The Global Monetary Policy of “Three Sheets to the Wind”

Sell first and ask questions later. That was the global investment strategy overnight. Whether it was JP Morgan’s $2 billion loss, Greece’s possible exit from the euro, or ‘Greece of America’ California’s $16 billion budget deficit, investors found plenty of reasons to sell everything. US dollar cash and US Treasuries rallied.

How soon could Greece exit the euro? Well, it may not be that easy. Remember, back in February we made the argument that Europe’s powers that be had to prevent a Greek bond default. They couldn’t allow a precedent to be set.

If it was okay for Greece to default, then why not Spain? Why not Italy? Confidence in Europe’s entire government bond market would be blown to smithereens, taking the banking system (capitalised by government debt) with it. The European Central Bank (ECB) would be collateral damage.

Mind you, no one in Europe’s establishment likes to mention Iceland. There’s probably a reason for that. It might give the Greeks ideas. In 2008, Iceland’s three largest banks owed foreign creditors more money combined than the size of Iceland’s economy. The government couldn’t guarantee the banks debts. So it didn’t.

The government DID assume the banks’ domestic obligations. But it told the foreign creditors to get lost. It defaulted. The currency fell by about 80% against the euro. The default and devaluation put Iceland back in a trade surplus a few years later and earlier this year ratings agency Fitch upgraded the credit rating on Icelandic government debt.

Now, you may be thinking that stiffing your creditor is a less-than-honourable decision. But it was done democratically. Iceland put the question of default to its people and 90% of the people chose default. They put the credit risk right back on the lender, which seems appropriate considering the borrowers were not the people but the banks. The people refused to accept the debt burden taken on by the banks. And the creditors? Too bad for them.

Greece has taken the other path. The politicians thus far have rejected what the people want. Greek politicians are taking their marching orders from Brussels, Berlin, and Paris. The debts of the private sector are now the debts of the people. Maybe this explains why the Greeks are currently unable to form a government. According to some sources, that government may have less than €2 billion cash.

Of course the main difference between Iceland and Greece is that Iceland had its own currency. The default was coupled by the devaluation. That’s what made the debt go away. It caused a short, sharp, painful recession. And in GDP terms, the economy is much smaller today than it was in 2008. But the debt was liquidated. That’s the important part. It hasn’t been preserved as a perpetual burden on taxpayers in order to satisfy creditors (the private banks).

The Greeks can’t devalue until they exit the euro, and the Europeans don’t want the Greeks to exit just yet. If the Greeks repudiate their foreign creditors, it means they repudiate the debts they owe to French, German, and other European banks. There’s no telling what would happen then.

Some people are already speculating that a massive ECB money-printing binge – on the order of hundreds of billions of Euros – would ensue. The intent would be to insulate the rest of Europe from a Greek euro exit. But an unintended consequence would be a devaluation of the euro…back to parity with the US dollar!

Now that would be a shocker. But then, we are in a kind of race to the bottom when it comes to currency values. Every country wants a cheap currency to boost exports. Exports lead to growth. Growth is better than austerity. But obviously, not everyone can have the cheapest currency. If Europe devalues…you can expect QE3 from the Fed soon. Heck, maybe even the Chinese will devalue as well. And the RBA may cut rates again sooner than anyone expected.

You can see the absurdity of the current monetary system in this series of tit-for-tat monetary expansions. The ‘race to the bottom’ in the competitive currency devaluation has lowered global interest rates. In the early stages, lower rates led to more borrowing – the credit boom. The biggest beneficiaries have probably been countries like Australia and Brazil. You got combined commodity inflation and demand for ‘risk’ assets like commodity currencies and resource stocks.

Around the middle of the race, you saw the expansion of government deficits. You can thank the Federal Reserve for this. The best example of this is the decline in 10-year US Treasury yields since 2007. You can see below the 10-year yield is once again near all-time lows. This has been a boon for US mortgage rates and, of course, for the US government, whose borrowing costs have gone down as its deficits have blown out.


But here in the late stages of the race we have JP Morgan losing $2 billion in the hunt for yield. And why is JP Morgan hunting for yield and losing money? Because ultra-low interest rates (negative in real terms) force you to speculate and take bigger risks to earn a real return. It’s not just mums and dads. Its investment banks too. It’s everybody. We are all Jamie Dimon!

Bill Gross, the manager of the world’s largest bond fund, reckons we are reaching the end of the race. ‘Major changes to our global monetary system lie on a visible horizon,’ Gross writes in a Financial Times article. Gross reckons the diffusion of low-interest rate sovereign bonds from the developed world has brought us to a tipping point which may lead to an entirely new monetary order.

He elaborates:

‘Now, with dollar reserves widely dispersed in China, Japan, Brazil and other surplus nations, it is fair to assume that there will come a point where 2 per cent negative real interest rates fail to compensate for the advantages heretofore gained in buying sovereign bonds.

‘There is the potential for both public and private market creditors to effect a change in how credit is funded and dispersed – our global monetary system. What that will look like is a conjecture, but it is likely to be more hard money as opposed to fiat-based, or if still fiat centric, less oriented to a dollar-based reserve currency.

‘The developing credit cancer may be metastasised, and the global monetary system fatally flawed by increasingly risky and unacceptably low yields, produced by the debt crisis and policy responses to it. The great white whale lies on the horizon. Investors should sail carefully.’

Investors definitely should sail carefully, especially since the monetary policy response seems to be ‘three sheets to the wind’. The old sailing phrase describes the ropes that hold a sail in place, the ropes being sheets. When the ropes are loose, the sails flap and the ship cavorts around on the sea like a drunken sailor (mixed metaphor alert!).

The Fed, the ECB, the Bank of Japan, and the Bank of England are drunken sailors. The world’s monetary policy is three sheets to the wind. Insert your favourite nautical disaster metaphor here. Are there any lifeboats on this Love Boat?

Toscafund chief economist Savvas Savouri tells the Australian today that as the US dollar loses its reserve currency status, the Aussie dollar will climb to $1.70 against the greenback! ‘China needs to gorge on US Treasury securities at the moment to keep its exchange rate stable, but come 2014 that policy will likely change.’

We’re not sure what Dr Savouri is on about. Could it be the IMF’s reweighting of its special drawing rights in 2015? In the event, he’s not worried about China at all. Yesterday we expressed doubts that China can make the seamless transition from export-driven growth to domestic consumption. It’s going to be bumpy.

Dr Savouri disagrees. ‘People are naive if they think there’ll be any ‘landing’ in China…On practically every measure, such as bank reserve requirements or interest rates, monetary policy is much tighter in China than in the West.’ This reflects the belief that economic growth is just a matter of having the right policy settings.


Savouri says it’s all happening now. Or next year. ‘Next year will provide more economic fireworks than 2008…If, for instance, Russia or Norway announced that they would only part with their oil in return for a basket of currencies – rather than US dollars alone – many other countries would probably follow suit.’

Is he right? Well, there’s no doubt the dollar standard is near the end of its monetary journey. But there’s no land in sight. A lot of investors have chosen to maroon themselves on the island of US Treasury bonds. Is there a survival strategy you can use or are we all going down on the same ship?


Dan Denning
for Markets and Money

From the Archives…

Is the Australian Economy… Booming…or Busting?
2012-05-11 – Greg Canavan

The Art of Value Investing: How to Value a Business, Not a Stock
2012-05-10 – Greg Canavan

When Financial Markets Decouple From Reality
2012-05-09 – Dan Denning

Low Interest Rates Are A Dangerous Addiction!
2012-05-08 – Satyajit Das

The Bear Hunters and the Trigger Event for the Aussie Dollar
2012-05-07 – Dan Denning

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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