Today marks the 100th anniversary of one of the most told and repeated tragedies in modern history–the sinking of the Titanic. For those who don’t know this true story (and unbelievably, there are many young people who believe that the Titanic’s tragic story is only a fictional movie), it was a passenger ship considered to be the crowning achievement of mankind’s progress against nature and the elements in its day.
Though I had read and heard the story many times, I thought I would sit down and watch the movie “A Night to Remember” (released in 1958 and considered the original Titanic movie–before the DiCaprio and Winslet creation that became the most popular movie of all time) on the evening of the 100th anniversary. Yes, there was a previous movie to the DiCaprio version, and according to at least one Titanic historian, A Night to Remember is more accurate in re-telling the tragedy as it really happened–mainly because it leaves out the fictional side stories of romance in the later version.
However, my blog today is not meant to debate the merits of the two popular movies about the sinking of the Titanic (yes, the Night to Remember was a very popular movie in its hey day too)–but rather, I wish to make light of a couple of the lessons of the Titanic tragedy and how those lessons might apply to today’s precarious financial situation around the world.
Perhaps you have heard it said by a few market commentators and a precious few economists that today’s modern world financial moves by central banks and sovereign governments are akin to “re-arranging the chairs on the deck of the Titanic?”
What do these commentators mean by this comment, and what great iceberg lies out there in the darkness on the horizon that could prove to be capitalism’s undoing?
First, let’s understand what the news media and pundits had said about the Titanic in the year 1912 as it was christened for its maiden voyage–that it was unsinkable! Indeed, the words unsinkable and Titanic were often spoken in the same breath…as synonymous as reserve currency and US dollar are spoken of today. The Titanic had been designed with special compartments built into its hull that would trap and contain any leaks, should they occur, and allow the ship to stay afloat. The ship was the early 20th century’s equivalent to today’s Boeing Dreamliner (B-787)– a mode of passenger transportation that was the epitome of travel–sparing little expense for comfort and luxury–and quite fast and efficient as a mode of travel.
So confident were the Titanic’s designers about the invincibility of their ship that they placed only enough lifeboats on the ship to save less than half of the ship’s expected passenger loads–and that placement was only to meet a code in existence at the time. Otherwise, the designers might not have put any lifeboats on the big ship.
Now, back to the future….in 2008, as most of us know, the US and world economy experienced a dramatic unraveling of the world financial system which exposed many problems within a system that had previously been believed to be safely buttressed with back-stops and insurance mechanisms that would keep the machinery of finance running, even in a worse case scenario. However, as we now know, the worse case scenario was not even needed to cause a panic and unraveling of the global financial system.
If not for the quick actions of the Federal Reserve (the US central bank), the world economy might have fallen into a deep and dark depression. Many ills were exposed–long time axioms like “too big to fail” were severely tested and found to be false to some extent. Market insurance instruments such as derivatives like “swaps,” futures and options were found to be less secure than previously thought.
At the time, there was much debate about how to change the financial system to make it safer going forward–swaps would be moved to a transparent system such as a market exchange…institutions that were too big to fail would be downsized or slowly unwound and shut down, it was said. Today, some four years later, very little has changed, except for a maze of greater rules and regulations created by a Congress that little understands how the complexity of financial markets work–such as the Dodd-Frank Act and the Volcker Rule.
The Fed’s injection of liquidity certainly worked to end the immediate crisis–but it failed to do so for the cause of the ailments–namely a lack of solvency in many economies of the world. The Fed’s actions, and the actions of the legislative and executive branches of government, both here and abroad, have failed to address the underlying structural problems that created the financial mess in the first place.
As I said earlier, the words reserve currency and US dollar are often spoken of as if they are one and the same. Indeed, for the lifetimes of most people living today, the US dollar has often been called “king dollar” because it has long assumed the role of “money.”
For what is money, but a store of wealth that people everywhere consider a safe place to store the credits of their fruit (the wages from work) until such time as they need to acquire something that fulfills a need or a want (spending). In short, a sound currency is perceived to be the place where people “bank” their savings until they make a purchase somewhere else. In its simplest form, a currency is store of wealth that can be transferred for purchases or investments. Without a currency, we would all be living in in a society as barbaric as the ones before the ancients where barter was the only way to acquire something from someone else.
Now, let’s go a step further, and think about this: it is often assumed by market participants that “risk on” investments such as stocks or commodities should be sold when there is a fear of downward pricing because of deflationary events. Included among the commodities are gold and other precious metals. Yet, to some observers, precious metals, and especially gold, are considered forms of money in themselves.
Few market participants stop to ask why it is assumed that when the world is troubled, one should seek safety in the US dollar currency–and in the assets of the government from which the dollar derives its strength. The main “assets” of the US government are its debt-backed instruments, the treasury notes and bonds that it sells to the investing public–and which offer a rate of investment return (interest) and relatively low volatility–and the promise that the debts will always be paid back in full by the US government.
Now, it goes without saying that for a good many years the US dollar was absolutely the safest currency in the world….up until the early 1970s…and again in some years of the 1980s, the US was a creditor nation. A creditor nation is one which takes in more money than it spends, either by government spending or by balance of trade with other countries–or ideally, by both scenarios.
But as luck would have it (or was it by poor planning?), the US over the years has become a debtor nation…and indeed, it is now the largest debtor nation in the world! Actually, let me define that one more step–the US is the largest debtor nation in the history of the world…and has been for a good many years.
Yet, somehow, the US dollar stays on as the main reserve currency of the world. Yes, the Euro came along and h
as also developed a reserve currency status as about 20% of the world’s reserves are invested with the Euro currency. Yet, as we know, the European continent is suffering from a malaise of over-spending and debt, which is restraining that currency from becoming the world’s predominant currency.
So, it is by default that the US dollar remains the world’s top reserve currency–but other challengers are growing with the Chinese currency, the renminbi being the greatest threat among the developing nations’ currencies. However, even China, with its $3 trillion dollar trade surplus has many hidden bombs within its financial system, such as the large number of under-performing loans to local governments by banks that are back-stopped by the Chinese government…and what some consider to be an over-heated real estate market backed by shaky mortgages.
What ALL of the paper currencies of the world represent are debts–they are not truly assets, but backed by debt instruments–which represent promises to pay. Take a look at the money in your wallet– a US dollar bill has this language printed on it: “This note is legal tender for all debts, public and private.” Notice the key word in that sentence is debt, which I have underlined. What does that mean? Does anyone really know?
I will tell you what I think it means: that all of the debt issued by the US treasury…and all of the debt issued by US private companies such as financial firms like banks or large industrial companies is what backs up the value of the US currency. This might come as a surprise to many of you, but the US dollar is a function of this nation’s debt, and it represents a promise by the debtors to repay those debts. Consider that the US dollar is a reserve note of the Federal Reserve and since the Fed is essentially a bank, like all banks, it thinks of debt as assets. Ask any accountant who does the books for the banks, and in their realm, a loan (debt) is classified as an asset. (Conversely, in a bank, a deposit by a saver is viewed as a debt of the bank, because the debt must eventually be re-paid to the depositor when the depositor withdraws the funds.)
So, does that mean that our currency and all paper currencies should be treated as worthless? The short answer is no. This is because the realm of finance, and indeed, the realm of most commerce relies on debt to function efficiently. Short term debt can occur in many forms, such as the traditional business transaction that allows a business a certain number of days to pay for a shipment of goods–for those who operate a business, the term “net 10 days” or “net 30 days” should be a familiar term. This term means that a business promises to make payment on a shipment of delivered goods within the time limit and will often receive a discount for doing so. A good and trustworthy customer is usually “good” for the terms of the agreement–the paper currency we carry around in our wallets is the conduit that allows this type of finance to occur. Of course, many other forms of finance exist from simple short term loans to longer term loans; nearly every American has taken on some form of debt to obtain the dreams of tomorrow today.
Indeed, debt has long been the American way–it is debt that helped to build this country into the greatest, most powerful country the world has ever known–so long as that debt was taken on in a responsible way and our proper planning and ingenuity allowed us to take that debt and invest it as capital to increase the expansion of our country’s economic prowess. Healthy debt financing is a good thing! Without some way to finance things, the world would be a bleak place indeed.
The opposite of a debt currency is an asset based currency. Truly, there are no asset based currencies except for gold (and sometimes silver). Gold is not always regarded as a currency by the believers of debt currencies–i.e., paper money (“fiat” money). But gold is the anchor in the world economy when debt grows out of hand–gold forms a relief valve which balances out all the debt in the world. As Alan Abelson of Barron’s admirably points out in this week’s edition, the central banks of the world are worried about their own money printing policies–thus they are now net buyers of gold. However, gold is another subject entirely, and not where I wish to go with tonight’s blog, but I only mention it here to show the counter-balance that exists in the financial world to debt.
Now, what has happened in the last few decades is that we as a country have allowed our debt to become unmanageable–and indeed, many of the developed countries have done the same. If one takes the $15 trillion in US government debt and attempts to run it through a long-term finance payoff formula (amortization of debt), say over 40 years or more, one finds that the debt would consume a fair percentage of everyone’s paycheck for a very long time even at the low interest rates we currently enjoy… and I haven’t even mentioned the private debt of the citizens of this country and the under-funded pension debts everywhere. The problem is, no one wants to buy $15 trillion in debt from us on a long term basis–this is why the Treasury Department is often rolling over short term debt–the proverbial “kicking the can down the road” approach to dealing with a problem that has become nearly unmanageable.
So, where am I leading to with all of this? The point is, so long as the debt is managed properly and growth is maintained to help accommodate the debt, then America would be in good shape. However, this has not been the case for many years now.
Like the passengers on the Titanic who re-arranged the deck chairs even as the captain realized that many of them were doomed and would not live to see the morning….
We Americans assume that the world will always honor our debts. We assume that our currency, the US dollar will always be the main reserve currency of the world. Many Americans have taken to conservative strategies like keeping a good portion of their money in money markets, CDs and US treasury bonds. It seems like a smart and sensible strategy for safety, even if the returns aren’t very good in an ultra-low interest rate environment (engineered by a Federal Reserve with a weak balance sheet exposure). Indeed, the financial advisers that many well-off Americans listen to for advice espouse a similar strategy of staying conservatively invested in CDs, money markets and treasuries.
They sit smug in the comfort of their chairs on the deck of the most prosperous country they have ever known–this is America, after all. It’s a given that our dollar will always be strong, and our debt will always be honored, no questions asked. When Europe is failing and when China is landing hard, all eyes will be cast toward America–it’s always been this way, and so it shall be again in times of distress.
Forget that there is no captain in the wheelhouse of this ship–yet, let’s just keep re-arranging the deck chairs to catch a fresh breeze or another view of the moon on the horizon. We need not worry even as the ship tilts nervously to one side–we shall ignore the warning signs–until it is too late.