Thursday, September 20, 2007

Is the globalization put expiring?

Whose put is it?

Many readers of financial commentary are likely familiar with the phrases "Greenspan put" and "Bernanke put." These phrases refer not to an actual contract but to a belief that the two successive Fed Chairman would ensure that fear of cascading defaults should not be part of the calculus of financial speculators.

In my usual role as an iconoclast I take a different view of the source of this put. It is not, I argue, faith in the abilities of these two men and their money machines which has kept a floor under equity and bond markets over the past 15 or so years, but faith in the economic virtues of globalization.

This isn't to argue that Greenspan and Bernanke haven't done their job of enforcing the faith, they have. Each time faith in the current experiment in monetary globalization fades, the Fed punishes the unbelievers. But the faith which backs the put is not, I contend, in these two men, but in the virtues of a globalized economy- economies of scale and reductions in redundancies.

I argue that the faith is not in the Fed Chairmen because there have been other Fed Chairmen who played fast and loose with policy, Arthur Burns comes to mind, who did not inspire the same effects. Loose monetary policy during Burns' time, when economies were more autarkic, led much more rapidly to domestic inflation- an effect I believe will become more prevalent as time passes.

War and free trade as opposites

Although there are many bumps in the road to a truly globalized economy, notably impediments to the free movement of labor, and the desire to retain sovereign rights to issuing debt, which most nations are loath to lose, in my view, the stake in the heart of the current attempt to globalize, which mirrors the cause of the end of last attempt in the early 20th Century, is war, and the fear it engenders, loss of sovereignty.

The commercial benefits of economies of scale arise, in part, due to the reduction in redundancies. David Ricardo's work on free trade and comparative advantage speaks to these benefits. And, I believe, the willingness of the financial world to accept what would, in other eras, have been considered imprudently loose policy, as prudent, is due, in large part, to the hoped for benefits at the end of the globalization rainbow. Nor, I believe, is this faith misplaced, in theory. Sadly, for those invested in globalization, theory needs to become practice for the benefits to accrue. Redundancies need to be reduced in order for the hoped for future to materialize and war is the greatest impediment in their reduction.

Waging war effectively requires just the opposite intent as free trade commerce- redundancies become necessary because you cannot rely on your enemy to trade with you. You cannot partake in your enemy' comparative advantage nor can he in yours as they will both be used against each other.

US military might as accepted comparative advantage and its loss

The US, in the aftermath of the first Gulf War, due to the wisdom of Bush the elder's administration in operating under the aegis of the United Nations and opting for a police action rather than a change in sovereignty, found itself in the position of both having a comparative advantage in warfare, and having the trust of other nations that the advantage would not be used against them. Other nations of the world, back then, did not, in the main, fear that comparative advantage. They were content to pay the US for its services when the need arose as the US would pay the Saudis for their comparative advantage in producing oil.

The change in tactic by the team of Bush the younger, away from the UN, and towards unilateralism, has engendered this fear of the US' comparative advantage in war. This fear has led to a resurgence in military spending in other nations- redundancies are coming back into vogue.

And it is this return of redundancies, from military might, to energy and food, which signals the expiration of the globalization put to me. Resources will not be seen as something which are shared and directed to those with comparative advantage at using them, but things to be hoarded by each group, for fear of getting left out.

Moreover, globalization requires a breakdown of national boundaries, such as partially occurred with the Euro, the imposition of which was, in my mind, the high point for this round of globalization. Of late, the trend seems more towards the breakdown of previously unified political blocks. Iraq itself seems ready to degenerate into 3 separate countries, which will engender further redundancies. If the current intra-European tensions become more intense,
due to further inflation, et. al. and the Euro itself is abandoned, globalization will be truly dead, for this era. I'm not forecasting this, but the possibility seems open.

Why should the put expire?

If, instead of betting on the expected reality of the virtues of free trade, which have been slow in coming of late, people had merely hoped for the virtues of free trade, there would be no put to expire. But massive bets, built on the faith that international imbalances would not be a problem in a globalized economy, which would be, to some extent, true if such would come to pass soon, have been placed. Each of these bets, as with all financial transactions which settle in the future, has an expiration date, so too, conceptually, do the aggregate of those bets.

As faith in the realization of imminent globalization fades, concern over the resolution of international imbalances will grow. What used to be considered un-problematic (Cheney's purported quip that deficits don't matter) will be seen in a new light, call it financial revelation. Failure to resolve these imbalances gracefully will only exacerbate the growing distrust between nations. In extremis, international trade itself will decline and a new round of autarkic minded governments could come to power as happened during the days of FDR.

Of course, current trends need not be continued. The US could reduce its presence in Iraq and let them operate under their own sovereignty, and avoid further confrontations with Iran. The US could, that is, come back to the UN and use its military as a UN police force of sorts. Unfortunately,
having invaded one country, it will be far more difficult to earn the same trust which was evident after Gulf War I. Moreover, the domestic drive for war is difficult to stop once war finance has metastasized through an economy and significantly altered the flow of funds. These changes will be difficult to make, and thus I don't see much hope for the globalization put living much longer.

Brass Tacks

Although I suspect the globalization put is expiring I don't think this will mean that Bernanke will stop enforcing the faith as he has been doing. Rather, I believe that their efforts in adding liquidity will create more inflation than they have in the past, as seems to be happening now. Faith in the virtues of globalization masked concerns over imbalances and monetary laxity, and the lack of faith will have the opposite effect, the leaving Bernanke and his successors in the "anguished" position of Arthur Burns.

A breakdown of trust between nations, such as might occur if international imbalances are not resolved gracefully, may well reawaken faith in the virtues of hard money. One doesn't need to trust in a foreign nation's monetary policy when imbalances are settled in Gold, rather than currency.

As a practical matter, investments in the precious metals and commodities in general should thrive if the scenario I've painted comes to pass. On the flip side, the current period of low interest rates will likely end, which will weigh heavily on both bond and equity prices.