The Daily Reckoning PRESENTS
Should we care that China has revalued its currency, the yuan, by approximately 2.1%? And if we should care, in what fashion? Justice Litle explores...

"Global inflation, interest rates, bond yields, house prices, wages, profits and commodity prices are now being increasingly driven by decisions in China. This could be the most profound economic change in the world for at least half a century." - The Economist

"There is great disorder under heaven...the situation is excellent." - Mao Zedong

Is it the tip of the iceberg, or merely a tempest in a teacup? Should we be pleased and relieved by Beijing's move - as Washington so clearly seemed to be on hearing the news - or should we be worried, fearing what may come next?

Concern is warranted, but there is little point in worrying. The purpose of worry, after all, is to spur some sort of productive action. Global currency movements are complex, but the action to take in response to the yuan revaluation is simple: If you haven't done so already, buy gold. Not as a knee-jerk response to a single announcement, of course, but as a calculated and farsighted response to what is coming.

China's revaluation of the yuan is the equivalent of a hairline fracture in the Hoover Dam. On first glance it appears, to be nothing serious... and yet it is the beginning of something deadly serious. Over time, the hairline fracture will grow. A network of cracks will spread. And the dam itself will eventually burst. We don't know when the climax will occur, but we do know the endgame has begun.

But why worry, the perma-bulls say. After all, the consumer is getting along famously, the dollar is still the world's reserve currency and Asian exporters have no better place to stash their cash than Treasury bonds.

Before answering the perma-bulls directly, it's helpful to recall the natural human tendency of projecting trends out to infinity. For a combination of psychological and empirical reasons, it's the easy thing to do. Thus, real estate investors currently expect house prices to rise for the next decade - and by "decade," they really mean "as far into the future as we can imagine." Just as '90s investors expected dot-com stocks to rise ad infinitum, '80s investors had Japan, '70s investors had inflation, '60s investors had the Nifty Fifty, and so on. The pattern of extrapolation excess appears consistent, going as far back as market history records. Good or bad, if a trend dominates the period for long enough, it is eventually assumed to have no end. Whether the masses believe in infinite trends or not, they often act as if they do.

This is an odd thing, because market history so clearly teaches the opposite. With very few exceptions, even the longest trends tend to end, often abruptly. Bull and bear markets have life spans, just like people. As do empires.

In May of 1925, Chancellor of the Exchequer Winston Churchill made these closing remarks to Parliament: "If the English pound is not to be the standard everyone knows and can trust...the business not only of the British Empire but of Europe as well might have to be transacted in dollars instead of pound sterling. I think that would be a great misfortune."

Prophetic words. Why did the pound sterling give way to the dollar, and the British Empire to the United States? There are two ways to answer the question.

The first way is to look at 20th-century specifics. World War I devastated Europe and spurred a massive wealth transfer to the United States, with the same dynamics roughly repeated in World War II. Meanwhile, the United States drew strength from a massive influx of immigrants, the rise of industrialization on a grand scale and a powerful advantage in natural resources - with a brilliantly conceived political system and a unifying ideology to hold it all together.

The second way to consider Britain's fall and America's rise is within the sweeping context of history. Simply put, the sun was bound to set on the British Empire at some point, for reasons that were bound to come about. Change eventually dislodges incumbents; it was only a matter of time before the order of things shifted. In the same light, predicting an eventual sunset for United States hegemony is not necessarily pessimistic or controversial. The inevitability of change is an idea rooted in long-term historical observation, not moral pronouncement or value judgment.

For all the talk of China's rise, it is not a given that one superpower will simply be replaced by another, either. It may be that multiple countries come to share the 21st-century world stage, with none gaining a clear and permanent advantage. No one knows exactly how things will unfold. We can say with certainty, though, that the old order of things is passing. Globalization is remaking the world in ways that few expected - and in many ways, these changes are the results of success, not failure. The creation of 2 billion new capitalists (in China and India) is an incredibly positive development in the long run. But in the short run, massive change creates turmoil and upheaval - and the more it is resisted, the more chaos is created in the transition.

This is where the role of gold comes in. But first, a bit of history.

Joseph Schumpeter, of "creative destruction" fame, noted, "Economic progress, in capitalist society, means turmoil." Looking back at the economic and monetary history of the world, or even just the considerably shorter history of the United States, we can see that Schumpeter's observation is all too true. Historically, long periods of peaceful expansion have been the exception, and turmoil and upheaval more the rule.

Financial crises are far more common than many might expect, and the basic workings of international finance are far older than many might realize. The technology has changed, but it's the same old game - like toddlers learning to walk, countries and capital markets mature through a series of blunders, bruises and mistakes. For example: in the 19th century, the United States Treasury nearly went broke multiple times. The fledgling superpower was bailed out more than once by bad weather in Europe, allowing U.S. farmers to export their bumper crops in exchange for precious gold reserves.

The 1860s introduced the joys of fiat money, with inflation eroding the value of the greenback more than 60% by the Civil War's end. In 1890, an emerging market disaster unfolded in Argentina, threatening to bring down Barings Bank, cripple the Bank of England and bankrupt America for good measure (the Yanks pulled through, but it was a close call). The crisis had all the elements we are so familiar with today: speculative boom, hot money withdrawal, international bailout, global backlash. Ironically, the principal players involved - Barings Bank and Argentina - saw fit to revisit their crisis roles a century later (Barings brought down by Nick Leeson in 1995, Argentina by sovereign debt default in 2001). J.P. Morgan was the Alan Greenspan, George Soros and Robert Rubin of his day - probably with more influence than all three men rolled into one.

As for calculated currency movements and mercantilist foreign exchange policies, Europe had been playing the game for centuries by the time the 20th century rolled around. The difference today? Scores are kept with electronic blips on computer screens, rather than gold and silver reserves. And yet, just in case, the gold reserves remain.

In terms of monetary policy, the last century was a gigantic, ongoing experiment (which still continues today). Before and after World War I, belief in the gold standard reigned supreme. Peter Bernstein captures the mood in his excellent (though somewhat critical) book The Power of Gold:

"The international gold standard shimmers from the past like the memory of a lost paradise, embodying all the nostalgia of the Victorian and Edwardian eras - stability, harmony, respectability. The glow attached to this nostalgia is not based in myth but stems from vivid reality. From the end of the American Civil War to the outbreak of World War I - a brief period of only 50 years - the international gold standard acquired a mystique that radiated far beyond the simple discipline that it imposed on its members. The control of gold over the affairs of human beings has never been so absolute, nor the worship of gold by hardheaded financiers and statesmen so humble."

It was only with the onset of the Great Depression that the standard-bearers wavered as the ideas of John Maynard Keynes gained traction and persistent hoarding caused gold to lose its glitter. Keynes argued that the traditional gold standard policies of austerity and fiscal rigidity had only made the Depression worse. While political leaders preached of belt tightening and sacrifice for the sake of sound money, Keynes took the opposite tack, urging the government and the people to forget about gold and open their wallets. His "paradox of thrift" explained how actions that are rational for the individual can yet prove devastating to the economy: It is good for families to save rather than spend, but if all families cut back their spending at once, the economy is worse off:

"Suppose we were to stop spending our incomes altogether and were to save the lot. Why, everyone would be out of work... Therefore, oh patriotic housewives, sally out tomorrow into the streets and go to the wonderful sales which are everywhere advertised. You will do yourselves good - for never were things so cheap...And have the added joy that you are increasing employment..."

What government must do, Keynes further argued, was to act as a counterweight to the business cycle, spending money when times were hard and saving money when times were good. Spending money in hard times, of course, requires running persistent deficits, potentially substantial ones. Such an idea was considered sacrilege at the time.

More than 15,000 banks (!) failed in the four years following the '29 crash (with the Federal Reserve nowhere in sight). An environment like this naturally encouraged more hoarding of the yellow metal, with seemingly no safe place to put the last of one's money. Into the breech stepped the recently elected President Roosevelt. Public surrender of all gold and silver was required, in exchange for paper notes, as declared by the Emergency Banking Act of 1933. (It is hard, if not impossible, to imagine such a brazen act being pulled off today.) FDR then took the apostasy further by declaring the right to adjust the dollar/ gold ratio as he saw fit, prompting at least one fiscal observer to declare "the end of Western civilization."

But Western civilization kept plugging along, and after a managed creep upward, the price of gold was fixed at $35 per ounce in 1934. There it stayed for almost four decades, through the Second World War, the establishment of Bretton Woods, the challenge of De Gaulle and the rise of Keynesian policy. Indeed, around the time Nixon finally shut the gold window in 1971, he uttered frighteningly appropriate words: "We are all Keynesians now."

Regards,

Justice Litle
for The Daily Reckoning

© 2005 Justice Litle, Outstanding Investments
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Justice Litle is an editor of Outstanding Investments. He has worked with soybean farmers, cattle ranchers, energy consultants, currency hedgers, scrap metal dealers and everything in between, including multiple hedge funds. Mr. Litle also acted as head trader for a private equity partnership, and made contributions to Trend Following: How Great Traders Make Millions in Up or Down Markets, a popular trading book by Mike Covel (FT/Prentice Hall)

Justice Litle is also a member of an elite group that meets occasionally to debate and discuss the new trends in the financial world and investment ideas - among other things. This monthly gathering includes the cream of the crop of financial minds - and for a limited time, the Agora Financial Reserve is open to the public at a 98% discount. Get your invitation here: The Birth of an Elite Club http://www.agora-inc.com/reports/AFR/WAFRF972 

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