James Grant at the TMA Conference

Last week I attended the Turnaround Management Association Conference in Las Vegas. On Thursday, Jim Grant gave an overview of the monetary and fiscal situation facing the United States and the rest of the world. Following is my summary from his presentation. Any errors regarding his views can only be attributed to my poor note taking!

He described the US Dollar as the greatest monetary achievement in the history of the world, as it is an uncollateralized obligation, dependant on Congress and the Federal Reserve (both with their many failures), yet is accepted worldwide. Based on this exalted status of the dollar, Americans have had the luxury of living life on the sweat of someone else’s brow.

US Dollars go from the US to exporters in Asia. Those exporters turn the dollars in to local banks in exchange for local currency. The local banks send the dollars to the central bank, which in turn buys US Treasuries, basically sending the money back to the US to be spent again. He describes that this limitless credit card of American debt is coming to an end.

In his view, QE2 has focused the world’s attention on the true nature of the dollar. I believe he sees this with QE2 and not QE1, as most might see QE1 as necessary to stabilize a crisis. It seems QE2 (and the risk of further QE actions) has made clear to much of the world that the Fed and Congress will use the dollar in ways other than those necessary to provide a stable medium of exchange and store of value.

The most levered financial institution in New York is the Federal Reserve Bank of New York (FRBNY). He described it as having leverage of 80:1, with $15.5 billion of capital. At less than 1.5% default on its assets (or reduction in value), the equity is wiped out. Then what? He asked to consider the impact of a rising interest rate environment on the value of this portfolio.

He noted a new footnote on the Fed’s balance sheet, dated January 5, 2011. The Fed will not transfer earnings to the Treasury if the $15.5 billion equity is impaired. In Mr. Grant’s view this will eliminate the possibility of the Fed ever facing a solvency issue. I believe the Fed transfers all profits to the Treasury annually, resulting in $50 billion or more per year each of the last two years. Such amounts would certainly help offset the Fed’s balance sheet woes, but will only exaggerate further the poor state of US fiscal balance.

The FRBNY is owned by member banks. These banks acquire their interest with 50% cash and 50% pledged as a capital call, on line for solvency issues. He did not say anything more on this, but left unanswered if he felt this would be called before the Fed withheld payments to the Treasury.

In a brief overview of 20th century monetary history and default, he outlined:

1931: Britain renounced their gold standard. The pound went from 1/4 ounce of gold to 1/850 ounce of gold today.

1971: Nixon renounced the gold standard for international redemption. The dollar went from 1/35 ounce of gold to 1/1350 ounce of gold today.

From 1946 – 1981, we saw a bond bear market, with rates rising from about 2% - 3% to well over 15%. But the period from 1946-1956 was relatively benign, only about a 1% change in that time. The acceleration occurred thereafter. Since 1981, we have seen the reverse – a bond bull market, with ever-lower interest rates fueling many asset classes higher.

Are we now in the time of this to reverse? Will we see a similarly benign period of low interest rates followed by another prolonged bond bear market? As to a prolonged period of benign rates, Mr. Grant doesn’t think so. He describes that today, unlike the periods before 1971, the US now has a “weightless dollar,” un-backed by anything. He believes this makes the entire system much less stable. The world’s “faith” will not last that long. He however, does believe that we will see ever-higher interest rates.

He described the economics of the trade in currencies, and the overwhelming size of this market. If I captured it correctly, he states that world trade in currency is approximately $4 trillion per day, while world trade in goods is about $40 billion per day. This trade can change for many and any reasons, and overwhelm the ability of governments and central banks to manage a significant change in perception and reality.

In his view, QE2 changed the game. The manipulation of the dollar is fully exposed for what it is – not to stabilize world financial systems, but solely to benefit the US and, seemingly fund its debt and protect its banks. The Fed is creating ever-growing excess to address the problems caused by previous periods of excess.

Will the dollar system persist? The clear and present danger is complacency on the part of US policy makers. What will cause a change from the dollar being the reserve currency? He does not say, but notes that this change in status is quite possible with significant ramifications for the US.

We may be embarking on a new cycle of rising interest rates and potentially an entirely new monetary system. He did not discuss the ramifications of this, but in the case of rising interest rates, these are significant and reasonably predictable. In the case of a new monetary system, I believe large dislocations arise. For the US and those who have lived from the luxury the world’s reserve currency offers, I believe this will be most dramatic. The luxury of living from the sweat of someone else’s brow will be greatly reduced, if not eliminated.