Ad Hoc Commentary – saving the world monetary system
The Bretton Woods system was born on 22 Jul 1944 and was destroyed on 15 Aug 1971 when President Richard Nixon severed the US dollar link to gold. Thus, the system we have in place today is a system that had lost its golden anchor. Instead of a golden anchor, we have a US dollar anchor. Becoming the anchor of the world monetary system is a privilege – one that is coveted by many for many decades. The Europeans dreamt dreams of replacing it with the Euro anchor, and recently the Chinese dreamt dreams of replacing it with the Chinese Renminbi. Yours truly believe that the privilege will remain forever American.
Let us look briefly at the two alternatives:
1. a return to the gold anchor, or
2. a move to a certain sovereign currency
A return to the gold anchor had been the dream of many gold bugs. The most prominent of them is retired Senator Ron Paul. Yours truly thinks that a return to gold is not probable because we have drifted too far from the gold equilibrium. A move to a certain sovereign currency is also not probable because it will involve too much political bickering. Thus, the most probable solution is a move to an electronic non-denominated currency. Advancements that we made in information technology and cryptography in the years following 1971 make this the most probable solution.
However, between now and then, we need to take a deep look at our US dollar anchor and ask ourselves if we can make the transition. The answer perhaps lies with the World Bank. We remember that the Bretton Woods conference that gave birth to the monetary system also gave birth to the IMF and World Bank, also known as the Bretton Woods sisters. The IMF was to govern over short-term stability, while the World Bank was to govern over long-term stability. The sisters could be the light at the end of the tunnel if only world leaders allow them to be.
The US dollar anchor is at most risk today because the preferred securities to hold US dollars in (i.e. US treasury bonds and bills) are under the threat of the sovereign debt crisis. The debt ceiling is but a symptom of the sovereign debt crisis. Central bankers all over the world (the US Federal Reserve included) and local agencies holding on US treasuries are playing the prisoner’s dilemma. They must cooperate to solve the dilemma.
This is a crisis where extend and pretend will not work because we are dealing with compound interest. As Albert Einstein once said:
“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
When the financially unaware masses are entertained by bread and circuses, then it is politically expedient to kick the can down the road and pay the compound interest. However, the recent US government shutdown and the recent French football shutdown had brought awareness to a large fraction of the masses. We cannot afford to wait until all the financially unaware gain awareness. Responsible world leaders should pre-empt that.
Let us appreciate that it can only be the US dollar anchor or an electronic anchor. And, any real solution will need to stabilize the US dollar anchor short term. That is the most immediate need. To keep the US dollar as the anchor, the first step is to create a large enough US dollar denominated asset class to capture US dollars that wants to exit US treasuries in response to the sovereign debt crisis. Just as the French welfare state outsourced welfare to the non-governmental organizations in the crisis of the 1980s; the Americans should outsource infrastructure development to the Bretton Wood sister today. In doing that, the US government can free up balance sheet and focus on what the government does best, and support the balance sheet of world-class development banks to do what they do best – improve infrastructure.
Due to large needs for infrastructure, infrastructure financing is perhaps the only feasible asset class large enough for serious money looking for a home outside treasuries. However, having an asset class denominated in US dollars does not automatically guarantee buyers. We must be mindful that pundits had been talking about the great rotation from sovereign bonds to equities since the beginning of the year. We need to be creative to make infrastructure attractive. The most fundamental is pooling debts into securities via securitization. The main motivation for securitization is to provide investors with a diversified bond holding that is not sector specific. We also need to create tranches as part of the securitization process because infrastructure bonds are unlikely to be AAA. It is probably closer to BBB. Investors need different tranches to suit their risk appetites. Infrastructure finance will not be the love of every fund manager out there, but it will provide a deep enough asset class as an alternative to sovereign bonds and equities. Without it, we would probably see a disorderly rush when the inevitable time comes.
A similar bond can be launched in Europe and the securitized infrastructure bonds can then be used as banking reserves to prevent further Cyprus-like mishaps. This could be the next best thing to the Eurobonds that Germany would never agree to. Once we have all these in place, we will end up in a world with less strained sovereign balance sheets. The elites must then use this financial peace to put the world monetary system on an even more stable footing. In times like this, where taxes on the rich are openly discussed, it is probably prudent for the elites to outsource their infrastructure needs to those who do it best.
Good luck in the markets.