Beggar thy Neighbour

Toby Birch, Managing Director, Oppenheim & Co., Guernsey; gives an insightful analysis into the financial crisis, looks at the solutions that have or can be used and their consequences.

This term is used to describe destructive economic actions of countries pursuing national self-interest at the expense of others. This was particularly prevalent during the Great Depression where protectionist tariffs favoured domestic producers in tandem with currency devaluation. Such tension-inducing tactics soured relations and damaged international trade. Attempts to slice a bigger piece of a smaller pie inevitably led to a clash of knives. The Bretton Woods agreement of 1944 was visionary in that the Allies had learned the lesson of WWI; that defeated countries must be encouraged, not crushed, and that exchange rates must be stabilised to prevent the escalation of such economic behaviour in future. Given that America held the bulk of the world’s gold then it made sense to use a Gold Exchange Standard where the US Dollar became “as good as gold”. The system of fixed exchange rates worked wonderfully with Japan and Germany nurtured into industrial giants. Even when the Standard broke down with excessive printing of dollars during the Vietnam War, Japan and Germany were still able to power ahead in spite of their soaring currencies. A lesson we have failed to learn is that high savings and strong currencies are more than a match for the perceived solution of ‘growth’ via debt-fuelled consumption.

Many financiers consider Ben Bernanke (chairman of the US Federal Reserve) to be a hero for his actions in recent years. Others are dubious and fail to understand how dumping debt on future generations can ever be beneficial, leading to a remorseless dilution of the dollar. This is forcing food and energy prices to soar with enormous social consequences, as we are just beginning to witness. As long as oil and commodities are priced in dollars there is an in-built demand for America’s currency. This works well with good stewardship but if devaluation becomes the unspoken intention then it plays havoc with other countries. This is especially the case for emerging economies that are now enduring imported inflation. Through the magic of statistics these ‘volatile’ figures disappear from western indices such that anaemic inflation figures bear little relation to our daily experience with household necessities. Nevertheless, the numbers do not lie in North Africa where food and energy typically make up half of consumers’ expenditure. When such items double then vast swathes of the population have nothing to live on and have nothing to lose through revolution and revolt. As ever, historical precedents abound. While it is highly unlikely that Marie-Antoinette ever uttered the words ‘let them eat cake’ when faced with starving peasants demanding bread, the sentiment is symptomatic of out-of-touch leaders. Any single component of inequality, injustice and inflation is bearable but the combination of all three will see the undoing of any despotic or democratic regime. It is no coincidence that the US Constitution was written in 1789, the same year as the French Revolution. While ‘Madame Guillotine’ no doubt induced fear among many monarchs, America’s Founding Fathers shared a vision of doing the right thing for generations to come.  As a new financial feudalism ensnares our offspring with student loans we will see how they cope with our legacy of higher taxes and inflation. Meanwhile some supposedly developing countries are sowing the seeds for prosperity with young populations, a skilled industrial base, access to raw materials and a surplus of cash rather than debt.

There is much debate about America’s right to hold Reserve Currency status and as yet there are few feasible alternatives in the short-term. Nevertheless, the likes of China should have nothing to fear from disentangling from a diluting dollar, to counter the disingenuous accusation that they are ‘manipulating’ their currency. The main downside for China is the fact that they hold so much junk paper in the form of US Treasuries whose price will doubtless plummet. Needless to say they are in a race against time to diversify into real assets while pretending that they are content with the status quo by mopping up the haemorrhage caused by Quantitative Easing. Given Japan’s recent tragedy and China’s reluctance to engorge yet more paper, it is no surprise that the Federal Reserve continues to amass billions of dollars of bonds in an attempt to stave off the inevitable surge in yields which will wipe-out millions of mortgage holders and pull down banks in the process.

In the meantime we will no doubt be subject to yet more rounds of Quantitative Easing and Basel regulations that fail to counter the core problem; that of banks using customer deposits for their own speculative use, monopolising credit creation and charging interest for the privilege. Aside from enabling governments and states to issue their own interest-free money, we need to restore faith in our currencies to avoid a re-run of the 1930’s with its inevitable conclusion in the 1940’s. It may seem retrograde to resort to old money in the form of a Gold Standard to regain stability. In any case, it is not a long-term solution as mining companies only have ten years of proven reserves. Given that 2 billion people will be added to the world population by 2050 then there is no way the dwindling supply of such an asset can match the monetary needs of the future. Nevertheless, financial systems function on trust so perhaps a wider Precious Metals Standard could be considered, combining gold, silver and platinum in an attempt to match the vast sums of money created in recent decades.  Historically, the money supply of the 19^th Century was never fully backed by gold so a modern version need not differ. How this would work in practice in an environment of protectionism and polarisation into new trading blocks is another matter. Either way we desperately need financial stewards who will benefit rather than beggar our neighbours as the world’s power and population shifts inexorably from West to East.