The Decline of the G7, of Bretton Woods II, and Monetary Neo-Colonialism

Perhaps this policy discussion may cast some light on the efforts of the paper-producing nations to dampen global commodity prices and control certain geographic areas of essential resources.

At some point the Rest of the World may realize that having any nation's fiat money as the international reserve currency is nothing more a thinly veiled form of colonialism.

Policy is a matter for The World, not just a Rich Club
By Jean Pisani-Ferry
The Financial Times
August 12 2008 19:40

As the collapse of the trade talks in Geneva in July made clear, there is no longer any   meaningful  trade negotiation without the main nations from the emerging world. The year 2008 may go down in history as the one in which rich countries discovered that this applies to macroeconomic policies, too.

In January it looked as if the opposite lessons could be drawn from events. For a while, Ben Bernanke at the US Federal Reserve and Jean-Claude Trichet at the European Central Bank seemed to be the only relevant policymakers in the world – and they were, as far as liquidity strains were concerned, if only because the US and Europe account for about two-thirds of the global supply of financial assets.

But as months went by, it became clear that countries affected by the shock represented merely a half of world gross domestic product, two-fifths of global energy demand and not even a third of world cereal consumption. Furthermore, rich countries have significantly less weight at the margin: their contribution to world growth is about half their share of world GDP, so one-quarter of the total, and the same rule of thumb applies even more to the demand for oil and foodstuffs. So in the market for scarce commodities, the effects of the slowdown in the US and Europe were offset by domestic booms in the emerging world.

By the end of spring, policymakers in the Group of Seven leading nations had awoken to an uncomfortable reality that focusing on a regional financial shock had led them to ignore a global commodity shock. Worse, thanks to the fact that most emerging and developing countries in Asia and the Gulf were part of a de facto dollar zone, actions taken by the Fed to address financial stress in fact compounded runaway domestic demand in those countries and fuelled global hunger for commodities. In spite of rising inflation, real interest rates in the main emerging countries are still inappropriately low or even negative.

Stagflation is not here to stay. East Asia is unlikely to remain immune from current near-zero growth in Europe (to where it exports about 5 per cent of its GDP) or, even more, from forthcoming deterioration in the US (to where it exports almost 7 per cent of its GDP). Commodity prices have started to decline. However, the underlying issue will not go away, for two reasons.

First, lingering scarcity of fossil energy and agricultural commodities is likely to remain and to change the macroeconomic scene significantly. For about two decades, since the start of the current wave of globalisation, it seemed that there were no real speed limits to global growth. Disinflationary forces coming from the increase in the global labour force and the weakening of organised labour were powerful enough to ensure an environment of low prices worldwide. This Goldilocks era has ended and the world economy is likely, over and again, to test the speed limit stemming from constraints on the supply of commodities.

Second, in the same way German unification revealed the fault lines in the European monetary arrangements of the 1980s, the current episode has exposed the fault lines in the so-called “Bretton Woods 2” arrangement, whereby a large part of the emerging world pegs to the US dollar. But for the direction of the shock (a boom then, a slump now), what is happening now is in many way a repetition of what happened then to the European exchange rate mechanism: here, a shock to the anchor country that desynchronises it from its monetary bedfellows.

So the question is: what do we need to manage interdependence better? A straightforward solution would be for the main countries or groupings to target domestic inflation independently in the context of flexible exchange rates. The proviso is that for such a solution to work participants would have to target total, not core, inflation (this may seem obvious but it has apparently escaped some policymakers, who claim that there is nothing they can do about inflation because it is not home-made). This is more or less the arrangement industrialised countries came to a decade or so after the collapse of Bretton Woods. It involves minimal co-ordination and can accommodate differences in preferences. In the European case, it has proved compatible with tighter regional agreements – including a single currency.

The problem is that a large part of the emerging world, starting with China, is not ready for independent floating. There are genuine obstacles to it, such as incomplete financial liberalisation and resistance stemming from the fear of uncontrolled appreciation. However, there is no reason why a preference for managing exchange rates should imply the status quo remains. Ad­justments are needed and the current de facto dollar pegs are often at odds with the countries’ foreign trade. From basket pegs involving currencies other than the dollar, especially the euro, to innovative solutions such as the commodity peg advocated by Jeffrey Frankel of Harvard, there is a large menu of options to choose from for reformers looking to strengthen domestic and world stability.

But with managed exchange rates comes closer policy interdependence. If they are to remain prevalent in one form or another, there will need to be more co-operation in setting reference rates and monitoring aggregate demand. This implies multilateral discussions on exchange rate arrangements as well as on domestic demand policies and domestic subsidies to oil and food consumption. From an institutional standpoint, this also implies going beyond the existing loose arrangements or mere lunch invitations such as the last G8 summit in Hokkaido. The G7/G8 is not the appropriate forum for macro-financial matters any more. A frank policy dialogue between emerging and developed countries requires an appropriate venue.

The one option that is not advisable is to ignore the lessons from this year. For some time now, globalisation has been increasingly difficult to sustain politically, in spite of having brought income gains and low prices to the citizens of the advanced economies. It will already be much harder to convince the same sceptical citizens that they must accept it despite the fact that it brings higher commodity prices and lower incomes. It would simply be impossible to make the case for it if, in addition, it were to be perceived as a source of enduring instability.

Exchange rate arrangements and their implications for global macro­economic management should thus be a priority topic for the international community and especially the International Monetary Fund. The Fund is looking for a renewed purpose; here is one that belongs to its core mission and where it has no substitute. Success, however, will only be possible if the G7 countries admit that the days when they were running the show are over.

The writer is director of Bruegel, the European think-tank

The Next Six Months May Be the Heart of the Financial Storm

The Administration and the Fed are fully deploying their bag of tricks to patch up, prop up, and disguise what is really happening in the credit markets and the economy. The intervention has increased considerably in the last week.

They *may* be successful, which will only defer the reckoning with past malinvestment and the destruction of productive capital into the future where it will fester and grow. When the bankers intervene they often can only create the appearance of health and vigor temporarily as in the Crash of 1929. After this the decline is worse since it impacts so many who are late entries and poorly equipped to absorb the losses, capitulating in a panic.

Time will tell. We may be seeing the end of a long phase of central bank influence in the world as they spend the last chips of their credibility. If this is for the benefit of the financial insiders who are exiting their own positions then no punishment will be too severe for such a disgraceful betrayal of the public trust.

The next six months may be the heart of the storm, but the reconstruction and repair may take the heart out of an entire generation of Americans. Equitable punishment will serve as a deterrent and as an act of justice which may restore lost credibility in corrupt governance not only in the US but in Europe and Japan.

August 12, 2008, 11:07 am
The Wall Street Journal
Who’s on the Other Side of That Trade, Anyway?
Donna Kardos reports:

A growing proportion of U.S. firms are seeing credit-default-swap counterparty risk as a serious threat to global markets, and think another major financial company will go under due amid the global-markets crisis, according to a study by research firm Greenwich Associates.

The study’s results, which say the proportion seeing CDS counterparty risk as a serious threat is approaching 85%, highlight the perceived concern of another financial firm going down. Only 27% of the institutions surveyed think there won’t be another casualty along the lines of Bear Stearns, Greenwich consultant Frank Feenstra said in a statement.

The research firm said of the 146 U.S. and European banks, hedge funds and investors it surveyed, most “believe another major financial-services firm will fail as a result of the ongoing crisis in global markets — and they expect it to happen sooner rather than later.”

Almost 60% of the respondents expect another big financial firm will collapse within the next six months, while another 15% see it happening in six to 12 months.

“If you are looking for a silver lining in these findings, it seems that most institutions think we are currently in the most dangerous period for global financial-services firms,” Feenstra said. “Perhaps if the markets can make it through the next six months, the level of pessimism may begin to subside.”

Greenwich said nearly 80% of the firms in the study say their banks have tightened margin or collateral requirements since the outbreak of the global credit crunch. More than a quarter of those companies said the new requirements have caused them to reduce their trading activity.

Concerns about counterparty risk have caused institutions to cut back on their CDS use. Among fixed-income survey participants that employ such swaps, 62% said higher counterparty risk has caused them to limit their use.

Meanwhile, nearly two-thirds of the firms in the survey said they try to limit their concentration of exposure to a single counterparty, while three-quarters said the establishment of a centralized clearing entity would be effective in mitigating credit-default swap counterparty risk.
In Europe, institutions are “at least slightly more sanguine,” Greenwich said compared with U.S. firms surveyed. It said just more than 55% of the European companies surveyed see CDS counterparty risk as a significant danger.


AP
JPMorgan shares tumble on widening 3Q losses
Tuesday August 12, 11:44 am ET

JPMorgan shares fall after bank reports widening losses related to mortgage debt in 3rd qtr

NEW YORK (AP) -- Shares of JPMorgan Chase & Co. tumbled Tuesday after the bank said it has heaped more losses in its mortgage investments so far in the third quarter than it did in the previous three-month period.

In a filing with the Securities and Exchange Commission late Monday, the bank said turbulence in the credit markets has caused it to lose about $1.5 billion, after hedges, in its mortgage-backed securities and loans to date in the July-to-September quarter.

That's more than the $1.1 billion in losses JPMorgan incurred in its investment bank's portfolio during the second quarter.

The news set off fresh concerns about the scope of the troubles in the credit markets and the overall health of the financial sector.

Meanwhile, New York Attorney General Andrew Cuomo said Monday he is expanding his investigation into the collapse of the auction-rate securities market to include JPMorgan, Morgan Stanley and Wachovia Corp.

In its quarterly regulatory filing, JPMorgan said it is cooperating with the investigations.

Long Term Gold and US Dollar Charts

Our working hypothesis is that there has been a coordinated intervention by several central banks to support the dollar, perhaps tied to an overall message to Russia from the Bush Administration. Foreign central banks, most notably Japan, have been supplying significant capital to the Fed via the custodial accounts as noted in the last chart.

One or more of the big multinationals became aware of this and have taken the opportunity to trigger a forced liquidation among the hedge funds as they unwind cross trades, such as short financials - long oil. The funds are also strangled for short term liquidity as the banks suck up the available capital.

We may see several hedge funds and commodity brokers fail because of the steepness of the decline. We think the predators will emerge and become known. They may even be the same ones who helped to trigger the run on Bear Stearns.

We doubt this is a major trend change simply because the fundamentals for the dollar and the economy are so negative, and world growth has not gone on permanent hold. The demand-supply figures are compelling.

The mantra now is "Yes the US is bad but Europe is worse." Perhaps, but the jury is still out and it does sound a little too Orwellian.

The dollar is at serious resistance, and gold has strong support at 790. Let's see what happens.

Corporate Defaults 'Could Hit 10%' as the Credit Crisis Worsens

Nothing has changed. The fundamentals continue to deteriorate in the US financial system and economy. What this headline implies is that ten percent of US businesses could become bankrupt in the next year or so. Think about that.

So why is the dollar strengthening and the stock market rising? For two reasons.

First, as the fog of war descends on the Caucasus, so too the fog of government meddling if not outright intervention has been descending on the financial markets. It would take a leap of faux faith to believe that Georgia launched their assault, timed with the opening of the Olympics, without informing the US which is supplying logistical support and military advisors. Cheney has shown rare personal involvement as well. At the least we are sure that there is more to this than meets the eye.

Secondly, a significant amount of liquidity has been arriving at the NY Fed's custodial accounts, coming from Japan and other foreign central banks, which explains much of the short term financial markets action during the thinly traded late summer months.

Nothing has changed. Things continue to worsen in the real economy. We will look for the markets to reflect the underlying trends again soon enough.


Corporate debt default ‘could hit 10%’
By Nicole Bullock
The Financial Times
August 8 2008 01:28

Defaults on corporate debt are ratcheting up as economic weakness takes it toll on the financial health of companies.

The global default rate is expected to climb to 6.3 per cent over the next 12 months and it could reach 10 per cent should the US sink into a protracted recession, Moody’s Investors Service said on Thursday.

“The storm is gathering for default rates moving up,” said Kenneth Emery, Moody’s director of corporate default research.

Fellow rating agency Standard & Poor’s also warns that credit conditions are deteriorating. “We have long been proponents of the view that the credit euphoria of the prior boom years beginning with 2003 would necessitate a shake-out and purge,” S&P said in a recent report.

“This would result in substantially higher downgrades and defaults, concentrated in the US, but not without repercussions in other parts of the world.”

A year into the credit crunch, defaults have begun to move higher, but they still remain well below the levels reached in other economic downturns. Moody’s default rate hit 10.4 per cent in 2002 and the all-time peak was 11.9 per cent in 1991.

In July, the speculative-grade default rate rose to 2.5 per cent from a revised level of 2.1 per cent in June, marking the largest monthly increase since the default rate bottomed at 0.9 per cent in November 2007, Moody’s said. A year ago, the global speculative-grade default rate stood at 1.5 per cent.

“Certainly, this year the lack of issuers with debt coming due and the prevalence of covenant-lite deals have helped to keep a lid on defaults,” Mr Emery said. “As we move through this year and 2009 that lid will be removed.”

In the past few years of easy lending, issuers refinanced debt and obtained so-called covenant-lite deals, which do not include traditional default triggers that safeguard lenders.

In the US, the consumer transportation companies, primarily airlines, will have the highest defaults, Moody’s expects, while in Europe durable consumer goods companies will be the most troubled.