2007-10-26

A realistic view of the international monetary system and its prospects

This essay explores, in a math-free language, the essence of the current international monetary system and its prospects. It discusses the real meaning of the worldwide use of the fiat currency of one particular country as the international trade and reserve currency, why the US Federal Reserve's policy is fostering the conditions for a deep and fast plunge in the value of the US dollar, what fair and logical framework can be used to assess the relative intrinsic value of currencies, why the dollar is grossly overvalued according to that framework, and why the loss of privileged status for the dollar could be extremely disruptive for the US. It finally adds the issue of Hubbert's Peak to the analysis whereby making it even more cogent.


1. A tale on the evolution of the international monetary system to this day

Once upon a time, in a planet with countries A to Z, precious metals were the medium of exchange used for all economic transactions, both within a country and across national borders. Later on, transactions within a country were increasingly conducted using paper notes, which were originally redeemable for precious metals but eventually lost that property, when it became clear that internal monetary policy had to be unleashed from the "golden fetters" if "patriotic housewives" were to be persuaded not to postpone their purchases of non-essential items. However, transactions between countries were still conducted using gold or at least a paper currency that could be redeemed for gold by foreign holders. (In the meantime, silver had fallen out of the world's monetary favor.) That system was universally viewed as fair, in that it prevented any country from getting an unfair advantage, something for nothing, a "free lunch". In the last stage of that system, it was country A's currency that which was redeemable and used for international trade.

Over the years, country A developed a deficit in its balance of payments, sending more of its currency abroad than what could be backed up by country A's gold reserves. Noticing that, foreign holders of its currency became increasingly uneasy and started to redeem its holdings for gold at such a pace that it quickly became evident that country A's gold reserves would soon be exhausted. Faced with that prospect, the government of country A ended the convertibility of its currency for gold at a fixed exchange rate - if foreigners wanted to exchange its currency holdings for gold, they could now do so on the open market (at a much higher price, of course). After that moment, all national currencies were just fiat peers on an equal standing, whose intrinsic value outside the issuing country arose exclusively from the possibility of using it for purchasing goods and services FROM THAT ISSUING COUNTRY, or for acquiring property rights wherein, in a reasonable timeframe. This is a key concept we need to have in mind to understand the real implications of the evolution that the international trade system underwent thereafter. (In this essay, "intrinsic value" of a fiat currency refers to its "intrinsic fiat value", not to the value arising from the rather limited direct usefulness of the physical piece of paper.)

As could be expected, after the severance of its linkage with gold, country A's currency was still the only one used for bilateral transactions between country A and the other countries. Though that arrangement gave country A a slight advantage, in that the other countries first had to sell something to country A and only then were able to buy something from it, that was not a big deal. Let's say that it gave country A a free beer.

It should be found surprising, however, that countries B to Z continued to use country A's currency for their bilateral transactions. That arrangement did give country A a significant advantage, in that all other countries needed to first sell goods, services and/or property rights to country A, directly or indirectly, in sufficient quantities to acquire the amount of its currency that was necessary to conduct trade with the other countries. Following the analogy, we could say that this amounted to giving country A a free lunch.

As time passed, a trend developed called "globalization" whereby production of different goods was increasingly relocated to different countries to profit from their competitive advantages. A side effect of this phenomenon was that, as a result, countries B to Z now needed increasingly higher quantities of country A's currency to conduct their trade. (To see why, let's say that countries B and C used to produce their own bread and butter, so that those goods were traded within their boundaries using their respective currencies. After globalization, country B produced only bread and country C only butter. Now all bread consumed by country C and all butter consumed by country B were traded across borders, using country A's currency.) That implied a corresponding increase in the amount of goods, services and/or property rights that countries B to Z needed to sell to country A, directly or indirectly. In our analogy, we could say that globalization gave country A a free ride (on top of the free lunch).

And finally some countries, with at least rather dubious wisdom, started to accumulate reserves of country A's currency [1] in much higher quantities than those reasonably needed as buffer for their international transactions. Rounding up the analogy, that was like giving country A free housing (on top of all the above).


2. What the world would expect to see from the US, and what it is actually seeing instead

Given the circumstances described above, a reasonable observer would expect country A to behave smartly with the aim to preserve a system that gave it such an incredibly advantageous position. He would expect country A's Central Bank to acknowledge the important role its currency plays in global trade and to assure all countries that its monetary policy would be geared first and foremost to preserving the purchasing power of its currency for international transactions, so that they could confidently hold it (or debt denominated in it) as a store of value.

Imagine then the observer's surprise when he sees country A's Central Bank openly set its monetary policy with the only objective of avoiding the possibility of any internal recession, however slight and brief - not getting out of a deep or prolonged recession, which would be understandable, but preempting the occurrence of an arguably remotely probable one. And moreover do that at a time when the purchasing power of its currency, when measured in internationally transacted goods such as crude oil, industrial metals, grains, and of course gold, the barbarous relic, has already declined considerably over the last years and is lately doing so at an accelerating rate. He would see such monetary policy as amounting to country A telling the world: "Look, the only thing we care about when setting our monetary policy is the level of our internal economic activity. And by that we mean mainly the production of goods and services that you can't buy from us. We don't care much about our currency holding its purchasing power internally, [2] let alone when measured in internationally traded goods. So, if you use our currency to trade between yourselves, it's your problem. And if you are so stupid as to use it (or debt denominated in it) for holding your savings, you do need professional help."


3. What can now be expected to happen

What could then be expected as a response from countries B to Z? A straightforward possibility would be to switch to country's E currency for foreign trade and reserve purposes, totally or partially. But that does not really solve the problem. Because if the root of the problem is the fact that country A is getting a free lunch, ride and housing, the solution cannot possibly be to take that from country A and give it to country E (much less so when E's Central Bank has lately shown its willingness to print whatever quantities of its currency are needed not just to prevent a recession but to prevent any bank from falling!) The only radical solution is to set up a system in which no country has an unfair advantage, which means to adopt for international trade and reserves a currency that cannot be printed by any country: gold. (Silver could be used in addition for reserve purposes only, but it is clear that changing industrial demand makes it impossible now to fix the ratio between the values of both metals.)

Back to Earth 2007, the likelihood of this radical solution being implemented in the short and medium term is very low, mainly because worldwide official adoption of gold as international currency would strongly encourage private citizens all over the world to adopt it too as store of value for their savings, in a "harder" version of the well-known dollarization phenomenon which could be called "metallization", and it is well known that a consequence of dollarization is the loss of effectiveness of monetary policy, hardly a desirable outcome for central bankers at this stage of economic thinking. Because the level of acceptance (at least domestically!) of their little printed papers as both medium of exchange and store of value holds the key to the effectiveness of Keynesian monetary policies to stimulate aggregate demand and thus foster maximum sustainable growth in output and employment [6], or, in a more cynical view, the key to the power of central bankers and to the spending possibilities of governments.

Therefore the most probable outcome is that central banks all over the world start to gradually switch part of their dollar forex reserves to currencies of countries having large current account surpluses, such as China, and particularly of those countries that are exporters of critical items like oil, natural gas and food [3], such as Gulf countries, Russia and Canada, and that these countries allow their respective currencies to appreciate against the dollar (for which they just have to stop their current intervention in the forex market, whereby they buy dollars to keep their currencies from appreciating against it, which is why they were accumulating so many dollars lately). [4] [5]

This outcome obviously implies a gradual devaluation of the dollar against those other currencies. Which in turn, to the extent that these countries adopt monetary policies conducive to price stability in their currencies, implies a gradual loss of purchasing power of the dollar against the previously mentioned internationally traded goods. That will make foreign goods (and those US goods that can be readily exported) preogressively more expensive to US citizens, which will lead to a fall in US imports (and a rise in US exports) and a consequent reduction in the US trade deficit.

As described, this looks like the right medicine for the US trade imbalance problem. And it certainly is. But, as will be seen below, it could turn out to be a very painful medicine for US citizens. The severity of the pain will depend on the speed and extent at which the dollar devaluates against the other currencies, which in turn will depend on the lack of regard of US monetary policy for the international purchasing power of the dollar. Greenspan's 2001-2003 monetary easing was painless because it began with the value of the dollar at its highest point in 15 years, though it eventually succeeded in taking it to near its historical low point by the end of 2004. Since that's more or less where it is today, it can be easily seen that going along a similar monetary policy path this time would have much more serious consequences.
This topic has been touched on by two interesting papers lately. One is from Benn Steil, the Director of International Economics at the Council on Foreign Relations, who in "Monetary Sovereignty as globalization's Achiless heel" wrote:
"The status of global money is not heaven-bestowed, and there is no way effectively to insure against the unwinding of "global imbalances" should China, with more than a trillion dollars of reserves, and other asset-rich central banks come to fear the unbearable lightness of their fiat holdings."

The other is from Paul Krugman, who in "Will there be a dollar crisis?" at
http://www.economic-policy.org/abstract.asp?vid=22&iid=51&date=16/08/2007&aid=183
wrote:

"So it seems likely that there will be a Wile E. Coyote moment when investors realize that the dollar’s value doesn’t make sense, and that value plunges. The case for believing that a dollar plunge will do great harm is much less secure. ... The United States in 2007 isn’t Argentina in 2001."

The rest of the essay will develop the ideas in the quotation from Krugman's paper, using a conceptual model model from Steil's.


4. Why exactly "the dollar’s value doesn’t make sense".

As said above, the only fair and logical conceptual framework in which to assess the relative value of national fiat currencies is one in which all of them are peers on an equal standing. Within that framework, the intrinsic value of any national fiat currency outside the issuing country arises exclusively from the possibility of using it for purchasing goods, services and property rights FROM THAT ISSUING COUNTRY in a reasonable timeframe. And it is logical that, the more essential the goods a country can export, the more valuable its currency can be.

Therefore, in a fair and logical international monetary system, for all relatively debt-free countries that are exporters of essential items such as fossil fuels and food, the following ratio should be in the same order of magnitude:

amount of currency (and debt denominated in it) circulating outside the issuing country
/
issuing country's annual exports.

Within that framework, then, the relative intrinsic value of the US dollar versus the Brazilian real and the Russian rouble comes exclusively from the possibility of using the mass of dollars outside the US for buying something from the US versus the possibility of using the mass of reals outside Brazil for buying something from Brazil and the mass of roubles outside Russia for buying something from Russia. And this is enough to tell us that today's valuation of the dollar has nothing to do with its relative intrinsic value, because, while it would take a very long time to use the enormous mass of dollars (and of dollar-denominated debt) floating outside the US to buy real things from the US at their current prices in dollars, there are simply no reals outside Brazil and no roubles outside Russia.

Therefore, the relative value of the dollar today is far higher than its intrinsic value, and it depends on economic actors worldwide accepting (outside of any fairness, logic and reason) that it is valid tender for goods, services and property rights from any country, not just the issuing one.

A couple of objections could be raised at this point. First, that the international reserve status of a currency depends on the development of the financial markets in the issuing country. This is proved otherwise by history, because in the 1950's, when the dollar reigned supreme, countries all over the world had capital controls in effect and therefore financial operators worldwide could not take advantage of US financial services. Notably, at that time the US had a hefty current account surplus, was the first world exporter, and moreover its currency was convertible to gold.

Secondly, the current lack of use of the currencies of countries with large current account surpluses and at the same time exporters of essential products might be due to the fact that those countries are in no condition to send their currency abroad because they are still heavily indebted to the world. To evaluate if that is actually the case, we calculate for each such country, using data from the CIA World Factbook, the following two ratios:

external debt (in all currencies) / exports ; external debt (in all currencies) / current account surplus
United States: 9.8 ; (deficit)
Argentina: 2.3 ; 13.5
Canada: 1.7 ; 33.3
Brazil: 1.3 ; 13.1
Russia: 0.9 ; 2.7
Venezuela: 0.5 ; 1.1
Saudi Arabia: 0.2 ; 0.5

Quite clearly this comparison shows exactly the opposite, namely that if there is one country that, due to an outsized external debt, is in no condition to send its currency abroad it is the US, precisely the very only country in the table that is doing it, and massively at that. Thefore we must conclude that - unless we expect the exports of Saudi Arabia, Venezuela, Russia, Brazil, Canada and Argentina to plunge in the near future and at the same time those of the US to surge, which is quite unlikely to say the least - the world's current monetary system accords to the US dollar a status that does not fit at all into the fair and logical framework we defined above (i.e. is unfair), is based in no objective reason (i.e. is completely arbitrary), and implies a gross overvaluation of the dollar with respect to its intrinsic value. The only plausible cause of this state of affairs is historical inertia: as said before, after WWII the US was for some years the largest oil and food exporter, did have a current account surplus, and moreover its currency was redeemable for gold. Evidently those past features, having gone away and actually reversed long ago, cannot possibly justify the continuation of the dollar's privileged status.

Now, the fact that the "generally accepted" fiat value of the dollar today is (unfairly, illogically and unreasonably) far higher than its intrinsic fiat value does not mean that US dollars as valued today are not "real" money. They definitely are, because the reality of the status of something as money exists (just as vanishes) in the minds of the people involved. I.e., what enables an entity to function as money is the social acceptance of its role as medium of exchange, store of value and unit of account. Money is a social psychological construction. It is within the minds of the members of a society (be it the world or a concentration camp) where a specific entity becomes a currency, where the main factors that prompt those members to reach such a consensus are the perceived intrinsic usefulness and scarcity of the entity (along with its durability). Thus, gold and silver were real money worldwide for many centuries, cigarettes were real money in concentration camps, and dollars as valued today are real money wordlwide.

In exactly the same way, it is within the minds of the members of a society that an entity can cease being a currency. Thus, just as central bankers worldwide agreed to demonetize silver in the 1870's, whereupon the value of silver against gold fell by 60% during the next 30 years, and just as, after being freed from the concentration camp, non-smoking former interns stopped accepting cigarettes in exchange for anything, so it is entirely plausible that in the very near future - prompted by the perception that the Fed's chosen monetary path is making the dollar less and less scarce - economic actors worldwide reach a new consensus whereby they agree to assign the dollar just its intrinsic fiat value.

Since this intrinsic value is far lower than the "generally-accepted" current value, the transition will cause significant losses to current holders of dollars (or of promises to receive dollars in the future). Thus, once the process starts, it is highly likely that a worldwide race develops to get rid of dollars and dollar-denominated debt, whereby foreign holders dump them into the US (the only place where they would still be accepted) in an attempt to get something real in exchange for them before its value falls even further. It is even likely that such a panic could temporarily drive the value of the dollar far below its fair intrinsic value (overshoot). Should the US institute capital controls to stem the tide, that could further feed the panic. (Notably, those capital controls would restrict bringing dollars into the US. In the past, capital controls instituted by other countries restricted taking dollars out of those countries.)


5. In what way "the United States in 2007 isn’t Argentina in 2001."

Surprisingly, the last statement in the above quote is literally true, but in exactly the opposite way its author meant it: the present situation of the US has far more downward potential than that of Argentina in 2001. This might be shocking for anyone familiar with the magnitude of the adjustment that Argentina underwent at that time, best illustrated by the fact that imports dropped from 20 billion USD in 2001 to 9 billion USD in 2002. Why and how could possibly the US face an even harder adjustment?

To understand why, we will use Jacques Rueff's tailor metaphor as quoted by Steil (2007), after making a couple of observations to it. In the first place, it is just not true that dollars are of no use outside the US, at least today. Because as we have said, the dollar today is regarded as valid tender for goods, services and property rights from any country. So, in order to pay for Saudi oil or Brazilian soybeans, China must have in hand and tender US dollars, not bonds or stocks. Secondly, and related to the above, to use the metaphor in a more realistic way, we need to include, along with Steil's Chinese tailor, an Arabian shoemaker.

So, here we have a customer (the US) to whom a number of providers sell real things (suits, shoes) in exchange for IOU's. (And by IOUs we mean US dollars themselves, not US bonds, because as we have said, a fiat currency abroad is intrinsically a promise to the holder that he will be able to exchange it for goods, services or property rights from the issuing country. A bond is just a promise to get more promises.) The providers have been doing that for some time and by now have piled up a huge stack of IOUs, to the point of starting to worry whether they will ever be able to exchange the IOU's for real things from the customer. And as they see that the customer is showing no sign of lowering the amount of IOU's he issues per year (and much less stopping issuing them, and even less starting paying them out!), they can be reasonably expected to take action about the situation. What kind of action? Basically, stop selling anything to the customer until they have cashed out (exchanged for real things from the customer) at least a large part of their stacks of IOUs. Which in the real world is particularly important for the shoemaker because the product it sells (oil) comes from a finite, absolutely exhaustible endowment.

And this makes the first difference between the US in 2007 and Argentina in 2001. Even if some of the products the US sells to the world are absolutely essential (e.g. grains), there are enough dollars (and dollar-denominated debt) outside the US to pay for those products for an extremely long time. So the world can buy those products from the US without the need to sell anything to the US for that time. In contrast, there were no Argentinian pesos circulating outside Argentina in 2001 or anytime. Therefore, if someone wanted to buy Argentinian soybean or wheat, they had to tender the international means of payment (US dollars) for that. Argentina repudiated their debt, not their currency.

The second difference lies in the respective quality of imports. In 2001 Argentina was an exporter of not only food, but also of oil and natural gas. So the drop in imports did not involve anything essential for running their infrastructure. In contrast, today the US imports 59 % of their consumption of crude oil and petroleum products. The disruption its stopping could cause is mind-boggling.

Now as to how this could happen, to apply Rueff's metaphor to today's world we have to take into account that the tailor and the shoemaker have been using the IOU's of their customer for trading between themselves for some time. So, if they decide to get rid of their stacks of IOUs, they must agree on another means of exchange. Which brings us to a very important point: we said above that a fair international monetary system would be one in which, for all relatively debt-free countries that are exporters of essential items, the ratios of (the amount of currency circulating outside the issuing country / the issuing country's annual exports) was in the same order of magnitude. It follows then that in a fair international monetary system there would be Canadian dollars circulating outside Canada, Brazilian reals circulating outside Brazil, Russian roubles circulating outside Russia, etc. etc. In other words, in a fair international monetary system all those currencies would be international trade and reserve currencies. How could that possibly be?

Just by means of assertiveness. Of Russia one day telling the European and Chinese: "Look, starting a year from now, you will have to pay for our oil and gas in roubles. You don't have roubles? Good, you have a year left to sell us cars, electronics, and other niceties in exchange for roubles. You don't like it? Good. Try living without our oil and gas for a couple of years then. We can perfectly live without your goods for that time."

The perceived remoteness of this development was felt by the essay's author as the weakest point of the essay until
this Reuters news item
appeared on October 12:

Fund sees move away from dollar-based commodities

LONDON (Reuters) - Resource-rich countries will move away from the dollar as a base for the commodities they produce to protect their earnings as the dollar's slide accelerates, UK-based Emergent Asset Management told Reuters.

The debate about commodity denomination has heated up over the past few months because the dollar has come under persistent selling pressure as markets started to price in economic slowdown and falling interest rates in the United States.

David Murrin, chief investment officer at Emergent thinks the chances of a re-denomination are high, but that it could take some time.

"I can see countries like Russia trying to price commodities in some other currency, possibly roubles," he said. "Keep your eyes open for when and how rebasing starts to creep in."


6. The two paths to rebalancing.

The bottom line is that the US current account WILL eventually be balanced, but, depending on the US Federal Reserve's chosen monetary path, it will happen in either of two ways, which could be envisaged as follows:

A) The Fed follows a tight monetary policy focused on food and energy inflation and the US government adopts a sound fiscal policy, sharply curtailing its military spending and starting an orderly retreat of the troops in Iraq and Afghanistan. The housing market implodes and unemployment rises. Most "structured investment vehicles" and "conduits" fall as banks cut their credit lines to them, honoring their status as "off-balance sheet" entities. The illegal immigration problem solves by itself as millions of former construction workers return to their home countries. The recession causes a substantial drop in non-essential imports (mainly from China) and in the trade deficit. The dollar manages to remain one of the main world trade and reserve currencies.

B) The Fed relaxes its monetary policy as necessary to try to avoid a US recession. Countries with current-account surpluses allow their currencies to appreciate against the dollar - first their central banks stop buying dollars and then, as the dollar loses more and more value, they start dumping them. There is a race to get rid of the dollar whereby its value plummets against those currencies (Paul Krugman's "Wile E. Coyote moment"). Producers of oil and other commodities start pricing them in their own currencies, and consequently their prices shoot up in dollars. As a result, both imported goods (including oil) and US-produced goods that can readily be exported (including grains and most food items) become much more expensive to US consumers, who have to sharply cut their consumption thereof. All imports drop sharply and the trade deficit switches to surplus. Subsidies to farm products are terminated, and there might even be taxes and quotas imposed on agricultural exports to try to moderate the rise in their domestic prices.

The unwillingness of foreigners to buy further dollar-denominated debt causes a surge in long-term rates and renders the cost of funding from the open market prohibitive. As a result, the Fed becomes the buyer of last resort for all new issues of US government debt. The massive inflation arising from debt monetization reduces the real burden of both public and private US debts, but feeds a further abandonment of the dollar as international reserve currency and a further plunge in its value. Developing countries indebted in dollars party big time.

In reprisal to oil exporters not accepting dollars and demanding to be paid in their own currencies, the US mandates that US food exports cannot be paid in dollars and can only occur within a "food for oil" framework, whereby a country will be able to buy US food only for the value of the oil and natural gas it has sold to the US during the previous year. Such a de facto repudiation of the dollar puts the last nail on the coffin of its international status. Canada, not needing US food, cuts all exports of oil and natural gas to the US. Out of oil and natural gas scarcity, electricity prices skyrocket. Cities heavily relying on air conditioning and far-fetched supplies like Las Vegas become forsaken. As the rise in gasoline prices makes commuting progressively more expensive, the price of suburban houses falls and their construction stops altogether.

Unable to procure supplies for its network of military bases around the world, the US decides to dismantle it (the network, i.e.) The withdrawal of US troops from Iraq and Afghanistan starts as gradual but turns into a rush out of popular pressure after the TV shows images of soldiers lacking all kinds of supplies. In the US, food and fuel price rises trigger a wave of riots and looting. Martial law is enacted and troops just arrived from abroad are posted to gasoline stations and supermarkets to keep order.

Peak Oilers must have immediately noticed that scenario B looks exactly like the doomerish kind of scenarios forecasted for after PO. And that is because scenario B is "Peak Oil now" for the US only, not because of the peaking and subsequent decline of world oil production, but because of the peaking and hard decline of the US' purchasing power for oil (and everything else), brought about by the loss of value and rejection of its currency.

If the US wants to avoid scenario B and retain at least part of its monetary most advantageous position, it needs to do some serious shock and awe. Not of military power, but of monetary and fiscal soundness. In the words of an earlier version of Steil's paper: "This is the only sure way to keep the United States' foreign tailors, with their massive and growing holdings of dollar debt, feeling wealthy and secure. It is the market that made the dollar into global money -- and what the market giveth, the market can taketh away."

And since, as said before, the key factor that prompts the members of a society (which may be the world) to regard an entity desirable as a currency is its perceived scarcity, it follows that the required monetary policy to avoid scenario B consists simply of making the dollar more scarce, by targeting (at least indirectly) money supply growth. Specifically M3 because dollars abroad are not in M2. (And it would help if the Fed restarted publishing M3, to send a signal that they are targeting the real thing and not a possibly fake perception of it.) Which is wholly in line with the words of Professor Bernanke in his famous 2002 speech:

"Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services."

Obviously such monetary discipline entails a price: if the Fed sticks to a direct or indirect money supply growth target, it must be willing to refuse to print dollars whoever asks for them. Which includes be willing to:

a. let banks fall if they have a run
b. let the government default if it cannot roll over its debt
c. let foreclosures rise and the housing market implode as more ARMs reset their rates.

Comments on each of these:

a. Most banks will not fall if they just cut their credit lines to "structured investment vehicles" and "conduits", honoring their status as "off-balance sheet" entities. (SIVs and conduits would fall, of course.)

b. The US government can prevent this through a fiscal shock, raising taxes while cutting spending. The obvious candidates are reversing the Bush cuts, instituting a gasoline tax, and withdrawing from Iraq, etc. A long-term solvency shock is also needed, basically ending the entitlement illusion.

c. As said above, that could contribute to solve the illegal immigration problem. Additionally, from a Hubbert's Peak-aware perspective, it is clear that further suburban and exurban construction whereby even more people become dependent on long commutes for everything (and further arable land is lost) is a real tragedy that must be stopped for its own reasons.


7. How Hubbert's Peak fits into this picture.

The above analysis has intentionally ignored the issue of Hubbert's Peak, and as such is valid irrespective of how many years away the world's economy is from bumping against one of the toughest physical "limits to growth". The fact that, according to current data from both the IEA (OECD) and EIA (US), the world is doing that right now [7], reinforces the argument in this paper in two ways.
In the first place, it strengthens the case for oil and natural gas exporting countries to stop exchanging their ever more precious, finite, absolutely exaustible resources for paper which they will never be able to exchange for anything as valuable.

Secondly, since oil supply will not grow, oil demand cannot either. And there are basically two mechanisms whereby that can happen:
1. endogenously, by way of recession, or
2. exogenously, by way of high enough oil prices.

These mechanisms are not mutually exclusive, in that in any particular situation both could be playing with different relative weights. But before proceeding with the analysis, we must take into account a couple of additional facts.

First, according to the IEA July 2007 report, "direct" US oil demand for 2007 averages 21 Mbpd, which is 24% of world total oil demand of 86 Mbpd.

Secondly, the huge trade surplus of China with the US means that an important part of the Chinese consumption of oil and its products, as both energy source and feedstock, ends up "embedded" in goods subsequently shipped to the US, making up which can be called "indirect" US oil demand since there are no matching products being sent back from the US to China (hence the trade surplus). While we single out China because of its weight in world oil demand and its outsized trade surplus with the US, an identical consideration can be applied to other non-oil-exporting countries having significant trade surpluses with the US, such as Japan. Which means that the total share ("direct" + "indirect") of world oil consumption arising from US aggregate economic demand is significantly higher than 24%. (Trying to quantify the "indirect" demand from the ratio of US trade deficit to US GDP would severely underestimate it because a significant part of US GDP consists of services which are very low energy-intensive.)

From these two facts it is clear that the US economy holds the key for the convergence of (until now) growing world oil demand with stagnant world oil supply. Basically, the total ("direct" + "indirect") US oil consumption must go down. Which can happen as a result of each of the two mechanisms mentioned above (or of any mix thereof), where each mechanism corresponds respectively to each of the scenarios described above. The peculiarity of scenario B is that the drop in US oil consumption would take place even if world oil production were still far from its peak.

Notes:

[1] The fact that those countries actually exchanged a large part of their reserves of country A's currency for bonds (= promises to get even more of that currency in the future) is irrelevant in this analysis. What matters is that they were trading real things for printed paper. It does not matter that subsequently part of that printed paper was exchanged for promises to get even more printed paper in the future.

[2] Beyond "hedonically adjusted" official US CPI statistics, this can be verified by The Economist's Big Mac index for the US. In April 2001 it stood at $2.54 while in July 2007 it was $3.41. That implies an effective annual inflation rate of 5% over the 6 years.

[3] The US is in fact an important producer and exporter of food and other critical items such as aircraft and large data processing systems. The problem is that the amount of dollars already outside the US is orders of magnitude larger than what the world would need for decades for buying these items from the US at their current prices.

[4] It is possible that, even in this case, private citizens will increasingly turn to precious metals to park their savings and even as medium of exchange for transactions involving very expensive items. Such possibility was suggested in the quoted 2007 papers from Steil.

[5] As this case, later called "scenario B", can develop into extremely painful conditions for the US, it is conceivable that the US themselves could eventually push for the adoption of gold as international currency, because of two reasons. In the first place, they would start from an initial advantageous position, provided the US actually holds the gold reserves they officially claim to have (a point disputed by many gold bugs). Secondly, when one can no longer have advantage in a game (as the dollar has today), it is preferable to play in a level field than in one in which other players have advantage.

Notes specifically related to Hubbert's Peak:

[6] Economic growth based on increasing rates of consumption of absolutely exhaustible resources like fossil fuels is not sustainable in the long run. Therefore fostering such growth was (and is) most unwise, and even tragic when such growth brings society into a state of ever greater dependency on those resources for its basic functioning. It is probable that economists will realize this only well after Hubbert's Peak has become evident to most. Then they will see that Keynesian monetary policies intended to stimulate aggregate demand are no longer of any benefit (if they ever were). Because it will be obvious that the by then negative growth rates in economic output are not the consequence of insufficient demand but of physical constraints imposed by Nature, and that stimulating aggregate demand with monetary policy is no longer able to increase output at all.

[7] In the IEA June 2007 monthly report, the message was encoded as: "The evolving 2007 global oil balance presents a more immediate challenge. The stark conclusion from our supply/demand balance is that the call on OPEC crude and stock change rises by 2.5 mb/d from its 2Q low to the 4Q07 high point. In contrast, without substantial recovery in Nigerian production capability by the end of the year, OPEC net crude capacity gains amount to only some 700 kb/d."

On the other hand, EIA statistics show that:
- the peak production rate of both (Crude oil + lease condensate) and (Crude oil + Natural Gas Liquids) was in May 2005, and
- the average production rate for both aggregates, as well as for "all liquids" (which includes biofuels), is down in 1H07 when compared to 1H06.

13 comments:

Eddy said...

Even if the dollar keeps falling, the option of asking for yens, rubles or yuans for their exports is cumbersome for the exporting countries.

Because that would revaluate their currencies against ALL other countries (not only US), damaging their industries.

A more clever answer woud be "accept the dollar. But change it quickly for things that ARE NOT FALLING in value".

Even in hiperinflationary countries people still accept the currency (and they rush to exchange it for goods).

That is what is happening today. Pay me in dollars, and i will buy something more valuable ASAP (hence the sovereign funds rationale).

In a sense the world is still searching for a replacement standard currency, and that can only be gold.

Gail the Actuary said...

Thanks for posting this! It is very good.

This post adds additional insights regading why it makes no sense for our imports at their current high levels.

ET said...

I have never heard a reasonable explanation of how gold could be used as a currency given that the supply of gold does not conform in any meaningful way with the absolute size of the world economy.

On a broader note: It seems that the development of any international currency would be plagued by the same problems of 'funny business' manipulation that plagues the US Govt's CPI. In this sense, I don't see that there is any 'ideal' monetary system.

Harold said...

This is an outstanding, comprehensive look at what will--necessarily--happen to dollar holders and earners in the next few months to a year. I think this should be required reading for anyone who wants to avoid deep misery!

Lisa said...

This is very interesting. Who are you?

Murray said...

The last time I checked, about 3 weeks ago, against a trade weighted basket of currencies the dollar was just getting back to its 1997 level, but at that time the dollar was strengthening from a weaker level. The danger now is that it is on a downslope. However I have to believe that Bernanke and Co. at the Fed run scenarios like these all the time, as well as communicating with the central banks of major trading partners, so are well aware of the dangers of whatever decision they make. Murray

Anonymous said...

This is a fine piece of writing. Clear, concise and very informative. Particularly well laid out. Thanks.

Beach Boy said...

My sincere apologies to the posters of all previous comments for my not realizing that I had turned on moderation on this blog!

I hope that, considering that it was my first blog and my first blog entry at that, you will be kind enough to forgive me.

And thank you all for your comments! I will respond below some of them.

BTW, I have just sent a proposal to Professor Goose to have this entry posted on TOD. Let's see what he thinks.

Beach Boy said...

To Eddy:

Your scenario is exactly what happened in hyperinflationary countries. People would cash their salaries in pesos, rush to the supermarket to spend as much as they could, and exchange the rest for dollars (strong money at that time) right away.

But there was a significant difference with today's world: NO ONE WAS HOLDING A BIG STACK OF PESOS at that time.

Beach Boy said...

To et:

Certainly not at the current gold price and the current world trade volume level.

However, if you are familiar with TOD's Westexas' oil "Export Land Model" (ELM) and my own (though by no means so extensively developed) food ELM, you know that the prospects for the volume of international trade are in only one direction: down.

And of course, if fuels and food exports drop, I wouldn't expect iPhone exports to exactly soar.

Beach Boy said...

Murray,

good for you if you think so!

But if you have perused Peak-Oil oriented forums, you might already be aware that the majority there do not hold exactly such high expectations for the authorities regarding their handling of energy issues. And the same is probably true regarding monetary/economic issues.

Bernard said...

This is one of the most brilliant commentaries that I have ever read on the Internet (and I am not speaking facetiously). You appear to be a true intellectual in the purest sense.

I would really appreciate your candid assessment of a commentary that I wrote earlier this year:

http://www.silverbearcafe.com/private/toomuch.html

Should you wish to send me your feedback, you may send it to bber_2005@yahoo.com.

Beach Boy said...

Bernard, thank you very much.

Re your article, the main difference between 1929 and now is that then the world economy was quite far from the physical "limits to growth", and lack of demand out of monetary reasons was the limiting factor to output that caused the Depression. In contrast, now we are bumping against those limits as we speak. And no monetary stimulus will lift them.