By John Mauldin
August 15, 2003

This week we further explore  part three of "How the World Really Works" from my friend, Art Cashin. Many thanks to him for allowing me to use his work so that I could  get a little R&R this summer. Next week it is back to the heat of Texas and full weekly letters. Now, deadlines approach and I have to go give a speech. It is time to finish and go to Part Three of Art Cashin's essay.

How The World Really Works, Part Three

To better understand both global trade and the currencies that make it move we must again go back to basics. This time the basic is the very concept of money.

Almost from the time they learned to use language humans have traded with each other. In the early stages it was barter - the exchange of one item for another. If you raised pigs and your neighbor raised chickens you might, conveniently, swap him some bacon for some eggs.

But what if your neighbor does not want bacon. Suppose he wants cheese or fish. You then need to find someone who has what your neighbor wants (cheese) who is also interested in what you have (bacon). Whether your product is shoes or olives, you can see how cumbersome barter can become.

What was needed was something that would be readily accepted for almost any good or service. That is what we call money - an "agreed upon" medium of exchange. That last part is important. Like a poker chip on your dining room table, money is worth what we agree that it's worth.

On Tuesday night when Aunt Agnes has "the girls" in, the value might be a penny. On Thursday when the cigar crowd shows up, it may be a dime or even a quarter. It's the same chip. It is the agreed upon terms that differ. Many things have been used as money. From fishhooks to beads to fur, it was whatever people in that particular trading circle agreed to. On the YAP Islands, long isolated in the southwest Pacific, the islanders used 8- foot wheels of stone for money. That may seem strange to us but that's what they agreed to - and it worked. Well, it worked until some Europeans heard of the system and sailed into the harbor with a boatload of 8-foot stone wheels. It caused a local bout of hyper-inflation that Alan Greenspan has yet to cite. The search for the right medium of exchange has shifted over time from the useful (fishhooks) to the unique (gold).

Gold has had many attributes as a medium of exchange. It is very rare so small amounts could represent large sums (no 8 foot wheels here). It is virtually indestructible and almost impossible to counterfeit. You can lose it but you can't destroy it. When the Lydians and Phoenicians spread trading across Asia Minor and the whole Mediterranean, they used gold "coins" as the medium of exchange.

But (and I can just see the hate mail coming now) gold works only because we agreed that it worked. The YAK Islander or the Manhattes who sold New York to Minuit would not instantly see the value of your gold. It is pretty, it shines, but what do I use it for?

Gold has over 4000 years of history behind it. That gives it strong cultural credibility and acceptance. And it can't be inflated. But, an ounce of gold is worth only what we agree. Maybe it's a man's suit or a lady's gown or even a small computer. Mediums of exchange are all based on agreement.

Earlier, when we discussed the emergence and evolution of banking, we noted the convenience and safety of keeping the gold in one place and transporting the receipts. These banknotes carried the promise that they could eventually be redeemed for the gold (or silver, tobacco, or tea - a few of the things upon which money has been based).

In the last century, nations have determined that it is the promise that counts more - a promise of soundness. Thus, the U.S. dollar is no longer redeemable for gold. But the government shows its faith in its currency by accepting it in payment for taxes. That gives it both a sense of necessity and some credibility.

Thus, money is the convenient medium that we all (government and citizens) agree to use. If one side is suspected of failing its obligations, the other side will reject the medium (counterfeit, hyper-inflation, etc.). Nations also respect the exchangeability of other countries' currency, although not at a fixed price or ratio.

Money is the fuel and lubricant of global trade. Certainly barter is impossible despite eBay and the searchability of Google. But, if a currency does not appear to perform or conform to its standard as a "medium of exchange," the results can be sudden and violent. The Thai Baht and the Russian Ruble are a couple of recent examples.

Let's take a look at how global trade works - at least in classic theory. Suppose Americans suddenly went mad for French wine. They import every bottle they can get. They pay the French winemakers dollars - billions of dollars. The winemakers, however, find that the town baker prefers the local francs to dollars (this is pre-Euro).

So the winemakers need to exchange those dollars to get francs. They go to their bank who then goes to the Central Bank (there are other means but we're keeping it simple). The Bank of France could sell the dollars to other nations in exchange for francs. Unfortunately, this new supply of dollars would drive down the dollar versus the other currencies. In essence the dollar's purchasing power would decline outside the U.S. So, that bottle of French wine would cost the Americans more. They might stop buying or buy less. That would not make the French winemakers happy. They would buy less bread and cheese. Lot's of folks in France would not be happy.
Thus, the Bank of France has a problem. It can look around for someone (a central bank) who really wants dollars so that they will not drive the dollar down. This is not unlike the farmer with the bacon looking for someone who wants what he has.

The Bank of France has another somewhat less classical, alternative. They can avoid flooding the foreign exchange markets with dollars by buying U.S. Treasury bonds.

Over the last three decades, Central Banks around the world have adopted just that strategy. America has gone from a creditor nation (lender to others) to a debtor nation (borrower from others). The growth in this shift was aided and abetted by the Central Bank strategy cited above. This buying of Treasuries has had a very significant effect in the U.S. When the Fed buys U.S. Treasuries as agent for a foreign central bank, it has the same impact as if the Fed had bought for its own account. The foreign buying takes bonds out of your bank and leaves it with cash, which it will then try to lend, as you recall from our discussion of banking and the velocity of money.

Thus, foreigners and especially foreign central banks have given the Fed a tailwind in supplying more money. Put another way, they have facilitated the huge growth in debt we have seen.

How much of this is going on? The figures indicate - a lot. Sources tell us that over half the total reserves of all the Central Banks in the world are held in U.S. dollars. Let me repeat that - over half the world central bank reserves are in U.S. dollars. This is both an enormous amount of money and a stunning proportion of world reserves.
You could look at it another way. Let's examine it from the U.S. side. Foreigners hold between 30% and 33% of all U.S. Treasury bonds outstanding. We believe more than half of that is held by central banks. Foreigners are also said to own 14% of all U.S. Agency bonds. Foreign sources are also believed to own 20% of all U.S. Corporation debt.

These are numbers the size of glaciers. A sudden shift in sentiment or intent among foreign holders could have far reaching impact across the face of America.

Thus, we need to be aware or maybe even wary of how these banks evaluate things.....like our economy and our currency. Some cynics claim we have been "living off the kindness of strangers". I suggest there is nothing kind about it. They are operating in what they believe to be national self-interest. But whatever the motivation, it is the future evaluation that is important.

What events might cause these large holders of U.S. debt to change their minds, or at least their goals?
One might be inflation. At this time inflation is thought to be an unlikely near term outlook. There certainly is a huge amount of excess capacity around - not just in the U.S., but globally. Classically, inflation does not kick in with huge pockets of excess capacity around. It's hard to raise prices when your competitor has room to produce more (excess capacity) and might steal your customers by keeping prices steady.

Yet there is a seeming paradox in the current Fed posture. The Fed openly talks of "reflating" - basically pumping some inflation back into the system. Inflation, as you recall from our earlier discussion, favors the borrower and hurts the lender. The lender gets back money that buys less bread than the same amount of money had when he lent it. So we have the paradox of the Fed stating it wants to lower rates to promote inflation and bonds being bought for the lowered rates with no concern of bond erosion.

What could cause this seemingly counter-intuitive buying of bonds? There are three likely answers. First, the buyers of bonds might think the Fed will fail. Second, the buyers might think the Fed will succeed so slowly, at the speed of molasses, that the bondholders will have plenty of time to exit before they suffer any damage. Third, the bond buyers don't see the risk or, more strangely, don't care. The third alternative seems wholly implausible in the largest most liquid market in the world.

Nonetheless, the Fed is facing a tightrope feat. They believe they need to reflate to help the U.S. economy but cannot allow the huge number of foreign holders to sniff a surge in inflation. It will take historic dexterity and balance. And, we believe it will take better communications. The markets must not mistake the Fed's direction. The stakes are too high. That point was made strongly in the recent Bernanke speech.

Foreign holders (institutions) other than central banks have other motivations. Rates are low around the globe. In Germany rates are the lowest they have been since Bismark was Chancellor. That was a century ago.
Not everyone is a fan of low rates. Think about senior citizens. They have already made most of the purchases they might have to borrow for. They look to their lifelong savings and perhaps the proceeds of a house to provide them income. Low rates offer no benefit. This problem for seniors is also a global problem at least among the "developed nations".

With roaring stock markets mostly a memory, low rates are a problem for pensions, also. How can you "catch up" with rates so low? This is a major problem as the globe divides into "the old world" and "the new world." We are not talking about geography but rather about population and aging. Here is how the Economist assessed this topic of aging populations in a recent edition:

" Fertility rates across Europe are now so low that the continent's population is likely to drop markedly over the next 50 years. The UN, whose past population predictions have been fairly accurate, predicts that the world's population will increase from just over 6 billion in 2000 to 8.9 billion by 2050. During the same period, however, the population of the 27 countries that should be members of the EU by 2007 is predicted to fall by 6%, from 482m to 454m. For countries with particularly low fertility rates, the decline is dramatic. By 2050 the number of Italians may have fallen from 57.5m in 2000 to around 45m; Spain's population may drop from 40m to 37m. Germany, which currently has a population of around 80m, could find itself with just 25m inhabitants by the end of this century, according to recent projections by Deutsche Bank....."

" Combine a shrinking population with rising life expectancy and the economic and political consequences are alarming. In Europe there are currently 35 people pensionable age for every 100 people of working age. By 2050, on present demographic trends, there will be 75 pensioners for every 100 workers; in Spain and Italy the ratio of pensioners to workers is projected to be one-to-one. Since pensions in Germany, France and Italy are paid out of current tax revenue, the obvious implication is that taxes will have to soar to fund the pretty generous pensions that Europeans have got used to. The cost is already stretching government finances. Deutsche Bank calculates that average earners in Germany are already paying around 29% of their wages into the state pension pot, while the figure in Italy is close to 33%."

Japan is in the same shape. It is tough to make your economy grow when your population is stable or even shrinking, as they grow older and older. Where will the new family formations come from? A new family needs a new fridge, a new TV, etc. Static families only buy to replace what has worn out. Demand slows, then shrinks.
There are even terror-related issues that underlay the economics. In July of 2001, when the Twin Towers still stood, the CIA wrote the following: "Dramatic population declines have created power vacuums that new ethnic groups exploit. Differential population growth rates between neighbors have historically altered conventional balances of power....Our allies in the industrialized world will face an unprecedented challenge of aging.

Both Europe and Japan stand to lose global power and influence...." "The failure to adequately integrate large youth populations in the Middle East and Sub-Saharan Africa is likely to perpetuate the cycle of political instability, ethic wars, revolutions and anti-regime activities that already affect many of these countries. Unemployed youth provide exceptional fodder for radical movements and terrorist organization, particularly in the Middle East."

These factors, aging and large dollar holdings have enormous economic and societal implications.
John Mauldin