Defining Moments

November 14, 2013

The approaching 50th anniversary of former President Kennedy’s death offers an appropriate juncture to reflect on how well-prepared are foreign exchange markets to handle a truly transformative surprise.  Global GDP growth appears to be improving but from an extremely weak and fragile state.  Improvement is not widely felt by populations.  These are not satisfying times.  The euro area is just emerging from its second severe and prolonged recession in five years.  Unemployment there is at a record high, and U.S. employment is over 30 million workers below its pre-2000 trendline despite considerable monetary policy support.  China is at an environmental crossroads and settling for a new growth norm several percentage points below the old one.  Other key developing economies like India and Brazil are struggling and performing much worse than the standard to which they’d become accustomed.  Japan’s policy plan, an experiment of new tactics to end fifteen years of deflation and restore sustainable 2%+ growth, has many skeptics.  

Many elected governments are broadly unpopular.  Voter approval ratings in the United States are under 40% for President Obama and less than 10% for the Congress.  The President of France and Prime Minister of Britain are under siege.  Democracy itself seems on trial.  Ed Snowden’s leaks of classified information have created revulsion both at the how much national security one person may have compromised but also the extent of institutional spying being routinely done by the U.S. Federal government at taxpayer expense.  Distrust rather than cohesion and a sense of common purpose characterizes policymaking at so many levels these days, including within central banks.  The ECB Governing Council was split over last week’s rate cut.  Bernanke’s thinking has dominated Fed policy, but some Fed officials are clearly on a different page.  The Bank of Japan Board is in somewhat less agreement than thought.  Extremist right-wing politics is on the rise in Europe and questioning the merit of sharing a common currency.  A new political movement in the United States dedicated to dismantling government has infiltrated the institutions of government and is managing to achieve its ends from within as well as outside the beltway.  Distrust permeates relationships among allies as well as foes, adding to the general mood of the day where “uncertainty” has become a buzzword for not having the foggiest idea about what lies ahead.

This is fertile ground for shock forecasting.  One soothsayer is predicting a 90% implosion of U.S. share prices.  Presumably, 90% was chosen because that matches the size of the DOW’s decline from 381 in September 1929 to 41 in July 1932.  Currencies haven’t gotten caught up in this maelstrom of fear talk, but it seems apparent that the most important currency pair, the euro’s value against the dollar, does not represent fundamentally constructive value.  Euroland desperately needs a weaker exchange rate to stem encroaching disinflation and to promote less unbalanced current account positions, yet the euro pushed up another 0.5% over the past five trading days and is in the mid-1.30s.  The higher the euro stays and the longer it does so, the greater is the risk that the monetary union will break apart. 

The good news is that truly defining moments in the dollar happen very rarely.  I count just five in the forty-plus years of market-determined currency values.  Most can be pinpointed to a day.  The first, July 6, 1973, happened just four months into the experiment of a new international monetary system.  When the dollar floated, no role for currency market intervention was conceived.  Worse than the dollar’s decline was the progressive deterioration of market conditions impeding the ability to make simple transactions.  It all came to a head on Friday, July 6, and market conditions experienced on that day forever afterward have defined what constitutes disorderly trading that needs the calming support of the government’s visible hand. 

The second defining moment was really a two-part event.  Part one was the dollar rescue package of November 1, 1978, including an unprecedented one-percentage point hike in the Fed discount rate.  The dollar had been slumping badly in 1977-78 and abruptly reversed direction.  Alas, the fix did not endure, and this prompted a more dramatic shift when the Fed on Saturday, October 6, 1979, unveiled a program of quantitative tightening that eventually doubled the external value of the U.S. currency and defeated excessive inflation.  The third transforming event was Black Monday, October 19, 1987, when the DOW fell 22.6% in a single day, easily eclipsing any day’s loss in the Great Depression.  9/11/01 was the fourth defining moment, and the fifth was the collapse of Lehman Brothers engineered with the consent if not outright encouragement of the U.S. Treasury Department on September 12, 2008.  That miscalculation bumped the global debt crisis and recession into a much higher and damaging gear.

The most profound defining moment that I personally recall was the Kennedy assassination, which seemingly triggered a U.S. political chain reaction.  From an origin that, the pendulum of ever-widening political swings continues.  On that Friday in 1963, the international monetary system was still the fixed dollar-to-gold and dollar to other monies scheme proposed at the Bretton Woods Conference in 1944.  Initial wire reports of shots fired at the presidential motorcade around 01:35 eastern standard time immediately paralyzed currency trading, but order was restored with just $23.5 million of intervention over the rest of that afternoon.  The Fed bought U.S. currency mostly against German marks and sterling but also versus some Dutch guilders, Canadian dollars, and Swiss francs.  Global daily forex volume nowadays exceeds $5 trillion, by comparison.  One can conjure up other defining moments and near-misses such as the assassination of a Serbian Archduke that ignited the First World War after some badly handled exercises in diplomatic game theory.  The murder of Lincoln that produced a botched century of reconstruction was another, and a third is conjured up from the hypothetical thought experiment of currency market conditions if the Cuban missile crisis had not managed to be defused without the U.S. and Soviet Union coming to military blows.

Governments do not seem well prepared to handle another defining moment, yet weakened politics and structural economic resilience seemingly increase the risks of stumbling into the abyss.  Better coping mechanisms to handle worst case contingencies are needed.

Copyright 2013, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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