Sunday, 24 October 2010

The Great Pretender - the Bluff Call of 1971 - the Nixon shock.

In 1971, one of the greatest poker game ever played came to halt. It marked the end of the Gold Standard and the convertibility of the US dollar in Gold.

In this post I will revisit this great moment and highlight some of the contributions of one of the great adversary of Keynes to this moment, Jacques Rueff.

The context of the Nixon Shock of 1971:

"By the early 1970s, as the costs of the Vietnam War and increased domestic spending accelerated inflation, the U.S. was running a balance of payments deficit and a trade deficit, the first in the 20th century. The year 1970 was the crucial turning point, which, because of foreign arbitrage of the U.S. dollar, caused governmental gold coverage of the paper dollar to decline from 55% to 22%. That, in the view of Neoclassical Economists and the Austrian School, represented the point where holders of the U.S. dollar lost faith in the U.S. government’s ability to cut its budget and trade deficits.
In 1971, the U.S. government again printed more dollars (a 10% increase) and then sent them overseas, to pay for the nation's military spending and private investments. In the first six months of 1971, $22 billion dollars in assets left the U.S.[citation needed] In May 1971, inflation-wary West Germany was the first member country to leave the Bretton Woods system — unwilling to deflate the Deutsche Mark to prop up the dollar. In order to prevent the dumping of the Deutsche Mark on the open market, West Germany did not consult with the international monetary community before making the change. In the next three months, West Germany’s move strengthened their economy; simultaneously, the dollar dropped 7.5% against the Deutsche Mark.
Because of the excess printed dollars, and the negative U.S. trade balance, other nations began demanding fulfillment of America’s “promise to pay” - that is, the redemption of their dollars for gold. Switzerland redeemed $50 million of paper for gold in July. France, in particular, repeatedly made aggressive demands, and acquired $191 million in gold, further depleting the gold reserves of the U.S. On 5 August 1971, Congress released a report recommending devaluation of the dollar, in an effort to protect the dollar against foreign price-gougers. Still, on 9 August 1971, as the dollar dropped in value against European currencies, Switzerland withdrew the Swiss franc from the Bretton Woods system."

The great imbalances we have witnessed in the last couple of decades come from this defining moment of the summer of 1971, when the great poker game played by the US came to halt as more and more countries called their bluff, worried by the US deficits. The agressive demands coming from France had been initiated by the advisor of General de Gaulle, Jacques Rueff, Keynes greatest opponent.

"The conditions which formerly were able to give rise to the ‘gold exchange standard’ have changed. The currencies of the Western European States are restored, to the extent that gold reserves of the Six today equal those of the Americans … This means that the custom of ascribing a superior value to the dollar as an international currency no longer rests on its initial foundation – I mean America’s possession of the largest share of the world's gold. This unilateral facility which is granted to America is serving to cloud the idea that the dollar is an impartial and international medium of exchange, when it is a means of credit belonging to one State … Gold has real value."
- Charles de Gaulle, February 4, 1965.

With great power comes great responsibility.
Stan Lee - Spiderman

The abuses of Bretton Woods.

The US have behaved irresponsibly for too long, putting us all at risk.
The privileged status of the US which was granted under the Bretton Woods arrangements, made it possible for the US to run a deficit that would never disappear while the dollar standard prevailed. Jacques Rueff concluded that this privileged status would inevitably lead(dollar standard and associated deficits) to a global economic crisis that would end in tears, an event akin with the Great depression. This is the situation we are currently going through.

Jacques Rueff has proven to be right and the Keynesians dangerously wrong.

A recently published biography on Jacques Rueff by Christopher Chivvis, The Monetary Conservative, is reviewed using the below link. It gives you a brief insight on Rueff's belief and contributions to economic policies:

The clear abuse from the Dollar domination was very clear with the 1985 Plaza Accord of the 22nd of September 1985. I went through the consequences for Japan in a recent post relating to the bogus currency wars and the attitude of the USA towards China. Japan's never fully recovered from the economic suicide they committed by allowing the Yen to rise very fast again the US dollar.

The US survived the Saving and Loans Crisis by pushing Japan to the floor, and ruining in the process their largest creditor at the time. The US are attempting the same game with China today, this time around let's all hope they will fail. China is trying to curb hot money pouring in as well as taming inflation. They recently raised one year lending rate to 2.5%. It is becoming extremely difficult for China to slow hot money flows. Some countries have already implemented capital controls.

For Jacques Rueff, the only solution to remove the great current imbalances, would have been to reform the system and avoid a currency like the US Dollar to play the role of the world's leading currency or any other currency. Would a return to a Gold Standard work? Or a Bancor currency as advocated by Keynes? Bancor was indeed proposed before Bretton Woods led to the US Dollar assuming the role of the World's currency. Both Rueff and Keynes did not want the US Dollar to be the prevailing currency. They both understood the risks.

Tim Geithner's latest proposal targeting trade deficits and surpluses is basically an attempt to go back to Keynes Bancor proposal.

Felix Salmon recently wrote a post on Geithner's proposal in Seeking Alpha:

"Tim Geithner has proposed to his fellow G-20 finance ministers that trade surpluses and deficits be capped at 4% of GDP. The idea is already running into criticism from countries that run big trade surpluses."

QE2 is the nuclear option the US are currently playing with. They are willing to export inflation to the emerging markets to force their hands.

Ambrose Evans Pritchard in an article published in the Telegraph on the 10th of October discuss what is currently happening, paving a road to a potential new Bretton Woods, and the removal of the US Dollar as world reserve currency.

"The atomic bomb, of course, is quantitative easing by the Federal Reserve. America has in effect issued an ultimatum to China and G20: either you stop this predatory behaviour and agree to some formula for global rebalancing, or we will deploy QE2 `a l’outrance’ to flood your economies with excess liquidity. We will cause you to overheat and drive up your wage costs. We will impose a de facto currency revaluation by more brutal and disruptive means, and there is little you can do to stop it. Pick your poison."

The US are playing the Great Pretender game.

The United States has had the luxury of being in a position to avoid economic adjustment in spite of its deficits for too long. It is time to adjust to the reality and stop pretending.

The Great Pretender
The Platters/Freddie Mercury:

Oh yes I'm the great pretender (ooh ooh)
Pretending I'm doing well (ooh ooh)
My need is such I pretend too much
I'm lonely but no one can tell

Oh yes I'm the great pretender (ooh ooh)
Adrift in a world of my own (ooh ooh)
I play the game but to my real shame
You've left me to dream all alone

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