The New Bretton Woods : Where The Trade Wars Are Headed



In 2005 the United States is projected to run a trade deficit of $806 billion, up from $668 billion in 2004. The International Monetary Fund forecasts that the trade deficit will rise to $890 billion in 2006 and then to what can only be called a staggering $980 billion in 2007. How in the wide, wide world of global trading can one country run an almost 1 trillion dollar trade deficit? What is the rest of the world going to do with all those dollars?

Declaimer: This article was originally in August 2019, and some of the data points may be outdated
Will central banks want to buy almost $2 trillion more in US debt in just the next two years? They own approximately (and at least) $1.5 trillion today, accumulated over many years. Do they want to own all of our government debt? At the level of projected trade deficits, that could happen in just a few years. Is this sustainable?
The above is an extract from a reputed newsletter by John Mauldin, about 15 years back. Looking back at this today, we have China alone with Fx Reserves of $3+ trn, India at a paltry $430 bn, and the US still at $620 bn, rather down in inflation-adjusted terms compared to 2007. For 15 years now, I have been hearing arguments about the demise of the USD, based on these arguments.

At the end of the Second World War, the US found itself holding most of the world’s Gold Reserves, and the world ran out of ‘cash’. So it was decided that the US would issue ‘IOUs’ (a.k.a. Dollars) against these holdings of Gold. And that’s how the US Dollar became the repository of the world’s faith, the basis on which Trust was communicated. The Dollar had a fixed ratio (for convenience) of $35 per ounce, so it was the equivalent of Gold.

Since the US also had roughly half the world’s manufacturing capacity, it was not envisaged then that there would be much international trade without the US on one side of the transaction. This then was a mercantile system quite unlike today, where the US accounts for slightly less than 25% of world GDP, and roughly the same in mercantile trade.

So like lemmings, we started to follow the Pied Piper, obsessed with little pieces of greenbacks. Like the proverbial frog in the boiling pan of water, we never understood how the environment changed. We certainly were not prepared for the emergence of China/ India, global capital flows, and generally, Globalisation. Most Emerging Markets carried fixed (or variable) pegs to the Dollar, and the world evolved into a Fake Reality that the “Dollar Was The New Gold”. Except that the Treasurer turned out to be treacherous. In 1971, Nixon removed the peg to Gold and ran away with the printing machine.

For a generation after that, it was party time for the Americans. They outsourced almost all their manufacturing and hard work to the Chinese and sat back playing the tables in Las Vegas and on Wall Street. The idling of America and Americans created huge social change in the US but gave the Chinese jobs and pulled millions of people out of poverty.

Over time, a second convention has emerged. Far from resisting the hegemony of the Dollar, the world has gravitated to it, deciding that this unlimited supply of ‘new gold’ is needed to lubricate the growing Asian economies. So there emerged a Nash Equilibrium, where it turned out to be everyone’s interest to denominate their Trade, both imports and exports, in the US Dollar. The valuation of an individual country’s currency to the Dollar reflected its ability to sell to the US and hence accumulate more of the green stuff.

Bretton Woods Two is a Nash equilibrium. In game theory, the Nash equilibrium (named after John Nash) is a kind of optimal strategy for games involving two or more players, whereby the players reach an outcome to mutual advantage (or often as not mutual disadvantage). If there is a set of strategies for a game with the property that no player can benefit by changing his strategy while (if) the other players keep their strategies unchanged, then that set of strategies and the corresponding payoffs constitute a Nash equilibrium.

So it became an incestuous system, where the US became both the world’s Banker and its main buyer. The world started to be centered around the US Dollar and US consumption. But both of these became capricious, as the US went into huge trade deficits (and hence the world’s most indebted country, dependent exclusively on the return of its Trade Deficit in the form of T-bills), while the aging of its Baby Boomers exhausted its consumption engine.

Remember how this system is not a formal arrangement, but a Virtual Reality, like the flawed belief that the Earth is flat. The implication is that the US has absolutely no incentive to maintain the value of its currency on trade account (hence balance its Trade Deficit). That’s exactly the opposite of what Trump is trying to do just now. If he has his way, and the Trade Deficit drops, the USD would rise and the world economy would tip into Depression. Because Asia is never going to need the stuff that the US no longer imports.

All activity in Asia is focused on either US consumption of US Dollars (intra-Asia trade). While Trump is not against the use of the US Dollar (although he does try and use it in Sanctions against Iran), his attempt to deny access to US consumption, gives Asia a motive to promote its own (consumption). This is evident from the destination of Chinese Steel export surpluses, which are now 40% distributed across Asia and only 8% is going to the US. But now the rest of Asia is going to start running up surpluses with the US, it’s not like these jobs are going back to the US. And Asia is locked down by this competitive need to use its surplus manufacturing capacity to get Dollars. So there’s just a redistribution of the Dollar bonanza, not a structural reduction.

But there’s going to be a slow shift in favor of each other (Asia) and away from the US. Which will then marginalize the Dollar progressively, leading to a slow decline in the US Dollar relative to Asia. Amazingly, that gives China a reason to appreciate the value of the CNY, not reduce it. But that’s only over the long term.

Which brings us to China’s options during the Trade War. The Nash Equilibrium referred to, is of multiple players. Here, we have the US & China, locked in a mad battle that has no resolution. The US cannot stop importing widgets from China, and China cannot stop exporting them. And China cannot sell its US Treasury holdings because that would weaken the Dollar while strengthening the Yuan.

American importers will look for alternate countries to import from, but those countries may not choose to keep their surpluses in US Treasuries, which could weaken the Dollar. That is not going to be to Trump’s taste, and he could well be shooting himself in the foot. But that’s Trump for you….

The net result of this could be a progressive marginalization of the US from global trade and commerce, both as the world’s pre-eminent Banker and as the world’s mercantile counterpart. The current tantrums of the Trump Administration could result in the US losing its position in the Centre of Gravity. And American consumption losing its pre-eminence at the center of the world economy, as it loses purchasing power in line with the loss of the Dollar’s Numero Uno status.

Behaviourally speaking, if the engine of world consumption shifts to Asia, the net impact of debt as an engine of consumption will reduce. An extra Dollar of debt will not do in Asia what it does in the US. That’s bad news.

Perversely, India could emerge as exactly the kind of consumption engine that the US is withdrawing from. Much smaller, of course, but the model is similar. If India starts to get FDI flows, our consumption would rise with the higher purchasing power that the overvalued Re would garner. This the government has to guard against

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