John Butler's Contributions

Earlier this month, in a previous report, we discussed how European monetary union (EMU) did not eliminate intra-EMU currency risk but rather transformed it into credit risk. In recent weeks, this credit risk has surged again, with spreads for Greek, Portuguese and Irish bonds soaring relative to benchmark German government bonds, known as Bunds. Why now?

By the late-1990s it became clear to informed observers that the substantial portion of EU countries that had signed the Maastricht Treaty in 1992 were going to proceed with a European monetary union (EMU) as codified in the Treaty, most probably on schedule, in 1999. Previously dismissed as a Franco-German political pipe-dream, there was a growing air of excitement in financial markets as the political winds blew ever stronger in the direction of making EMU a reality.

Back in 2006, while working for a major US investment bank, I was asked by the Chief Global Economist to participate in a small survey to estimate the probability of the US economy facing a currency crisis—that is, one that forces interest rates higher—during the coming two years. Concerned that an eventual bursting of the US credit/housing bubble could lead to the dollar losing its pre-eminent reserve currency status, I placed the probability at some 60%, which was the highest response in the survey.

How do we measure wealth? In some unit of account. Money is meant to function, among other things, as a unit of account, the denominator for any given asset value. But if the purchasing power of a currency is unstable, either due to inflation or deflation, this distorts the way in which real wealth is measured. For example, if your benchmark unit of account is the Zimbabwe dollar, you have made outrageous profits during the past few years almost regardless of your choice of investment.

Recent market developments have attracted substantial attention from those who are anticipating another financial crisis ahead. Credit spreads are widening as liquidity conditions tighten. Equity markets around the globe have corrected meaningfully and the technical picture looks increasingly dangerous. Is this the beginning of the next crisis?

The Great Bailout of the global financial system in 2008-09 may be comprised of many different parts—some of which are still being withheld from the public in whole or in part—and the specific government interventions taken may vary somewhat by country, but in general they all represent various forms of fiscal and monetary stimulus and also state guarantees for certain financial assets and institutions.

Much financial market attention has focused on China of late. Frustrated by China’s apparent unwillingness to allow their currency, the yuan (or renminbi) to appreciate, influential members of the US Senate—most notably Charles Schumer—apparently are once again seriously considering labelling China a “currency manipulator”. If they follow through on this threat, certain punitive US actions on trade relations with China would follow more or less automatically, unless President Obama were to oppose them.

Sir Isaac Newton knew a thing or two about physics. In one example of his genius, he demonstrated that the same force that causes things to fall to earth, gravity, also keeps the planets in motion around the sun. How did he manage that? Well, like all great scientists, he excelled at the scientific method.

Perhaps it is a sign of the times we live in that we feel the need to ask ourselves this question. The answer might appear simple, in that textbook definitions normally list the following three properties of money:

The idea behind this newsletter originated in early 2009, following the spectacular financial market developments of the previous year. Although by end Q1 risky assets had begun to bounce back—a trend that would continue more or less uninterrupted through the year—it was clear that this had been made possible by a number of unprecedented monetary and fiscal policy actions around the globe.