End of the American era

The first week of August 2011 will probably go down in history as the time when the American dollar effectively and finally lost its status as the world’s foremost reserve currency -- and European leaders were told by the market that it does not believe they have a credible plan in place to deal with the Euro zone’s sovereign debt problems.

The week started hopeful enough with the American congress, after weeks of political brinkmanship, at the eleventh hour reaching a bi-partisan deal to lift that country’s debt ceiling. But, within hours on the back of disappointing economic indicators such as manufacturing and employment figures, and renewed bad news from European countries like Italy, Spain and Portugal, it went pear -shaped.

By the end of the week, as European leaders were departing for their summer holiday destinations, there was carnage on world markets as investors fled for safe havens in what some commentators described as panic. By the end of the week some $2.5 trillion was wiped off the value of global equities.

To top the week off one of the three leading  rating agencies, Standard & Poor (S&P) stripped the United States of its AAA credit rating, just hours after the markets closed for the weekend.

In a way the S&P-move was just a confirmation of what the markets have been saying: America, because of its debt, is no longer the world’s safest investment destination.

Early in the week Bloomberg reported that the committee of bond dealers and investors that advises the US Treasury said the dollar’s status as the world’s reserve currency “appears to be slipping.” The committee said the outperformance of haven currencies (like the Swiss franc) and those from emerging nations, has aided the debasement of the dollar’s reserve status.

“The idea of a reserve currency is that it is built on strength, not typically that it is best among poor choices …,” one of the presentations by a committee member stated. “The fact that there are no currently viable alternatives to the US dollar is a hollow victory and perhaps portends a deteriorating fate.”

These words proved to have been almost prophetic in light of what happened at the end or the week.

A new global dispensation

It would seem as though the world of international financial relations will never be the same again, although it is at this stage not at all clear what a future dispensation will look like. What does seem pretty certain is that a period of great uncertainty and financial turmoil lies ahead.

Not all commentators and analysts are equally pessimistic, but according to Information Clearinghouse Mark Faber, editor and publisher of the Boom, Doom and Gloom Report, told CNBC-news on 5 August that “markets could rebound … but investors should see any bounce as a selling opportunity, as the world economy rolls towards total collapse.”

“You have a computer. Occasionally the computer will crash and you have to reboot it. That will happen to the global economy. Before this happens there will be much more money printing because basically the central banks are willing to do that.

“By printing money, problems are not solved, but they can be postponed, and they become larger.”

He added that “the next time we have a global economic crisis, it will be much worse than 2008. Before this happens there will be money printing and there will be war. The whole system will collapse.”

Ever since the US in the 1970s started moving away from gold as storage of reserves during the rule of presidents Nixon and Reagan, US government debt became a cornerstone of the world’s financial system and is held in large amounts by foreign creditors such as China and Japan. It is used as collateral on a daily basis by banks and investors.

China said in a commentary carried by the Xinhua News Agency that “the US government has to come to terms with the painful fact that the good old days when it could just borrow its way out of messes of its own making are finally gone.”

That situation has now become largely untenable. Ironically American companies like McDonalds (which also accounted for the little job growth there was in the US) and Coca-Cola are now regarded as safer investment destinations than the US government’s bonds.

The markets have highlighted the inadequacy of the political response in America, where the fate of the world’s largest economy and by implication that of the rest of the globe, has been used as a political football in a game of political brinkmanship between the two largest political parties.

S&P also warned that it would consider a further downgrade of US bonds if spending is not reduced.

The immediate outlook in the developed world is for a protracted period of belt-tightening and consequent sub-par growth. Developing markets, where growth rates, albeit slowing, will be comparatively attractive for some time to come and should benefit from the situation.

If the move towards deeper fiscal austerity on both sides of the Atlantic continues, as is anticipated, there does not seem to be any alternative to printing more money as an offset. This will be good for equity markets in the short term, but is likely to foster deeper problems down the road.

Signs of things to come

In the absence of adequate international governance for financial management, a quasi-regulatory role by default has gone to ratting agencies --  which are profit-making entities themselves --  to police the way in which companies and countries manage their debt obligations by assessing their risk profiles and informing investors.

This has clearly become a totally ineffective way of dealing with the matter. Italian prime minister Silvio Berlusconi might have given some indication of things to come, in his attempt to forestall panic.

Besides pledging action, including limits on public spending and calling for a meeting of the G7 country leaders (within days), he promised constitutional changes to legally enshrine spending limits. He also promised that Italy will balance its budget by 2013.

Increasing numbers of commentators are taking the view that the Euro zone will not survive the present crisis. The world might see in the months and years to come a new global currency dispensation develop.

Asset Protection Agency chief, Stephan Wilcke, for instance said that Italy could be much better off being in a currency union with Japan rather than Europe. “Japan has an ageing population, low growth and very high government debt, and therefore the Bank of Japan has very low interest rates. Those things are true for Italy as well, only they haven’t  got very low interest rates because their rates are being set by the European Central Bank for the whole of the Euro zone.”

Wilcke, the man charged with whittling down the Royal Bank of Scotland’s toxic debt told The Telegraph he doesn’t believe a financial crisis can be averted and judging by the first week in August it may already be here. “I’m very worried about the Euro zone. It has some very, very deep structural problems which require political solutions.”

In another development Latin American finance officials were planning to gather sometime during August to discuss ways to protect their currencies and economies from the turmoil in the US and Europe.