US dollar hegemony

As World War II was coming to an end, 44 Allied nations met in July 1944 in New Hampshire, the US, to design a new set of  rules that would govern the post-war international monetary order.

1994:  Bretton Woods Conference

In 1944, the US dollar officially became the world's reserve currency.  The Bretton Woods Conference pegged all other currencies against the US dollar.  To ensure confidence in the system, the US dollar itself was convertible to gold at a fixed rate of US$35 an ounce.  The US at that time, held some three-quarters of the world's official gold reserves.

The system worked well enough in the initial years, on the back of robust demand for US goods and services from Europe and Japan for their post-war rebuilding efforts.

1960s:  Balance of payments crisis emerged

It started to fray  going into the 1960s, when European and Japanese exports became more competitive and the US share of world output declined.  Huge military spending during the Vietnam War further pushed the US into persistent deficits.  Demands for the US to balance its budget were ignored.

A balance of payments crisis emerged.  Official US dollar liabilities held overseas mounted, exceeding its gold stock multifold - the US dollar was overvalued.  By the second half of the 1960s, European nations demanded gold for their US dollar holdings, creating a run on US gold reserves.

1971:  End of Bretton Woods and end of gold convertibility

With rising inflation, unemployment, a weakening US dollar and the risk of running down all of its gold reserves, President Richard Nixon ended gold convertibility on Aug 15, 1971.  This also, effectively ended the Bretton Woods system.  He imposed a wage and price freeze to control inflation and levied import tariffs to boost US production and jobs.  The US dollar crashed and the world "stagflation" was coined.

The international monetary system transitioned from a gold standard to one based on pure fiat money, backed not by any underlying assets with intrinsic value but by faith in the US government.  It was due in  no small part, to the rise of "petrodollar" in the 1970s.

1974:  Rise of Petrodollar - "oil for dollars"

In 1974, Saudi Arabia made a deal with the Nixon administration that includes the condition that all its oil exports would be traded exclusively in US dollars.  This "oil for dollars" was later embraced by other by other members of the OPEC.  Given oil's critical importance in every economy, this all but cemented the US dollar's position as the pre-eminent medium of exchange as well as store of value.  The recycling of petrodollars into US dollar-denominated assets, including Treasury bonds, further anchored its reserve currency status.  

Over time, US dollar dominance extended to the entire commodities complex and the rest of the world.  Today, central banks typically hold about two-thirds of their foreign reserves in US dollar assets.

US enjoys an "exorbitant privilege".

US dollar as a world reserve currency allows US to enjoy an "exorbitant privilege".  

The insatiable demand for US dollar allowed the US to sustain the world's largest current account deficit, with no negative consequences.  The US is able to finance ever-growing fiscal spending with cheap borrowings - to keep building on its military superpower status, fortify its unparalleled influence in economics, finance and technology, pursue expansive social programs, support American consumerism and elevate living standards for its population, all the time compounding the positive feedback loop.  

Many believe that the US dollar hegemony has driven American foreign policy over the years.  This US exceptionalism was paid for largely by the rest of the world.  Its dominance is a legacy of the Bretton Woods system, which it created nearly eight decades ago.  Will this remain the case 20 years from now?

Reference:  Tong's Portfolio 2  Its all a matter of trust

Relative and Absolute Price Earnings Ratio

Relative PE ratio

Relative PE ratio moves up because people expect either the industry or the company's prospects to be better relative to other securities than they have been than their preceding view and that can turn out to be justified or otherwise.

Absolute PE ratio

Absolute PE ratio moves up in respect to the earning power or the perspective earning power of that is viewed by the investing public of the future returns on equity and also in response to changes in interest rates.

Warren Buffett

Bacteria and Bricklayers

Bacteria and Bricklayers

Bacteria

In bacteria populations, growth is fixed. Subject to the resource constraints of the environment they inhabit, bacteria grow at a constant rate indefinitely.

A simple example to illustrate the point:

Let's say we have some bacteria that reproduce on a fixed time schedule, one doubling per minute to keep the numbers simple.

We start with a single bacteria cell. After one minute, we'll have two bacteria. With time, the population grows as such:

• 1
• 2
• 4
• 8
• 16
• ...

Now we ask the question, how fast does our bacteria population grow (in percentage terms)?

The minute-over-minute growth rate is:  1 or 100%.

This is an example of perfectly compounding growth, also referred to as exponential or geometric growth.

Put simply, how fast the bacteria grow is entirely independent of population size. In other words, growth and scale are perfectly uncorrelated.

Importantly, most things do not work this way.

Layering on

Let's look at another example - constructing a brick wall.

Assume a bricklayer can lay 10 bricks per hour. The brick count will proceed as follows

• 0
• 10
• 20
• 30
• 40
• ...

The brick count grows by 10 bricks per hour.

Going through the same growth rate calculations from above:  initially we are growing the brick count quite fast - 100% in fact. But by the time we reach 30 bricks, our forward-looking growth rate has fallen to 33%. At 100 bricks, we'll only be growing 10%.

Notice that the growth rate depends on how many bricks we've already laid. This is linear or arithmetic growth. Because the number of bricks laid each hour is static through time, growth (in percentage terms) necessarily slows down. Scale is in the denominator. Therefore, growth and scale are negatively correlated: more scale -> less growth.

Trade tariffs

Lessons from the past

In 1930, the USA enacted the Smoot-Hawley tariff, which raised tariffs on imported goods to record levels.  These tariffs reduced demand for foreign goods.  Foreign countries retaliated by imposing their own tariffs.  The result was a collapse in world trade that worsened the effects of the Depression.  It took decades to rebuild the world economy.

The costs of tariffs

Why politicians continue to impose policies that are likely to damage the overall economy, even though the costs are widely known?

A small number of large domestic producers and their workers - suffer a visible impact from cheap imports.  They are 'protected and saved'.

However, the potentially larger number of consumers who have to pay higher prices because of tariffs, and those workers in affiliated industries who might lose their jobs through knock-on impacts, are dispersed around the economy.

Examples of effects of tariffs:

• US tariffs on Chinese car tyres in 2009

 In 2009, China accused the USA of "rampant protectionism", for imposing heavy tariffs (taxes) on imported Chinese car tyres.  The decision to increase tariffs came after pressure from US workers who had seen tyre imports grow from 14 to 46 million from 2004 - 08, reducing US tyre output, causing factory closure and creating unemployment.  

However, the USA had previously accused China of unfairly subsidising its own tyre industry, so tensions mounted.  China's response was to threaten retaliatory increases in import taxes on US cars and poultry. 

Tariffs produce effects that ripple through economies.  Any protection gained for US tyre producers from  the tariffs on tyres, for example was counteracted by other negative impacts.  Higher tyre prices increased the costs of US cars, making them less competitive and reducing the numbers bought by US consumers.  The retaliation by China also damaged US export industries.  The jobs of some US tyre workers may have been saved, but in the wider economy, many more jobs were lost.

• India removed tariffs on cheap Indonesian palm oil imports

When the government of India removed tariffs on imports of cheap palm oil from Indonesia, it had the positive effect of raising the living standards of hundreds of millions of Indians, but it destroyed the livelihoods of 1,000,000 farmers who grew peanuts for oil, which was now passed over for palm oil.  The peanut farmers cannot simply transfer into the production of other goods, because their investment in capital is immobile - a machine that processes peanuts has no other use.  

The future of globalization

Today, markets are more integrated than ever as transport costs have continued to fall and most tariffs have been scrapped altogether.  

One vision of the future of globalization involves the elimination of other kind of barriers to trade caused by institutional differences between countries.  Markets are embedded in institutions - in property rights, legal systems and regulatory regimes.  Differences in institutions between countries create trading costs in the same way that tariffs or distance do.  

Despite the removal of tariffs the world is far from being a single market.  Borders still matter because of these kinds of institutional incompatibilities.  Complete integration requires the ironing out of legal and regulatory differences to create a single institutional space.