The Steussy Ranch

Very, very occasionally I read something that immediately strikes my brain as being absolutely unexpected and completely true. It has happened twice while reading the Economist. The first time was nine or ten years ago when I first read Steven Levitt’s academic work linking the legalization of abortion in 1972 with the rapid fall in crime rates in the 1990′s. The criminals simply didn’t exist; their unwilling mothers’ had the opportunity to say, “No”. Levitt is since famous for his book and blog, Freakonomics, which I read daily.

The second time was two weeks ago, when I read this Buttonwood article (link may be gated). Drawing in large part on a book written in 2002, Buttonwood lays out the argument that the entire post-Bretton Woods economic system we’ve had since 1972 or so is rather like an out-of control kid’s wagon headed down a steep hill. Yes, we’re going pretty fast, but there’s going to be a nasty stop sometime soon.

The Bretton-Woods post-WW2 system made international currencies peg themselves to one another and to a fixed price per ounce of gold. The US dollar was pegged at $35 per ounce. While there are lots of reasons to dislike this system, it has the one enduring quality that it keeps everyone in the system honest. Around 1972, faced with the costs of the Cold War and a hot one in Vietnam, Nixon decided to no longer honor requests to convert dollars to gold by other nations. This led to the current regime of floating currency rates.

The problem now becomes that the system no longer has constraints forcing basic honesty on the participants. Money supply can be extended indefinitely. This no longer requires a printing press (printed cash is a vanishing small part of the amount of money in circulation). Credits can be issued willy-nilly, with increasingly large factors of leverage applied. Financial firms on Wall Street, leading up to the August 2007 collapse, were up to 30 times leveraged in their credit.

The book cited in the article was the Dollar Crisis by Richard Duncan, a Southeast Asia-based official with the IMF at the time, now working with a series of hedge funds. I just finished reading it for the first time; I will read it again. The amazing thing about it is how prescient it is of our current situation, though it was written eight years ago.

The primary thesis is that since abandoning any link to constrain supply, the amount of money in circulation globally has increased logarithmically. Vast sums are being created, mostly in the United States since the dollar has replaced gold as the primary global reserve currency. While making all the right noises politically and economically, the US has been creating money through a series of Federal Government deficits, as well as annual trade deficits by the private markets. These have been increasing over the years.

This all works as new money in the global system, used to buy trinkets made in China, Japan and Europe; as well as funding increasingly bureaucratic Washington initiatives. As that money goes to foreign suppliers, those central banks are forced to keep the dollars in their original form (for the most part). Transferring them to the local currency would overheat their markets. So these countries are effectively forced to purchase US Government debt, corporate debt and equities, financing the next round of trade and government deficits.

This mass of new money rests with governments, sovereign funds and central banks for the most part, with some portion also within the financial systems. This “extra” money has found attractive means of investment from time to time, which results in tremendous bubble economies: Japan in the 1980′s, the Asian tigers and Mexico in the 1990′s, NASDAQ and the technology bubble of the late 1990′s, property in the 2000′s, and the current gigantic bubble-int-the-making in China. Each bubble was bigger than the one before it, and caused greater calamity when it burst.

Further, the “extra” investment monies are almost entirely in the hands of national actors or large financial firms. The monies have not “trickled down” to ordinary citizens. This has led to the counter-intuitive result of wholesale deflation in many cases. As the “extra” monies seek out any potentially profitable industry in which to invest, there is an over-investment in virtually all fields that have a profit potential. This leads to lower and lower consumer prices, and a spiraling deflation in commodities and manufactured goods.

Where do things end? When writing his book, Duncan was unsure whether the world would be caught in a spiral of hyperinflation (as would make intuitive sense) or spiraling deflation (as with the argument above, for which he found more evidence). Since these are diametrically opposite results, his investment advice essentially was to purchase whatever governments would be unable to devaluate in some way: traditionally, either gold or land.

This book is up with the Black Swan and How We Decide for the most influential books I’ve read this year. Of the three, it is also the least accessible (more statistics that require real thought, not as clearly written, etc.). I’m going to read it again, probably later this month, with attention to reviewing the graphs and statistics updated to 2010.

This book very clearly and strongly pressed on my This Is True button somewhere in my brain. It fits very closely with a lot of observations that I’ve made, and explains a number of very strange things (such as, why the heck is the Euro so strong?).