In search of the equilibrium

What has happened since I wrote my last article?

Due to the liquidity crunch, banks & businesses are getting lesser credit. Hence they cannot have enough funds to spend on capital outlay or day-to-day expenses. Several of them have already retrenched the workforce because those businesses are already affected. Several others have started the retrenchment to prepare for the rough weather. This means lesser consumer spending due to increasing unemployment leading to lesser funds for businesses & the vicious circle goes on. This is happening at times when US citizens don’t have enough savings in their bank accounts!

There are many things still being unfolded, there are still several unknowns & we are yet to see the end of it all. Anyways, let’s take a journey through this thing called money & the system that revolves around it aka International Monetary System.

A little bit of philosophy (bare minimum but necessary)

What is money anyways? Is money the piece of paper? Not really. If that were the case, then every piece of paper would have had similar value attached to it. Then what is money? Well simply put, money is “trust”. You are trained to trust it for generations. Money is a perfect example about how well one rules the minds of masses in making them believe that the piece of paper that they hold is really worth a bag of wheat or bottle of water or 2 hours of entertainment in a movie theatre. Nowadays money does not even get represented by pieces of paper; it merely can be a few bytes of data on some hard disk in some data center of your bank!! That is what we all are really trained to believe to be of immense value. That’s what we all call money. That’s what we run after our entire lives, ultimately to die leaving it all behind! Let me give you an analogy of 5 monkeys for us to better understand what I really mean by “we are trained to believe in this thing called money”.

Once, five monkeys were put inside a cage. The cage had a ladder with a bunch of bananas at the top. As soon as one monkey started to climb the ladder, cold water was sprayed on all the monkeys. When another tried to climb, cold water was sprayed on all the monkeys again. Soon, no monkey attempted to climb the ladder. One monkey was removed and a new monkey was put in the cage. The new monkey saw the bananas and tried to climb the ladder. Not wanting to be sprayed with cold water again, the other monkeys quickly pulled him down. The new monkey never understood why this was happening to him. He tried repeatedly but in vain until he understood & accepted the fact that the other monkeys will not allow him to climb the ladder.Another monkey from the original lot was removed and a new monkey was put in the cage. Again, the new monkey saw the bananas and tried to climb the ladder. Not wanting to be sprayed with cold water, the other monkeys quickly pulled him down. The first new monkey also joined the rest 3 old monkeys in pulling the newest monkey down!This exercise was repeated until all five original monkeys were gone, and five new monkeys were in the cage. None tried to climb the ladder, and none understood why!!

During the monetary system evolution in past thousands of years, mankind has witnessed multiple major phases. The monetary system moved from pure law of jungle to somewhat barter, to pure barter, to coins issued by various kings/ rulers, to gold-silver standard, to pure gold standard & right now a USD based standard. Even though the system seemingly evolved through these visible phases, the law of jungle has not gone away completely. During all these transitions & phases, perhaps thousands were killed in the past that refused to accept certain form of currency that the ruler offered. Hence due to fear ingrained in them as a result of these massacres, the generations of mankind have trained themselves to act like the last five monkeys in the cage. Same is true in modern monetary system history. Countries with sophisticated weapons coupled with technology, knowledge & willingness to use those weapons are virtually ruling the world. In 2000, Iraq converted all its oil transactions under the Oil for Food program (started by UN) to Euros. When U.S. invaded Iraq in 2003, it returned oil sales from the Euro to the USD. Even the original Oil for Food program was not restored.

We cannot consume anything like currency notes/ bullion/ precious metal. At the bare minimum we need social life, food, clothing, shelter, sex & entertainment. Natural resources hold the key in the real sense. Am I hinting at a barter economy? I am not trying to hint at anything in particular. Just putting the facts here.

Functioning of the current Monetary System

I thought it necessary to explain how the international wheels of money spin. We many a times act like the last 5 monkeys not completely understanding why, what & how of the system.

USA acts as the supplier of reserve currency to the entire world. USD is the de-facto world currency. USD to a lot of extent has replaced gold as the reserve currency for the central banks of the world. Any country that has positive balance of trade (exports more than imports) ends up adding on to their USD reserves. Obviously rather than sitting on idle reserves, the central banks of these countries invest those funds in US Treasury Bonds, ending up financing the US budget deficit. Take the example of a Chinese manufacturer selling a TV set to a US customer. He gets USD in return which in turn he sells to his bank to get Yuans. Chinese banking system starts piling up such USD. The central bank of China invests these USD in US Treasury Bonds that yield 4%-5% return. Now understand this carefully – the TV set exported to US obviously ends up in the USA. US economy adds to its own deficit since import of this TV set adds to their foreign payment obligation/ spending. US economy gets back the USD (by Chinese central bank buying treasury bills) that they paid to the Chinese manufacturer, thereby financing the US deficit! USA has the TV as well as the money to buy it too! Well, you might say that USA needs to pay back the debt through maturity of the Treasury Bonds, they need to also pay interest on the same. You are theoretically perfect. How does it happen in reality? Sure US Treasury pays back these liabilities… by doing what? By issuing more Treasury Bonds!!

On the other hand, since most of the industry has moved to cheaper destinations like China, India, Mexico etc. the biggest hope for US economy to grow is “consumer spending”. By continuously lowering interest rates, US Govt. encourages the average consumer to borrow & spend. However lower interest rates also mean that the Chinese economy (extending the TV example) finds investment in US Treasury Bonds less attractive. They may decide to hold their surplus in some other form – Euro, Gold or something else. That would mean lesser avenues for US economy to fund the deficit. However increasing the interest rates will mean the US consumers will be in a lot of pain & will slow down the growth. A real dilemma for the policy makers.

What is expected in the upcoming G7 extraordinary meeting in November?

Obviously USA & other troubled nations including Europe are trying to find an answer to the present unfolding disaster. I think following options or a mix of all those may emerge from these discussions.

1) Concerted interest rate reduction by all central banks – This has happened at least once in last 2 months. However the participation needs to be more wide spread by many other central banks.
2) Continue cajoling, coaxing, pushing & prodding the nations to continue their “trust” in the USD based current monetary system. One way to get these nations to pledge their renewed support is to play on their fear. If the current monetary system collapses, no one will be spared!
3) Continue strengthening the military prowess
4) Sweeping powers to the legislators thereby giving them access to touch the retirement funds or savings of US residents – Perhaps already initiated through the recent TARP, making all financial institutions in USA the Federal financial agents. In case the rest of the tactics do not yield the desired results of having all countries to continue trusting $ as the de-facto reserve currency, then US Govt. must find another way of financing the deficit – either through creation of more money (which means probably devaluating USD which would already be under tremendous stress in such situation) or by turning to their domestic savings, gold & retirement funds market to get the money required to finance deficit.

What next for individuals?

Like any other system, the financial system will strive to find equilibrium in the months to come. I don’t know what that equilibrium will be. The change could be good or ugly. However I can only say this – continue to be prudent, convert your assets in the forms that are traditionally considered safe (some may put gold & land in this category & for others it may be something else like food or water), develop & nurture the strength to safeguard your assets & be prepared for a rough ride… tighten your seat belts!