The ongoing financial crisis in Europe is the biggest financial story in the world today and is covered daily. The stories are filled with doom and gloom and predictions of imminent collapse of the currency and the monetary union. Our view is the euro sovereign bonds are in distress and European banks are mostly insolvent but that does not mean the currency will fail. The bonds, banks and currency are three different things and the failure of the first two does not mean failure of the third. The reasons for this are based on the fact that the U.S., China and Germany are united in their desire for a strong euro. The U.S. and China both need a strong euro so Europeans can buy more of their exported goods to maintain growth. China's leverage comes from the fact that it can prop up the European bond market with fresh purchases. The U.S. leverage comes from the fact that it provides the dollar liquidity Europe needs via central bank swap lines. Germany has a demonstrated capacity, dating to the 1970's and earlier, to remain an export powerhouse even with a strong currency and a strong euro all but eliminates intra-European competition. In this sense, the euro is the biggest loser in the currency wars.
The Chinese growth story is so taken for granted that markets and analysts have difficulty imagining anything else. In fact, Chinese growth is on the brink of collapse - something the world and the markets have not fully priced in. Chinese growth has been driven about 70% by investment mostly directed by the Communist Party. Initially this could be efficient as the low-hanging fruit of fairly productive projects such as ports and roads were harvested through the use of debt. The result was a "machine" of debt creation, infrastructure development, constructions, jobs, cronyism, kickbacks, bribes and new projects that fed on itself and cascaded into progressively less productive and even wealth destroying white elephant projects such as "ghost cities," bridges to nowhere and high-speed trains that fly off the tracks. This process will clearly end in a debt debacle and the leadership understands this. They will wind down investment and deleverage banks while increasing bank reserves and shutting down shadow lenders when they can. This will be problematic and time consuming at best and risks an investment collapse and bank run at worst. Meanwhile the much-vaunted Chinese consumer will find that his savings are suppressed to prop up bank balance sheets so there is nothing left over for consumption. The result will be 4% growth for the next ten years at best, or collapse at worst. In time, China may even devalue its currency, contrary to all expectations of upward revaluation, in order to help growth. The cumulative effect will be to pull growth from Europe and the U.S. thus exacerbating global problems of too much debt and not enough growth.
The U.S. has benefitted in the short run from the strong euro and the appreciating Chinese yuan. But if growth stalls in China, as expected, the Chinese may actually turn to currency devaluation again at the expense of U.S. exports thus hurting growth here. Also, as much as the U.S. and China both want a strong euro, declining growth in China and continued bond market and bank stock distress in Europe may cause a renewed flight to quality to the U.S. dollar and a strengthening U.S. dollar against the wishes of the Fed and Treasury. This will hurt U.S. growth, as net exports have been the one bright spot lately. It is also likely to lead to a third round of Quantitative Easing ("QE") under the name of "targeting Nominal GDP". The key to forecasting QE3 is not the level of interest rates but rather the level of the USD/EUR and USD/CNY exchange rates since the purpose of QE in the first place is to cheapen the dollar. So, if the euro remains strong, QE3 is off the table, but if the euro crashes on a flight to quality in the U.S. dollar, then you will see QE3. Using QE3 is the secret weapon of the U.S. in the currency wars.
The key to all of the above analysis is to move away from the traditional approach of thinking about "currency pairs" such as USD/EUR and USD/CNY and to see USD, EUR and CNY in a triangular relationship. If CNY and EUR are both strong then the U.S. is the winner in the currency wars and has some prospect of growth. But if CNY devalues on a Chinese growth collapse and EUR devalues on fears of financial distress, then the result will be strong U.S. dollars making the U.S. the temporary loser in the currency wars. At that point, the U.S. will bring out its secret weapon, Quantitative Easing, dressed up as nominal GDP targeting, to fight back and cheapen the U.S. dollar to preserve growth in the U.S. This is the ultimately futility of currency wars - it just propagates round after round of competitive devaluations. In the end, all of the major currencies will devalue at once against the only money than cannot fight back - gold. The result will be sharply higher gold prices and global commodity inflation, which will trigger consumer inflation - exactly what central banks want to devalue debt and stimulate the velocity of money. Will it work? Maybe, but maybe not. If it works we’re in for a bout of global inflation worse than the 1970's. If it fails there may be a collapse of faith in paper money across the board.
Jim Rickards’ clients include private investment funds and banks, government directorates around the globe in national security and defense and he has worked directly with the Fed and US Treasury. Jim is also a KWN resident expert and author of the extraordinary book, “Currency Wars: The Making of the Next Global Crisis.”
Edited by Asheron, 17 January 2012 - 04:23 PM.