John Taylor: Rushing Toward Smoot-Hawley v.2.0

Rushing Toward Smoot-Hawley v.2.0?
May 20, 2010
By John R. Taylor, Jr.
Chief Investment Officer, FX Concepts

Everyone studying the economic history of the 20th century learns about the Smoot-Hawley tariff and its role in “causing” the Great Depression. Senator Reed Smoot and Representative Willis Hawley and the President, Herbert Hoover, who signed that bill over the protests of 1028 economists and the leaders of American business, will carry the infamy of their decisions for many years to come. Of course, no modern politician would ever dream of passing a similar tariff-raising bill. We are well protected from making this mistake again, but then history never repeats itself. To use another shopworn aphorism, generals – and politicians – are always fighting the last war. Trade is an important factor in today’s world, but a far more important one is financial mobility, capital flows and the freedom to invest in one place and hedge in another. The spectacular global growth that we have all enjoyed since World War II actually began in 1950, with the start of the European Payments Union, an offspring of the Marshall Plan, and the precursor of full currency convertibility in 1958. Moving money from one place to another without restrictions has been a boon to every country that allowed it. The eurodollar market, born out of the dollar deposits that the French bank, Banque Commerciale pour l’Europe du Nord, would not deposit in the US because its Russian Soviet owners feared their dollars would be confiscated there, grew rapidly through the late 1960’s. That Communist bank, widely known as Eurobank, gave birth to this ultimate capitalist tool, the free-wheeling Eurodollar market allowing stateless money to go anywhere, invest in anything, and build economies everywhere.
Even in the 1970’s at Citibank, we measured the growth of the global financial system by the size of the Eurodollar pool. It was obvious, the faster it grew, the faster the economies grew. The eurodollar pool brought global monetarism to life and tied the major economies together. Over time, with floating currencies and free capital movement, the global financial system has become a somewhat selfregulating one, prodded and distorted by countries within it. Our understanding of how this system works is definitely incomplete, but we can forecast what will happen if someone games the system like China does by holding its currency steady while exhibiting high returns on capital. It’s simple: lots of capital goes there and Chinese reserves explode higher. The experience of 2007 and 2008 brought home the critical nature of this pool. The major global banks, the main conduits of this money, had expanded dramatically as they had to with the growing size of the market, making some very bad investments along the way, and then they all got into financial trouble at the same time. They stopped doing their job and the world almost stopped. Global trade collapsed and financial paralysis would have followed if the governments had not stepped in to basically guarantee all the bank flows.

Today, these banks are being widely castigated for their stupidity and cupidity. In both the US and in Europe, legal restrictions on leverage, on off-balance sheet vehicles, and on proprietary trading are widely supported in government circles and by the public. Universal banking is probably on its way out in the US. In Europe the rage against those who foresaw the weakness in Greece and protected themselves or profited has fanned the political desire to curb the movement of capital. Protecting weak credits by banning short selling or restricting offshore investors’ access to the markets will drive capital away. If banks can’t protect themselves against risk, they won’t invest at all. Eliminating SIVs and offbalance sheet vehicles may seem smart, but they are the investors in government debt and private bonds. Who will own this debt? Less leverage and smaller banks, plus restricted hedge funds, mean that the global money supply will drop and global GDP will too. Welcome to Smoot-Hawley v.2.0.

h/t Teddy KGB