Monday, December 17, 2007

A Tale of Two Currencies

Today, the world has two principal currencies. One, the Euro, is the officially adopted currency of the 13 countries of the Eurozone, which includes of most of the economic powers of Europe. The other, the U.S. dollar, is the officially adopted currency in six nations (the U.S., Panama, El Salvador, Ecuador, East Timor and certain Pacific islands). It is also officially or not quite officially pegged to certain other currencies, which in effect makes it a de facto currency of the pegging nation (such as China, Hong Kong, Macau, and Saudi Arabia). Although China has officially delinked the yuan from the dollar, it unofficially maintains currency parity, allowing the yuan to drift up ever so slightly from time to time without disrupting its fundamental relationship to the dollar.

We all know that the dollar has been falling and the Euro rising. Hordes of European tourists flood Manhattan, Florida, dude ranches and upscale shopping venues nationwide. Canadians lose their customary restraint whenever they cross the border and approach a mall. Fashion models demand payment in Euros.

Foreign and American investors are allocating more capital to non-dollar denominated investments. The foreign capital that is coming into the U.S. is being used to buy pieces of crown jewels of the American financial system. America continues to attract foreign investment, only at greater cost.

Short to medium term, foreign financial markets will probably provide returns that are as good or better than the U.S. financial markets. Foreign economies are less burdened by the losses emanating from the U.S. mortgage mess, and will probably grow faster. The U.S. economy may or may not fall into a recession, but it will surely slow down and bring corporate profit growth down with it.

But long term, bet on the dollar. Why?

Because the greatest economic potential remains in the dollar zone nations. With Germany, France and Italy at the lead, the Eurozone consists primarily of mature, highly structured economies with substantial social welfare systems. They have short work weeks and generous amounts of vacation time. Innovation and risk-taking are not greatly encouraged. Their cultures are highly developed and continental--meaning they indulge in a condescending cynicism that sometimes makes Americans feel inferior, but ultimately saps Europe of economic vitality.

The two principal nations of the dollar zone are the U.S. and China. Although politically quite different, they are economically almost two parts of the same nation. Numerous U.S. manufacturing and retailing companies rely heavily on Chinese suppliers. The U.S. government's budget deficit is financed to a significant degree by the central bank of China. Low American inflation rates and the flood of inexpensive consumer goods we have today are attributable in large part to America's economic ties to China. China's new found prosperity is heavily dependent on sales to America.

America is a nation of dreamers. Founded by immigrants, its aspirational qualities form the core of American culture. The American dream, and the gosh, golly enthusiasm of American tinkerers and entrepreneurs, continue to be vital.

The Chinese, too, are a nation of dreamers. Traditionally, dynastic China provided young, talented boys--including those from humble families--with the opportunity to advance by taking a series of imperial examinations. Those that were successful were given educational opportunities, and, ultimately, university professorships and high ranking government positions. Thus, the talented and ambitious could advance and confer the benefits of their abilities on the nation as a whole.

The Communist Chinese government, in making its turn toward capitalism, funneled these ambitions toward commercial endeavor. Chinese entrepreneurs responded with vigor, producing the economic juggernaut we see today.

The common tendency of Americans and Chinese to dream, aspire, and indulge ambition is probably one of the main reasons for the economic partnership of the two nations. While many third world nations can provide low cost labor, few peoples try as hard as the Chinese to win and please customers. There have been some stumbles along the way, most recently with some poorly manufactured toys. But Americans and Chinese find that they often work well together. And, given the interconnections between their economies, they have a strong interest in continuing to work together. Whatever it may say, the central bank of China will maintain close parity between the yuan and the dollar.

America is the center of high tech innovation. Nothing happening anywhere else in the world is about to change that. The best computer hardware and software is American. The ubiquitous Internet, an innovation that allows mass, simultaneous communication, could only have been made in the U.S.A. The core of technological knowledge here is an ocean compared to ponds in other nations.

China has become a manufacturing giant. Its engineers are becoming skilled at applied engineering, although they need to derive most of their inspiration from technological advances in other countries. The dollar-based economies of both nations links them together tightly, and they cannot (and would not want to) go their separate ways. Moreover, their aspirational qualities and drive will lead to more innovation and risk taking, qualities that will enhance productivity and economic growth.

In centuries past, nations became wealthy by building empires. The military aggression that required is no longer possible today. The Eurozone nations have tried to become wealthy by lowering trade barriers and currency translation costs. But you can build only so much wealth by cutting expenses. Ultimately, the wealth of nations now comes from technological advancement and risk taking. This is where the dollar zone nations have the distinct advantage.

The nation's and the world's economies, as we are now learning with the mortgage mess and credit crunch, move in cycles. No amount of overly clever financial engineering changes that basic fact. At some points of the cycle, conservative economies like the Eurozone will have the advantage, just as Japan had the advantage in the 1980s. But the long term advantage rests with the dreamers and schemers, the plungers and gamblers, the max-out-your-credit card entrepreneurs. For your long run investments, bet on the dollar.

Crime News: the rising popularity of pink penitentiaries.

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