It's the End of the World As We Know It

Marcellus: Something is rotten in the state of Denmark.
--William Shakespeare, Hamlet Act 1, scene 4

In the 1950s, Leon Festinger and two others infiltrated a UFO doomsday cult that was expecting the imminent end of the world on a certain date, and documented the increased proselytization they exhibited after the leader’s “end of the world” prophecy failed to come true. The prediction of the Earth's destruction, supposedly sent by aliens to the leader of the group, became a disconfirmed expectancy that caused dissonance between the cognitions, “the world is going to end” and “the world did not end”. Although some members abandoned the group when the prophecy failed, most of the members lessened their dissonance by accepting a new belief—that the planet was spared because of the faith of the group.

The economic crisis of the last two years provides a haunting corollary to Festinger’s study. In an interview on CSPAN on January 27, 2009, House Representative Paul Kanjorski defended the original emergency actions by the United States government to halt the financial crisis. Kanjorski stated that the move to raise the guarantee money funds up to $250,000 was an emergency measure to stave off a massive “electronic run” on money markets that removed $550 billion from the system in a matter of hours on the morning of September 18, 2008. He further asserted that, if not stopped, the run would not only have caused the American economy to crash immediately, within 24 hours it would have brought down the world economy as well.



As the “end of the world” did not come to pass, there are those who question Kanjorski’s account such as Felix Salmon of Condé Nast Portfolio; although financial writer Daniel Gross confirmed some elements of the story, but prefaced his remarks by saying “I don’t know if his numbers are 100 percent correct”. Such criticism raises the question of how we prejudice “fact” from “truthiness” in the so-called "soft science" of economics, which in turn leads to questions about the assumptions underlying economic models. Joseph Stiglitz, the Nobel Prize-winning economist and Columbia University professor, stated that economists are among those at fault for the financial crisis, which exposed “major flaws” in prevailing ideas. The now-flawed premises include the ideas that economic participants behave rationally and that financial markets are competitive and efficient. In a damning remark, Stiglitz claimed that “Globalization had opened up a global marketplace for fools.”

What the world economy now faces is cognitive dissonance on a global basis. The conundrum with respect to cognitive bias is that implicit in the concept is the standard of comparison. In other words, peel the onion and we’re left with the unsettling question as to which denomination do we use to value assets. Relativity, it seems, goes to the very heart of the inflation versus deflation debate. Are investors making rational decisions as a result of the currency in which they form their perspective of valuation? In a world in which the US dollar is no longer the world’s reserve currency, what substitutes as safehaven in a “flight to quality”?

The question of how banks manage their collateral deals with other financial players is usually not of interest to ordinary investors. Until recently, the widely held assumption that the credit standing of European countries and the US was secure resulted in banks not demanding collateral when sovereign entities are involved. Similarly, when banks made loans to western sovereign nations, they typically do not post big reserves since such debt is deemed “zero-risk weighted” in bank regulatory rules. However, as a result of seemingly remote events, or “tail risks” having come to fruition these past two years, debt default in a developed country is no longer unthinkable. In fact, once upon a time even the US repudiated its debt in 1933 by outlawing the private ownership of gold, and requiring creditors to be paid in “legal tender coin or currency”.

The Triffin dilemma is the fundamental problem of the US dollar's role as the world’s reserve currency leading to a tension between national monetary policy and global monetary policy. This is reflected in fundamental imbalances in the balance of payments, particularly in the US current account. According to Martin Wolf, chief economics commentator of the Financial Times, the host nation of a global reserve currency will inevitably run up a huge current account deficit that undermines the credibility of its currency and adversely impact the global economy. As it stands, the US currently has a national debt in excess of $12 trillion or almost $40,000 per citizen, with a debt to GDP ratio of more than 85 percent. “On the dollar, there is nothing to support this currency except the Chinese government and a few other governments that are prepared to buy it,” said Wolf at an event organized by the Singapore Institute of International Affairs.

More so, the perverse vendor-financing relationship between the Chinese renminbi and US dollar is highly destabilizing for the euro zone economy. The European Commission recently warned that public finances in half of the 16 euro-zone nations are at high risk of becoming unsustainable. Because there is little chance of European governments intervening in the foreign exchange markets to improve the competitiveness of the euro, American policy is effectively “shifting the recession from them(selves) to their trading partners,” according to Wolf. The decline of the US dollar underscores a phase of global power transition, with the balance of power moving from the US to Europe, China and India, Wolf argues, adding that the greenback’s loss of credibility as the dominant global reserve currency is part of this messy transition.

It is with this context in mind that one can begin to analyze the cognitive dissonance arising from the fundamental problem that the US cannot resolve this credit crisis by issuing more debt. Yet with the White House announcing that it had eliminated the maximum bailout cap for Fannie Mae and Freddie Mac on Christmas Eve, it seems that US policy-makers are finding yet another way to extend the process of quantitative easing. Such rule changes are the “tip of the spear” in a whole range of unprecedented policy actions which have hugely grown the monetary base in the hope that such action will “reflate” the economy. One likes to think that the US is a government-of-laws-not-men presiding over a level playing field, but in an effort to “save us from ourselves” it now seems that the US is constantly changing the rules anytime it wants. Unfortunately, such actions can only have the detrimental effect of undermining the moral standing of the US dollar long term. As the song says, “it’s the end of the world as we know, but I feel fine”.

- Mack Frankfurter, Managing Director