Our old friend Isaac Newton developed his laws of motion and published them in his work entitled, “ Philosophiae Naturalis Principia Mathematica” in 1687. The law basically states that an object in motion tends to stay in motion, unless acted upon by an external or outside force. I tend to think of the market in terms of the laws of nature and physics although not exclusively but there are many areas of the markets that do seem to obey the rules of nature. Dear reader you may be asking yourself yet again has your humble author lost his mind, how does this law of motion apply to the markets and why should I care; I will try and explain below.
The Bretton Woods agreement, which had its genesis out of the ashes of WWII in 1945, established institutions that we know like the IMF (International Monetary Fund) and the International Bank of Reconstruction and Development that we today call the World Bank. The Bretton Woods Agreement, so named after the Ski Area in New Hampshire where it was agreed to in the confines of the very elegant Mount Washington Hotel, established a monetary management system for commercial and financial relations between the countries of the world. The chief upshot of Bretton Woods was to establish a monetary policy in which each country would maintain an exchange rate of its currency with in a fixed value at the time plus or minus 1% in terms of gold; the IMF’s original charter was to bridge any temporary gaps or imbalances in payments in this world trade system. It should be noted that in 1971 President Nixon took the convertibility of the Dollar out of the Bretton Woods equation but that is a different discussion and not important to the jist of this missive.
The Bretton Woods agreement eventually gave rise to the US Dollar as the worlds reserve currency a privilege that the US has enjoyed for just about the last 70 years. The US has been able to use its special status as the Sovereign of the worlds reserve currency to allow the “American Empire” to not only grow very large in size but also to essentially live well above its means, not that I am complaining having been a beneficiary as a proud US Citizen. Along with the reserve currency a light needs to be shined upon the BIS or Bank of International Settlements. The BIS was actually established in 1930 so it is actually an older institution than the IMF or even the Bretton Woods agreement. I don’t want to delve in to the murky history of the BIS and the fact that it was once owned by a combination of government and private parties and even had shares that traded on exchanges; instead I would point out that today the BIS is wholly owned by member central banks. Moreover, the BIS is the conduit through which world commerce settles and the BIS settles its transactions in the reserve currency aka US Dollars. In other words if lets say Italy wants to buy oil and they go out in to the market to do so they must first convert their currency to US Dollars in order to settle the transaction. The old saying “money makes the world go round” is true but from a trade perspective it is “US Dollars make the world go round” and it has been that way now for several generations.
To paraphrase the thinking of Newton, the Dollar has been a trend in motion for the last roughly 70 years and is continuing on that path, however external forces are beginning to act upon the Dollar. As early as 2000 just after the launch of the Euro there were rumblings in various corners to try and exert external pressure on the Dollar to break it’s hegemony. In November 2000 Time magazine carried an article in which Saddam Hussein claimed that Iraq would no longer accept Dollars but Euros instead for oil , as he did not want to “deal in the currency of the enemy”. One could easily argue that Saddam was a bit player and never really got any traction with this issue, however, after 9/11 I theorize that part of the reason he was targeted in the “War on Terror” was more due to his threats regarding Dollar hegemony than terrorism. Although I have never heard any statements that would corroborate such a theory, but a loss of reserve currency status poses much more potential danger to the American way of life than any terrorism that Saddam supposedly plotted. Let’s put aside the conspiracy theories and move on to the next data point.
We all know that China who holds a very large amount of US Debt is unhappy with the currency situation that the US has created and lately has been critical of the FED’s QE. China has been not only vocalizing their dissatisfaction, but also they have been attempting to reduce the amount of US Dollars they hold and as a result have been on a worldwide buying spree especially of raw material assets they will need to grow their economy. Back in March of 2009 China and Argentina were near a $10 Billion Dollar deal to allow trade in their respective currencies. Then in June 2009 China and Brazil agreed to trade in their respective currencies bypassing both the US Dollar and the BIS. This year, Iran announced that currency reserves are going to be held in Euros rather than Dollars facilitating oil sales outside the Dollar Standard; this was mostly a political move to escape US pressure but it adds fuel to the anti-Dollar fire…no pun intended.
The Russians have been very vocal about their anti-Dollar feelings and in the irony of all ironies have taken to lecturing the US about hwo to run a capitalist system, but I digress. This leads me to the story coming across the wires today“China,Russia Quit Dollar”; the Chinese and Russians have agreed to conduct trade in their respective currencies.
Bit by bit all these currency agreements undermine and dilute the original Bretton Woods agreement and in turn take small steps to removing the reserve currency status of the Dollar. As I have stated the Dollar has been the defacto standard for a very long time and it will not be dethroned easily but the external forces acting upon the Dollars forward inertia are growing. Deals like the ones mentioned appear to be growing and the G20 being another indicator suggests that the disdain toward the Dollar and US monetary policy is growing causing a lack of faith.
The problem of course is what would replace the Dollar as it is the deepest market and has grown to handle all the volume of world trade; some would suggest that due to all the money printing it has well exceeded all the volume of world trade. There has been much talk about using an IMF currency of sorts called a special drawing right or SDR, but that is unproven and potentially very inflationary as it is essentially a bookkeeping entry not backed by anything. There have been many ideas floated regarding baskets of currencies and even Robert Zoellick has suggested some sort of gold backed currency; I am certain that over time the world will arrive at some standard but the process will be long and drawn out.
Followers of this blog already know my feelings about the Dollar under the current stewardship of “B52 Ben”, “Turbo” Timmy and the rest of the cast of characters who have abused the “Dollar privilege” to such a degree that the world is seriously looking for exit strategies. The Dollar’s reserve currency status is most definitely under attack and little by little chinks are appearing in the Dollar armor; the more of these chinks that appear the easier it is for other players to make their own deals and further erode the Dollar’s status. There are many people out there that consider the loss of the Dollar’s reserve status impossible or very far off in to the future; I am more concerned about “Black Swans” at this point regarding the dollar. I am concerned that it will be some innocuous event that will cause many players to abandon the Dollar in rapid succession and only history will be able to clearly see the events that lead there but those living through the situation will continue to have their blinders on. It is no different than the murder of the Archduke Franz Ferdinand of Austria in 1914; while those living then may have seen that this would cause Austria-Hungary to declare war on Serbia but I am certain very few were prescient enough to recognize that it would have been the genesis of WWI.
These reasons are why I am constantly harping on the fact that one should make sure that their net worth is tied up in “things” that will retain value in spite of the dollar at least in nominal terms. In a situation like what I believe we are facing the winners will be the ones who preserve their wealth and the real lucky ones will be the few who mange to expand their wealth. Those who subscribe to the theory that we cannot have very high or hyperinflation here in America because either it has never happened before or because we have not printed that much money or any other rationale ignore the fact that severe or hyperinflation are not just a result of money printing but of velocity of money cause by lack of confidence in said currency.
As I have stated before while inflation is always a monetary event conversely a severe or hyperinflation is more than a monetary event it is a human nature mass psychology event. The continual Dollar bashing along with the erosion of the reserve status through the currency deals becoming more frequent are a warning sign to be heeded. Nothing would please me more than to be wrong about this but with that in mind my suggestion is “prepare for the worst but hope for the best”. Take steps now to protect yourself just make sure that the steps you do take are not detrimental to you if by some miracle everything returns to the good old days. In the mean time each little force is acting upon the dollar and if it gets to a tipping point the Dollar could fall out of bed suddenly instead of slowly, we have all been warned.
*******************************UPDATE FROM YESTERDAY*******************************
As a follow up to yesterday's post "The Socratic Method" in which I also discussed the North and South Korea incident. The bargaining is already beginning and nothing has transpired since the incident yet the MSM(main stream media) is still unnecessarily hyping this story as it plays on peoples nerves and sells more dog food via commercials than stories about peace love and tranquility. The North did not directly attack the mainland due to their calculus that this their chosen action would get equal press coverage but the situation is much easier to diffuse since they are like a bully who makes threats but is fearful of actual confrontation, it is the North's modus operandi to create false tension in order to either enhance their bargaining position or obtain something and here is the start of that.