officials to ensure "financial stability"- a phrase which apparently means that equity indices must always rise, and that cascading defaults must be avoided.

But what, I wonder, if capital has been misallocated on a radical scale? In that event, the goal of "financial stability" runs counter to the primary function of the capital markets and the risk rises that procuring the necessities of life will become increasingly difficult for an increasing share of the population.

How, you might be wondering, could capital be misallocated on a radical scale? One way (there are many) is for capital to be allocated based on an erroneous view of the future.

For instance, capital could be allocated based on the assumption that energy costs would forever be cheap. As energy costs rose the misallocation would become increasingly obvious. Life, regardless of the King Canutes decreeing economic nirvana, would become harder.

And so it is.

The global financial system, it seems to me, has increasingly become a means for perpetuating the status quo, despite the fact that the status quo only worked under the (now clearly false) assumption of cheap energy. The global financial system, in my view, as currently managed, no longer seeks to allocate scarce resources amongst competing needs, but instead seeks to promote the illusion that capital is not scarce.

According to the FT, I'm not the only one who thinks something is awry in global finance.
Russian President Vladimir Putin recently said the world needed to create a new international financial architecture to replace an existing model that had become “archaic, undemocratic and unwieldy.

Nouriel Roubini and Brad Setser at the always informative RGEMonitor have also updated their views on the expected end of Bretton Woods II.

One improvement I would make to the current system is the removal of the illusion that capital is not scarce by making money "hard" again- call it a prescription of monetary viagra.

"Here we go again," I can almost hear the fiat money faithful sighing, "another nut calling for a return to the use of the barbarous relic, Gold, as a monetary standard."

"Guilty as charged," I retort. "
The thing is, as I look at the news of the world I don't see many signs that man has forsaken barbarism. Wars, instigated by the supposedly advanced cultures of the world, rage in Iraq and Afghanistan and are threatened in Iran. Meanwhile, the cold war between the US and Russia, the end of which was hailed as the provider of a "peace dividend" (which was spent on, ironicly enough, more war) seems to be heating up. Coincidentally, credit derivative portfolios are "blowing up" at an increasing pace. In a barbaric world where trust between nations is falling, not rising, the barbarous relic, Gold seems a safe bet."

"But why, " they might respond, "has the world managed to survive so well without a Gold standard for decades?"

While I dispute the contention that the world has "survived well" since the early 70s- it seems to me that the top tier has done quite well while the rest languished- I think a more pertinent argument is that the economic context has changed.

That is, I think the risks of "elastic" money, to borrow from the amendment that created the Federal Reserve, are most severe when underlying economic contexts change. So long as natural resources were, in US$ terms, cheaply obtained, increased productivity, a by-product of doing the same things over and over again in the same economic context, masked a fair bit of capital misallocation, like paying entertainers millions while paying educators thousands.

The 80s and 90s were decades of relatively cheap natural resources.

Increasingly, however, natural resources, in US$ terms, are not cheaply obtained. The economic context is changing and capital needs to be re-allocated in a manner that reflects this. As James Howard Kunstler argues both persuasively and humorously, one aspect of current capital allocation that needs to change radically is investment in energy expensive suburbia.

When Levittown, NY, the paradigmatic postwar American suburb, and, it seems worth noting, intellectual incubator of Bill O'Reilly, was being built, crude oil cost about $2.50 per barrel while average hourly earnings were 1.50- a ratio of 1.6 hours of labor per barrel. Currently, crude oil costs $72 while average hourly earnings are 17.3- a ratio of 4.2 hours of labor per barrel.

If oil prices rise to $100 in the next year or two, barring the emergence of radical "share the wealth" altruism on the part of the economic elite, which might lift average hourly earnings, the ratio will be well over 5 hours of labor per barrel.

A tripling (or more) of the labor cost of the sine qua non of suburbia, petroleum, not to mention the higher costs of other items that are increasingly excluded from government measures of "inflation" seems to me a radical change in economic context- a change that exposes capital misallocation.

However, until just recently, the US financial system was considered to be operating efficiently as suburban house prices in, among other places, Nassau County, which includes Levittown, were rising. While oil prices trebled from 1997 to 2007, Nassau and Suffolk County (NY) home prices rose by 50%. Efficient allocation of capital? I think not.

Of course, the capital that was, at least in my view, misallocated in, inter alia, US housing has increasingly come not from domestic sources, but foreign. And if the Iraq War proves anything, it proves that the fiat power of the US government extends only tenuously across our border. It is becoming increasingly difficult for the US government to force others to accept the current status quo perpetuating financial system as they increasingly feel that the status quo needs to change.

With Russia calling for a new global financial architecture while China's need for a system that allocates capital efficiently increases dramatically as it rides the dragon of its unleashed peasants dreaming of middle class status, US government efforts to commute the sentence of no-standard Bretton Woods II, the misshapen offspring of gold exchange standard, Bretton Woods will, in my view, prove as effective as King Canute's orders for the tide to retreat.

The debacle in Iraq exposes the US as a dishonest broker in international affairs and dishonest brokers lead people to seek elsewhere for their intermediation needs. Moreover, politicians, ever eager to blame the woes of the world on others, should be able to lay the blame for the coming economic dislocations on the War policies of President Bush. As you can see, the rats are already leaving that sinking ship.

Selling Gold, massaging statistics and injecting liquidity to ensure "financial stability" will not commute the death sentence of Bretton Woods II. Rather, I believe, these policies will obscure the death behind a facade of health, until, to wax Kunstlerian, the stench of its rotting corpse penetrates suburban SUVs.

Hell, we might discover, hath no fury like a Soccer Mom scorned.

So, what should one do to prepare for the imposition of this death sentence?

I say, buy Gold and other precious metals.

They have, throughout history, been both the means of wealth preservation during periods of transition from one economic paradigm to another and the concrete in the foundation of new monetary systems, whose managers will be eager to prove that the new currency is "as good as gold."


Ruby said...

Dude, you're back! M. King Hubbert of peak oil fame spoke of two systems, the matter-energy system, and the money system. According to King, they were able to coexist for until recently as they both grew exponentially. Energy grew exponentially as our ability to harness higher yields from increasingly energy dense materials, i.e. wood, to coal, to oil, and the money system grew exponentially by compound interest. But the earth can only take so many doublings of population and resource extraction before limits prevent further growth whereas the money system can, theoretically, increase exponentially forever. Thus, he argued, as we come to the end of the energy-matter system, the end of cheap oil, we need a new system of economics based on a steady-state. He proposed everyone getting "energy credits"! I am just learning about what a system like that would look like and am currently researching the possible scenarios, but as I understand it, King's proposal is a top-down, centrally planned type of situation whereby, knowing the amount of energy the world is able to produce, each would get their "share" by simple division.

It sounds pretty crazy, but steady-state economy doesn't. Things that can't go on forever don't go on forever. At some point, we human beings have to reach an equilibrium situation.

Anyway, you should check out Hubbert's paper, basically of a transcript of testimony to Congress which you can find here:

Dude said...


Yes, I'm back. I'm in the midst of building a new house which keep sme away from writing as much as I'd like.

I'm quite familiar with Hubbert's work, with which I, in general, agree.