Six years ago today, I started this blog as a tribute to something I'd
only discovered three months earlier. The fact that I'm still at it six
years later speaks to the depth of the material I had only glimpsed when
I started. I once started another blog on a different subject and lost
interest after only a couple of months. I do tend to lose interest
easily. In college, I changed majors and colleges several times, and after college I changed careers twice. Six years on one subject, for me, is remarkable.
I have no formal education or background in the subjects I explore on
this blog. Everything here I learned since 2008, through reading,
thinking and writing this blog. Once you understand the basics, it's
mostly common sense. But the real strength behind my subject matter is
the foundation I chose as my muse, the five years of Freegold archives
left behind by someone calling himself "Another" and his friend, "Friend
of Another" or FOA.
Many people write blogs related to their profession or area of expertise
and influence. This is not one of those blogs. If I have any level of
expertise or influence in the subject of my blog (which is not my
judgment to make), then it comes from writing this blog, not the other
way around. So I am deeply moved whenever real professionals make
comments praising what is essentially my hobby.
As this is an anniversary post, here are comments from a couple such
professionals over the past six years. Krassimir Petrov is an economics
professor from Bulgaria who has been blogging and writing articles
since well before the global financial crisis. He received his PhD in
economics from Ohio State University and now teaches in the Middle East
and Southeast Asia. In 2010 on his blog, he sent his readers to one of
my posts with this recommendation:
"This is one of the very best contributions in the inflation-deflation debate. It is long and detailed, but the topic is extraordinarily complex."
Two weeks later, after reading some of my earlier posts, he added this:
"FOFOA is probably one of the very best analyst in the whole world. The more I read from him, the more I am convinced of his vast superiority over most experts and analysts…"
In 2011, I wrote a post directed at Rick Ackerman. Rick is a professional trader, financial advisor and blogger with a large following, well known as a hard-core deflationist. My post was an attempt at addressing his 30-year aversion toward dollar hyperinflation as the final outcome, using FOA's reasoning. Within days of my post going up, he left the following comment on my blog which made the hairs on my arms stand at attention when I first read it:
"Sheesh! Where to begin? It's difficult to give up a belief system that took root 30 years ago, but I find your arguments irresistible. I took notes as I read the essay, thinking to rebut you point-by-point; instead, halfway through it, I found myself overwhelmed by the clarity of your thoughts. The real power of this essay is that each step of the hyperinflationary endgame it foresees is entirely consistent with human nature, particularly where self-interest and self-preservation are fated to play out.
I will have to find a way to break this gently to my readers, perhaps starting with the joke about not having to outrun the bear. It goes a long way toward explaining how the Masters of the Universe will actually benefit from hyperinflation. You've also helped me understand how I could have been so bullish on gold over the years even though I considered myself a hard-core deflationist. It was a conflict between head and heart, really, but you’ve resolved it with the most persuasive argument I’ve seen in favor of gold. Even better, you’ve provided a sound basis for arguing that at $1500 per oz., gold has barely begun to discount the dollar’s final fall.
I especially appreciate the patience and humility you showed in walking readers through your argument one gentle step at a time. By not trying to overpower your opponents, you have produced a treatise that is certain to engage many minds. Thanks for engaging mine -- at a depth that had eluded me for three decades."
Such comments are wonderful confirmation for my efforts and my presentation, but again, I have no real experience or background in the subject matter. My secret is my deference toward the view presented by Another and FOA. I work to hone the lens they left behind in order to share the view with others, but all credit for the view itself goes to them.
In my last two posts, I have been progressing toward the simple concept that Freegold is all about clean floating exchange rates. Not just a clean float in the price of gold, but in currency exchange rates as well. It's a little more complicated than that, but not really. To "float" simply means that the private sector (also known as the market) determines the exchange rate.
It's not a proposed change of rules or anything like that. Instead, it is the recognition that this is where things are heading on their own, without any further rule changes. It's not a system that will require a clean float or punish a dirty float. Instead, it is the observation that a clean float is what everyone who matters now wants. It is the direction they are all heading today, including the US, Europe and China, and that once a fresh starting point is reached, the rationale behind it will be obvious to everyone and exchange rate manipulation will, for the most part, become a thing of the past.
It's not even that floating exchange rates are the most fundamental principle involved. After all, the euro took many countries which used to have their own currencies and combined them into a single currency zone. There's no floating exchange rate between France and Spain. The more fundamental principle than floating exchange rates is functioning automatic adjustment mechanisms. This principle applies across all borders, whether they share the same currency or not.
The difference is, for adjustment mechanisms to function automatically, wherever an exchange rate exists, it must float, i.e., it must be determined by the private sector. Whenever the public sector intervenes in exchange rates, it prevents the automatic adjustment of imbalances and therefore causes imbalances to accumulate. It's a pretty simple concept.
Public sector intervention in exchange rates covers everything except a common currency and a clean float. Hard fixed, pegged, adjustable peg, dirty float, they all prevent imbalances from correcting gradually and therefore cause them to accumulate, which leads to an unstable and vulnerable situation. Using a common currency or having a clean floating exchange rate leads to balance, stability and invulnerability.
Covering this point properly would require an entire post, and it's one I may write in the future because it is somewhat controversial. But in brief, the reason it is controversial is because one famous economist in particular thinks that hard fixed exchange rates are essentially the same thing as sharing a common currency. They aren't, because what can potentially work in theory has been shown time and again to not work in practice. As FOA said, "This is the way fiats work, whether gold backed or not, they always break from strict printing discipline."
For hard fixed exchange rates to work like a common currency requires "strict printing discipline" in response to international imbalances, while a common currency and a clean float do not. And it's not just discipline that's required, because the complexity of getting the adjustments just right would challenge even a supercomputer. Yet it seems to follow that if a hard fix can work, then looser fixes or adjustable pegs are fine too. But the complexity and difficulty multiplies as you ease away from the hard fix, then it disappears suddenly when you finally give control over to the marketplace.
In any case, such academic exercises are irrelevant at this point as the trend away from fixed exchange rates toward either a common currency or a clean float has been established by those who matter for the last 40 years and then some. It is now "baked into the cake" as they say, so none of this is meant to be a discussion of possibilities. It is simply part of the lens and the view.
What a clean float from a fresh starting point (which I should stress that we do not have yet) will do is to balance trade automatically through the exchange rate. There will be no need for the systemic settlement of trade imbalances. Economy-wide trade imbalances will be corrected gradually, almost imperceptibly, over time through changes in exchange rates.
Different economies obviously produce different things, and different things have different (and constantly changing) relative values. Some economies produce more valuable products with less effort, while others produce less valuable products with more effort. Nor is consumption or the enjoyment of the fruits of one's production equal across different economies. The United States, for example, produces a lot of stuff, more than any other country in the world. We are, in fact, the largest economy in the world (unless you count Europe as a single economy) based on gross domestic product.
Yet even as the largest producer in the world, we still consume more than we produce. FOA said it well. "Collectively, [we use] our own attributes and require the use of other nation's as well… We cannot place [our attributes—our enormous resources and high productivity] up as example of our worth to other nations unless we crash our lifestyle to a level that will allow their export! Something our currency management policy will confront with dollar printing to avert."
Running a trade imbalance is a choice that is most easily made by the net-producer. The choice is to consume less than you produce, which is what makes one a net-producer by definition, and nearly anyone can make that choice. The choice to consume more than one produces, on the other hand, generally requires support from an external source.
Profits are income in excess of costs. They can be invested, saved or consumed, so profits alone don't define a net-producer. It is what you do with your profits that determines whether or not you are running a trade imbalance. Here's a rather confusing comment from Another in 1998:
"As you ponder these thoughts, consider that; all economies today are truly equal in production as the exchange rates are the manufactures of profit!"
As you think about this comment, recall that in my last post I quoted an article about Airbus calling for the ECB to intervene in the foreign exchange market to weaken the euro. The article explained:
"Airbus, which sells its aircraft in dollars but incurs costs in euros, is one of the most exposed groups in Europe to a strong single currency. Other groups such as Unilever, SAP and BMW have also faced currency headwinds."
The list price of an Airbus A380 is $400M (€298M at the exchange rate at the time of writing), but a tough market has forced them to discount the price significantly in order to sell airplanes. Having spent $25B developing the A380, plus the cost of producing each unit, it is estimated that the break-even point will be once they sell 420 planes. So far they have delivered 138 planes and have orders for 180 more.
The bottom line is that their costs of production are still higher than their income for this plane. They need to cut costs or sell more planes at higher prices in order to turn a profit. In a competitive market, you need to be competitive in order to profit. But there is a potential shortcut.
Just as a simplistic exercise, let's say A380 sales are happening at $300M per unit (€224M at the current exchange rate), and production costs are €230M per unit, for a net loss per unit of €6M. If the euro exchange rate was to decline 5% from $1.34 to $1.27, the $300M price would suddenly convert to €236M and the €6M loss per unit would magically become a €6M profit per unit. Without any cost cutting, competitive improvements or increase in price, a profit would have been magically manufactured by simply manipulating the currency exchange rate.
Now read Another's comment again and see if it makes any more sense the second time around:
"As you ponder these thoughts, consider that; all economies today are truly equal in production as the exchange rates are the manufactures of profit!"
Manual labor, like factory work, has the same basic output anywhere in the world. A screw turn is a screw turn whether you're Chinese, French or American. By moving the production facilities for certain parts to China, Airbus could cut costs because, even though the output is the same, the manual labor is cheaper. Part of the reason for that is China's support of the dollar. By weakening the yuan, China lowers the living standard of manual laborers which increases the nominal profits of the company owners, wherever they may reside. This is how exchange rates manufacture profits.
You may think that Chinese laborers work cheaper than, say, United Auto Workers in Detroit, because they are accustomed to a lower standard of living. While it may be true, it will be irrelevant with a clean float. I think we'll all be stunned by how quickly the purchasing power of comparable work on comparable products will equalize across borders between comparable economies with clean floating exchange rates.
Getting the ECB to lower the euro exchange rate through FX intervention would have a similar effect to moving production to another country that already manipulates its currency. It would lower costs at the expense of a lower standard of living for all workers in the local economy while elevating the nominal profits of the company owners, the bonuses of its executives, and the standard of living in America where we can buy overseas using an overvalued dollar. As FOA said, "the world does not hate America; rather they hate the free lifestyle our dollar's illusion value brought us yesterday and today."
There is another way, other than currency exchange rate manipulation, to manufacture profits. That other way is through real cost cutting and real improvement in output, in other words by becoming competitive. From the articles quoted in my last post:
"Currency manipulation is not a route to competitiveness, it is a soft alternative to hard explanations to the electorate."
"We have to concentrate on whether the European economy is competitive and then we will have an appropriate exchange rate."
With this latest honing of the lens, I think that the view of not only what is unfolding in real time is becoming clearer, but also some of Another and FOA's posts from 16 years ago are also making more sense. Here's another one that should be familiar to most of you. Please let me know if you think it makes any more sense with an improved lens:
ANOTHER 5/26/98: "The Western mind does focus on "what I buy today for the lowest price". Yet, in this modern world economy, the lowest price is always the function of "the currency exchange rate"? The Yen, it is compared to the dollar today, and used to purchase goods. One year later and the Japan offers these goods for much less, as the Yen has fallen to the US$. The currency value of this purchase, was it "true" today or a year ago? Understand, all value judgments today are as subject to "exchange rate competition"! It is in "this exchange rate valuations" that the private citizen does denominate all net worth! A safe way to hold the wealth for your future, yes? You should ask a Korean or the Indonesian?"
Here are a few more:
FOA 9/22/98: "The currency confidence factor comes from a strong positive exchange rate, much like that enjoyed by the dollar today. The average European will buy from the USA in the same way that Americans buy bargain goods from other countries. Using an overvalued dollar makes one feel as there is no inflation, even though there has been massive dollar currency inflation over the last twenty years (the real cause of price increases is when the exchange rate is allowed to balance a negative trade deficit)."
FOA 9/26/98: "The possibility of FXC (Foreign Exchange Controls) is very real. This topic has been discussed in several well written books spanning 25 years. In a way, the closing of the gold window in the early 70s was a form of FXC. Anyone outside the country could no longer get their gold because too many dollars had been printed to cover the gold in the US treasury.
Today, too many derivatives have been printed (paper gold is one of them) than can be covered by the outstanding dollars! The US Federal Reserve either prints a load of dollars to cover this contingent or the system falls apart. If the Fed prints, the Americans get inflation. If the Fed doesn't print, the world financial system, based on a dollar reserve currency, starts to implode and foreign holders of dollar assets try to exchange these for their local currency. To do this they must take the dollar home to the USA for exchange! During this exchange, if the dollar loses too much value in the exchange rate, these foreign holders just SPEND THEM in America!
Again, the US experiences price inflation, only this time it's during a global deflation in dollar assets. To stop this chain of events, this time the US Treasury closes the dollar window. It's usually a last effort to hold the banking system together. The gold window was closed by holding gold at a low price valuation and not selling any of it. The dollar window will be closed by buying dollar currency at a rate so low as to stop most major holders from exchanging. This usually brings a two tier market, dollars inside the country worth more than outside the country. For some time, all dollars outside the US were called Eurodollars! Will we see these Eurodollars exchanged for Gold????"
Very briefly, I want to draw your attention to these curious charts of Foreign Direct Investment or FDI in the US:
They come from here, and the data comes from the US Dept. of Commerce Bureau of Economic Analysis, or BEA. You can download the latest BEA Excel spreadsheet for FDI Financial Transactions here. I noticed a curious coincidence when I decided to compare the mysterious FDI outflow to the puzzling "Belgian" Treasury buying from the same quarter.
The net decline in FDI for the first quarter was $117B, but the decline from Europe alone was $124.6B w
