The Curse of the Reserve Currency

13^th July 2008
The Malta Independent on Sunday

There’s something strange going on in the financial world for which there is as yet no definite explanation. The world had grown accustomed to living smoothly with structural imbalances without great problems but suddenly something snapped and these imbalances no longer seem sustainable.

The USA, as the holder of the reserve currency of the world, has been running huge balance of payments deficits, which were being reflected in huge surpluses in oil-exporting countries and in China, Japan, India and other Asian economies. Notwithstanding the huge magnitude of such imbalances they did, for a time, seem to defy the laws of natural economics and appeared sustainable indefinitely without difficulty, as surplus countries accumulated reserve dollars which they gladly re-lent back to the US at cheap rates.

This worked well for the US consumers who could so afford to live beyond their means through easy credit on terms that indicated repayment could only come by taking a larger loan to re-finance. Larger debt was not considered scary, as the availability of cheap credit brought an asset price bubble in real estate making the net finances of consumers appear stronger, higher debt notwithstanding, for as long as the value of their immoveable, mostly residences, kept increasing.

It also worked well for the surplus countries as it permitted them to peg their own currencies to the US dollar in order to protect their price competitiveness by not allowing their own currency to revalue in accordance with the efficiency gains and development of their own economy.

Reality can be avoided for a long time but not forever. Something had to give and it finally snapped on both sides of pacific, and also in Europe, with unpleasant consequences.

On the US side, the property bubble burst with very severe consequences on the US consumers, who are witnessing the value of their property fall below the level of covering mortgages, leading to loan defaults, foreclosure and a glut of unsold property stock that is continuing to depress property prices, sometimes to exaggerated levels. The pendulum never stops in the middle when it is released from far out. This is causing the banks to register huge losses on their property exposure, weakening bank balance sheets, demanding massive recapitalisations and causing severe illiquidity on the financial markets, where even the most deserving are finding it difficult to access credit.

On the Asia side, the fall in the value of the US dollar and the corresponding fall in their own pegged currencies is causing accelerating domestic inflation, overheating their economies with an increased risk of economic collapse and huge foreign exchange losses on their foreign reserves if the rate of exchange of their domestic currency has to be allowed to revalue to mitigate the serious problem of inflation.

On the European side, countries who had experienced a property boom caused by their recent economic successes, such as the UK, Ireland and Spain, are now being hit by the burst property bubble and illiquid financial markets imported from the US. Euro area countries are suffering from an overvalued currency that had to absorb the fall in the value of the US dollar, which should have been absorbed by the surplus Asian currencies that however remain artificially pegged to the US dollar.

Every country is suffering under the severe strain of exploding energy prices and exploding food prices, which was contributed to partly by the mistaken policy of trying to solve the energy crisis by shifting to bio-fuel production the resources normally allocated to food production.

We are now in the painful phase of re-balancing structural imbalances which suddenly became unsustainable. The US economy is slowing, flirting with outright recession at a time when consumers are being hit right, left and centre. Their asset values are falling, their purchasing power is being hit by the doubling of energy prices and they are suffering withdrawal symptoms from credit dependence as credit is no longer available. This slowdown will reduce consumer demand, which will address the balance of payment deficit through rising unemployment and business defaults. Asia will also have to slow down its pace of growth if it is to address its domestic inflation problem. Higher domestic interest will make the currencies of Japan, China, Korea, Taiwan and other Asian tigers unable to sustain their peg to the US$. In the absence of a drastic decision to allow their currencies to float freely, monetary authorities will have at least to tolerate greater flexibility in their peg to the US$. A contemporaneous slowdown in the US and Asia will go a long way to address structural imbalances but only at the expense of a rather prolonged, even if shallow, recession. Such curtailment of demand would then reduce the rise in the price of energy and commodities and sometime in 2009 we could possibly look forward to growth based on a more sustainable base.

There are many theories as to why we have come to this point and why it has happened so suddenly, when until this time last year the world seemed perfectly comfortable with long-standing structural imbalances. My explanation to this is what I term the curse of the reserve currency.

The moment a currency is accepted as an international reserve currency there is born within it the seeds of its own destruction. The owner of the reserve currency, as the US has been since the end of the Nazi war, has the facility to acquire its needs from the rest of the world merely by creating more of the freely acceptable currency. In reality, it becomes an obligation to service world growth by creating more of the reserve currency entailing the reserve currency-owning country to start running chronic balance of payments deficits. In simple layman’s language, this means that the owner of the reserve currency will be duped to start living well beyond its means.

Too much of a good thing gradually starts creating its own problems, as reserve currency holders start getting restless with the large accumulation of reserves and growing doubt about the sustainability of its value. Six years ago the US$ was worth €1.290. Now it is worth €0.58. Its value has more than halved in Euro terms. Could the increase in the price of energy and commodities be explained, at least in part, by the policy of mass holders of US$ to convert them into real assets as quickly as possible by buying energy and commodities both spot and futures before the dollar falls further?

We are possibly at the sunset stage of the US$ as a reserve currency after suffering the curse reserved for such status. What will take its place remains to be seen.

Snippets

11^th July 2008
The Malta Independent - Friday Wisdom

Surcharge Subsidy
Many expressed doubts about whether the 30,000 households who are being exempted from the surcharge on their utility bills truly merit such subsidy or whether such list of social cases is effectively populated by households who in effect earn more than they declare and consequently are not only evading tax but getting a double whammy receiving undeserved subsidies on surcharges which are killing the rest of us.

If there is a reliable measure of what households truly earn it is their energy consumption pattern. It is not a perfect measure but still very indicative and in the absence of other evidence there is no doubt that high consumption is indicative of high earnings. So while gladly showing solidarity with genuine social cases who live too close to the breadline to afford paying the surcharge, it is only fair that opportunity is taken to weed out the blood suckers by checking that the subsidised energy consumption truly reflects the pattern of a deserving household.
Labour’s Extended Shadow Cabinet
The decision to include nearly each and every Labour MP in the shadow cabinet means that Joseph Muscat is treading carefully trying to solidify his position before proceeding to tough decisions – which however are inevitable if he is to make Labour electable.

This may be a wise move not to ruffle too many feathers before taking full grip of the party he now leads. But it is no long-term solution if the new leader really means to leave his positive mark on the party.

At some point in the not too distant future he has to start choosing his real shadow cabinet. Uncommitted voters need to identify themselves with faces that will form the executive of a designate Labour government.

Secretary General Selection Menu
The PN councillors were given a very restricted menu to choose their new secretary general from. Presumably in the PN’s case it does not really matter much who the secretary general is as behind him there is a brain bank which shapes the party strategy. MLP is different. The secretary general is basically the CEO with very thin resources behind him both to set the strategy as well as to help in the execution. Labour have much greater need than the PN for a resourceful person in role of secretary general.

When an incumbent is contested it sends a signal that not all is well with his performance. When an incumbent is vibrantly contested the way Jason Micallef seems likely (some five or six other claimants seem to be lining up for the post) then it is not a signal. It is writing on every wall that he failed and he should go.


Strengthening Democracy
Dr Joseph Muscat played his cards well when he told the Prime Minister that the pairing agreement can only be considered if it is included in a much wider package which strengthens democracy and addresses issues that have hurt Labour and abetted the PN in securing their extended stay in power.

The need to bring some discipline to party financing is supreme. Without it we will never have an effective democracy. I wrote extensively on this and still think that only total abolishment of political donations will work. Whatever threshold is established for donations still leaves an escape window to structure donations within such threshold.

Controls on what caretaker governments can do in the run up to elections is also another area where discipline is needed as in a two-horse race a few hundred votes make the difference between government and opposition.

However Labour would be more credible if its own statute is overhauled in parallel to ensure that the power of incumbency does not effectively weigh on who is elected to high party positions. The leadership election of 2003 and 2008 were both influenced by the power of incumbency. It should not be.

The Board of Discipline and Vigilance needs to be re-invented and renamed with its main task being the takeover of the party administration in the period between a general election and the general conference electing the leadership and the administration. The election commission should be answerable only to the board. During the rest of the time the board should be issuing codes of conduct and ethics for all in the party and making checks to ensure that such ethics are being adhered to. It should be a positive board armed with the authority of moral suasion rather the threat of discipline. Discipline will be reserved for the executive of the party only after the board would have exhausted all efforts to make moral suasion work.
Fair Value Destruction
The fair value accounting standard is forcing banks to make provisions on asset valuations which are by all measures fundamentally wrong and in the current circumstances severely undervalued. This is compounding problems and creating more uncertainty in the financial markets than needs be.

Fair value accounting is built on the principle that the market price is reflective of correct asset pricing. This notion has long been abandoned in the investment world where markets are known to overshoot in both directions so that market values tend to depart widely from the underlying fundamental values sometimes to the upside (irrational exuberance as in 1999/2000) and sometimes to the downside (irrational pessimism as at present).

It is time to review the fair value accounting principles. Banks that can show ability to hold on to assets till maturity should not be obliged to write fictitious losses leading to more pessimism and yet more fictitious losses. In such cases the concept need to change to long-term fair value rather than current market price.
Cheaper to Die

Liberalisation of the hearse service should make it cheaper to die. How about more liberalisation that makes it cheaper to live.

Spoilt for Choice

04^th July 2008
The Malta Independent - Friday Wisdom

This week I was spoilt for choice of the wrong type. I had too many topics to write about and this is quite unusual in summer when one is often forced to search through subjects left on the shelf from the colder months.

France taking over of the EU presidency and Sarkozy’s diplomatic skills, or lack of them, in devising a solution out of the Irish stalemate for adoption of the Lisbon treaty and in handling the clash of policies with the European Central Bank headed by another Frenchman, deserves a column on its own.

So does the raving debate in local blogs about whether continuous complaints about lack of quality service at the emergency department of Mater Dei Hospital and the lengthening waiting list for non urgent surgery, result from undue expectations about what universally free medical service can actually deliver or whether we are seriously experiencing the law of diminishing returns where the more we put in the less we get out.

The White Paper about an overdue reform for property under rental arrangements dating prior to 1995 is obviously a very topical subject. At this stage I would just say that as a consultative document it makes a noble effort to unblock a situation which has been jammed for decades and which clearly lost much of its original social purpose. While tweaking and refining will be necessary to address some questionable measures proposed in the White Paper, there is no doubt that its general orientation is positive and laudable.

However, none of these topics can overcome the supremacy and immediacy of the government’s decision to practically double the surcharge on utility bills as well as to increase the retail price of fuel at the pump by about 10 per cent. As a result the final utility bill will essentially increase by 30 per cent ({100% + 95%}-{100%+50%}) that is three times the increase imposed upon prices of fuel at the pump.

Before entering into the merits of such spread of the burden of higher energy prices, let me make clear that no one should be under any illusion that there is any realistic way that the consumer can be shielded from the shattering effects of exploding energy prices. Direct across the board subsidies are both unaffordable as well as economically inappropriate.

Unless energy price increases are permitted to filter down to the consumer (both intermediate and final) we will never achieve the much-needed adjustment in demand for energy products. This demand has to adjust to take account that energy is expensive and that the international terms of trade have worsened, apparently in a structural manner, against energy consumers and in favour of energy exporters. The only feasible response for such an unsavoury reality is by becoming energy efficient and such efficiency cannot be delivered except through price mechanisms. We simply need to adjust our living habits to drive smaller cars, use public transport, economise on heating and air-conditioning, and keep lower stocks in the house to be able to switch off the second freezer.

On a longer-term basis we do of course need to invest in renewable energy sources, and this both at country and individual level, but this cannot deliver the needed immediacy of results if we change exaggerated habits like using air-conditioning to freeze the room rather than to acclimatise it.

Some made the argument that government will be benefiting from increased tax revenue by virtue of the ad valorem duties and VAT applicable on fatter energy prices and government should use the extra revenue to cushion the energy price increases.

Government seems to have adopted this suggestion when it declared that the surcharge without government intervention would have been 115 per cent rather than 95 per cent and the difference is being footed by government by increasing subsidies to Enemalta.

The concept of across the board subsidies gives me a headache. The very idea that the State should subsidise to any degree excessive users who can afford swimming pools, air-conditioning in every room, and lighting as if there is no tomorrow is an insult to my social conscience. It would be more appropriate to consider limiting the subsidised surcharge to a cap reflecting “normal” consumption per capita and apply full surcharge without any subsidy to excessive consumption.

The government should also consider channelling part of the extra income it nets from ad valorem taxes and VAT, as well as savings that can be made by economising on street lighting (switching off every alternate lamp is not so drastic in these acute times) by subsidising public transport to make it more appealing to commuters. It will help consumers to contain the impact of high energy costs, reduce importation of high cost energy products, ease traffic leading to more efficiency, and make a significant contribution to a better environment.

Which brings me to the question as to why prices of fuel at the pump were raised only one-third the prices of utilities. This could be partly explained by the fact that utility prices were not adjusted for some eight months during which period fuel prices underwent some relatively minor tweaking upwards. However the main reason is otherwise. The main reason is that for the way we measure inflation the changes in fuel prices have greater impact on the retail price index than changes in utility prices. And given that we still have mechanisms which transfers measured inflation into automatic wage increases, the government is extra careful to avoid agreeing pricing structures which stimulate measured inflation with the risk of igniting second round inflationary spiral.

Valid as this is in the current circumstances nothing changes the fact that this is like the tail wagging the dog. Real inflation probably goes up just as much, or even more, by utility price increases as by fuel price increases. If anything, utility usage is somewhat less sensitive to price changes than usage of fuel purchased at the pump. The reality is that we are carrying outdated legacy systems for quasi automatic wage increases triggered by measured inflation which are totally inappropriate for an economy struggling to preserve its competitiveness following its membership in a hard monetary union with a currency that by all economic measures is fundamentally overvalued.