THE END OF AN ERA:
(by Olivier Monod, CCIM)
The World Order Before the 1910's
Before the 1910's, the world was in many ways a juxtaposition of several regional spheres of influence; each with its own currency, its privileged trading partners, its language, its customs, and its political regime. The political landscape appeared stable and was comprised primarily of monarchies and republics with little involvement in the business world - what could be called "early capitalism".
Extremes such as Communism, Fascism or Nazism did not exist at governmental levels - they were only the dreams (or nightmares) of a handful of intellectuals or of persons deemed "slightly off".
The World Order Between the Two World Wars
Unfortunately, the momentous destructions left by the Great War led what was 'marginal thinking' to become 'main stream'. Several large and powerful countries elected, chose or were sympathetic to causes which would have seemed insane a few years earlier (and which now appear insanely murderous with the benefit of hindsight).
These political changes were the first obvious sign of a change in the world order: Europe was fading away, while America was rising quickly. Yet for most people living in the 1920's, Europe was still at the top. What truly was a change in the world balance of power was initially perceived as a change in the mentalities of people, or more precisely, as a loss of faith in the old mentalities.
The first tangible economic sign of this evolution was a major crisis, which came down in History as "The Great Depression" or the "1929 Crisis". What caused it? The inadequacies between the system supporting the previous world order and the system necessitated by a world controlled by one new power: America.
In short, the manipulation of the rates of exchange on currencies, and excessive tariffs were what had kept the old world order afloat; but it was not appropriate for a world dominated by only one country, the United States.
In the old days, each currency had the strength of the economy behind it, and each major currency had the ability to be exchange for gold; it was the obvious value of each regional system. It was the norm back then - and it had for strong benefit the inability for each country to fudge too much with the true value of its currency. The system protected the relative strengths between spheres of influence.
Undervaluation: The Insidious Sin That Destroyed the System
Undervaluation, or the artificially forced way to exchange a currency below its true value when compared to another currency, did the final blow to the old world order (and with the modern twist of an ever more devaluated dollar, it may well be what we are experiencing today).
Here is why undervaluation is tempting on the short term:
Devaluations of currencies have, for immediate effect, the ability to boost exports by rendering manufactured goods cheaper to foreign potential buyers. Therefore, they carry strong political baggage; a devaluation is an easy way to create jobs and help the balance of trade...in the short term.
Here is why undervaluation is bad on the long term:
After a while, devaluations bring about deflation, which in turn slows down consumption (doesn't it sound familiar?) - with decreased consumption, increased unemployment follows. The last chapter of this sad succession is a decrease in the international trade; which is bad for everyone.
A Second Look at "Bretton Woods"
Where is Bretton Woods? Bretton Woods, or more precisely the "Mount Washington Hotel" in Bretton Woods, is a large palace and a fancy resort. The setting is breath-taking, in the northern mountains of New Hampshire. In the winter, wealthy guests can ski there. In the summer, the surroundings are conducive to nature walks, fishing and other outdoors activities. It is also a wonderful location for meetings requiring confidentiality and security.
What happened there? Toward the end of the Second World War, the bankruptcy of the previous system was obvious. Many nations, led by the United States and Great Britain, met at the Mount Washington Hotel in order to establish the new rules to govern the world's economy. It was the first "United Nations' Monetary and Financial Conference".
What was decided there? The agreement resulting from this conference was signed on July 22nd, 1944 by the representatives of over forty countries. The Dollar would become the only international currency. All international commercial transactions would be expressed in Dollars. Gold would still be part of the system, but in the background: the U.S. currency could be exchanged, at any time, at the US Treasury at the rate of $35 per once of the precious metal. In offering this "exchangeability", the U.S. Secretary of Treasury was not giving away much: the U.S. were back then holding over 80% of the world's reserves of gold. The "Gold Exchange Standard", as it was called, was simply the recognition of that fact.
Two well-known institutions were created in 1946, as a direct consequence of Bretton Woods: the World Bank (WB) and the International Monetary Fund (IMF).
The Built-in Flaw of the Agreements of "Bretton Woods"
A paradox was built in the system of Bretton Woods; this paradox was hard enough to grasp at first; it was hard to the point that even Keynes did not suspect it. This paradox was like a time bomb: at first innocuous, but at the end catastrophic. The paradox was that, the very need for a stable currency (namely the US Dollar) was gradually sapping this very currency's reliability.
Why? Because the Bretton Woods' world order implied that the United States should have a negative balance of payments, in order to supply the rest of the world with the means of trade and payments. In the long run, this would end up translating into an ever-weakening dollar; thus in the loss of confidence in the US Dollar.
The First Alert: 1971 - The Dollar Is No Longer Exchangeable for Gold
The system worked reasonably well between 1944 and the mid-1960's. The first twenty years were the honeymoon of Bretton Woods. They also coincided with the overwhelming worldwide position of the U.S. economic and industrial machine.
The system would have continued to work well if the dollar had not already substantially eroded compared to the fixed beacon represented by gold.
Then came August 15th, 1971: in order to prevent the total bankruptcy of Fort Knox (almost empty by now), where most United States gold reserves were kept, the Nixon Administration had to de-index the dollar from the fixed value of $35 per once. The relationship between the dollar and gold became one of free market - and gold began to rise quickly when compared to the dollar...
The year Coco Chanel died was also the year of our system's first step toward its own demise.
The Second Alert: 1985 - Free Rein on Printing Dollar Bills
The second alert was less brutal; it therefore happened greatly un-noticed. Or more exactly, it became noticed for other reasons. It was the Reagan era, and the new mantra in Washington was to use the dollar printing press very liberally. Yet, the Reaganomics were nothing more than the "good short term news" of the undervaluation cycle as explained four paragraphs above under the caption "Undervaluation - the Insidious Sin that Destroyed the System".
This action, very consistent with the inner logic of the Bretton Woods system, served also to accelerate its consequences and conclusion.
You will also remember that the United States went through a financial crisis at that time: high interest rates and an economic slow down crowned by what we then called the "S&L crisis" (named after the problems experienced by many Savings & Loans institutions).
Soon, the collapse of the Soviet Union would make us forget, in the euphoria of the celebration, that the time bomb of Bretton Woods was still ticking...
The Third Alert: 2008 - The Financial Importance of NY is Challenged
On Monday, September 29th, 2008, we heard that publicly traded stock lost $1.2 trillion in value in one single day, following the news that the U.S. Congress would not go along with the Bush Administration's rescue plan of $700 billion. This is another way to say that investors lost $1.2 billion that day. The worst loss in one day, ever.
This, along with a global loss of confidence in Wall Street, may prove to be one of the last globally significant (albeit negative) moves of the financial place of New York.
Financial centers, like us human beings, come and go. Two thousand years ago, it was Rome. In the early Renaissance, it was Florence. In the nineteenth century and through the beginning of the twentieth, the place to be was "The City" - London, that is...
The Good News: The Planet does not want us to sink
Today, because of the interconnections between world economies and investments, it is probable that all players will work together in order to minimize the impacts of this crisis.
Yet, if we think that minimizing the fall in the short term is going to save us in the long term, we might be sadly mistaken. The best interest of the countries where wealth is now produced, is to control production, stock market and currency. They are not in the charity business.
In other words, our trade partners might be willing - for now - to minimize the fall of the system based on the dollar because it is still in their best interest, but they are not likely to continue preventing an eventual collapse of NY as a financial power house and of the US Dollar as the international currency unit. Actually, they are likely to assist and contribute to this trend, but within a time frame beneficial to them.
In short, as Americans and as investors, we need to take drastic steps quickly, and not wait for a miracle to happen....
The Bad News: At What Cost Will We Be Prevented from Sinking?
The first consequence of what is now perceived as a collapse of our financial system, should be an ever-decreasing trade at all levels - starting with small hometown stores and going up the ladder of corporate America. This is a very dangerous cycle: less cash-flow coming into any business means risks of default on obligations and cutting down on personnel. These effects get compounded on the national and international levels. The "mortgage crisis" is nothing more than the tip of this iceberg.
The downward spiral might lead to consequence number two: political/social unrest and shifting of substantial capital reserves from the United States to overseas.
The third consequence should be the quick devaluation of the U.S. Dollar compared to other international currencies; and the loss by the U.S. Dollar of its status as the sole international trade currency. This has already started happening with oil contracts being increasingly entered in Euros. This trend should continue. We should go from a singular currency world, back to what the world used to be - a juxtaposition of zones of influence, each with its own currency. Also, don't be surprised if we witness soon a resurgence of higher tariffs.
The fourth consequence should be that, eventually, capital will remain where it is produced: the eastern side of Asia. Why would wealth generated in Manchouria be shipped to New York to be invested? If the yield is high and the capital safe; then, it makes sense. But when these two factors vanish, it makes more sense to wire the money to the Shangai Stock Exchange, and let the capital finance the growth of Chinese enterprises...
This crisis of 2005/2008 is, in a way, not as serious as the one of 1929, because the entire world feels that it is in the common interest to limit its consequences.
Yet, for us Americans, this current crisis is much worse than the one of 1929, because back then, we were on the way up compared to the rest of the world, and it took the second world war to affirm this hegemony. Now unfortunately, other powers such as China are on the way up, and this crisis is likely to seal our relative decline. Our ability to adapt to our new role in the world will make the difference between a more or less painful readjustment.
Consequences on Investments
The driving force is whether a commodity is tied or not to the U.S. Dollar as a currency, or to the U.S. economy as a whole. Under this assumption, here are some obvious consequences:
1. Stay away from Bonds: why? Because they are indexed on the dollar. Even if a bond yields 5% per year, if the dollar drops by 10% compared to other world currencies during the same period, it is likely that inflation in the U.S. will be at least 10%; therefore, the bond investment will lose 5% of its capital, without any return that year!
2. Stay away from U.S. stocks: for most investors, this is very obvious - stocks are very risky these days. (Remember the $1.2 trillion lost yesterday?) This is mainly true for corporations with more than 30% of revenues coming from the U.S.
3. Look at precious metals; They may represent a valid shelter option. Yet, they are cumbersome and do not yield cash flows to their owners.
4. Look at real estate: U.S. based real estate, when it meets one of the following criterion is probably the safest investment haven currently available:
- Unique residential properties
- Commercial prime properties with a Cap Rate >10%
In both cases, the properties must be located in an area with a future.