Editor’s Note: Effective June 5th, the price for new Diff subscriptions will be $20/month or $220/year. Current paying subscribers will not be affected, and will be able to renew at their current rate but future subscribers will pay the new price. So now is, in my somewhat biased opinion a great time to share the wealth. The current monthly price is 25% off June 5th’s sticker price, and the annual price is a 32% discount.
Bretton Woods Revisited
The US dollar has been backed by nothing, gold, silver and gold, nothing again, gold again, and, since 1971, nothing once more. Of course, the “nothing” is a rhetorical flourish: currencies have value if they can be exchanged for goods and services (or for other currencies that can be exchanged for goods and services, etc.). But what’s interesting about the present standard is that it’s oddly close to the US having a gold standard and a monopoly on gold mining.
Which is not necessarily a good thing. Being the only supplier of a good leaves you at the mercy of aggregate demand.
The way the modern system works is that money has network effects, and the US is a large economy with an extraordinarily well-developed financial sector, so any asset is priced in dollars by default. Bilateral trade between non-dollar, non-Euro countries countries is usually done in dollars, so a 1% increase in the value of the dollar leads to a 0.6-0.8% change in trade between all other countries.
This system is the ancestor of the Bretton Woods agreements, an incredibly ambitious effort to rewrite the global monetary system. Bretton Woods' structure was, in brief:
- Dollars are pegged to gold.
- Every other country’s currency is pegged to the dollar.
- Multilateral and bilateral agreements and institutions keep currencies close to their pegs.
This system was incredibly convenient as a way to encourage trade: a German manufacturer who bought French car parts for francs, paid German workers marks to assemble the cars, then shipped them to the US to be sold in dollars, could completely ignore the impact of currency in all these transactions.
But the system was deeply flawed: since dollars paid interest and were backed by gold, everyone in the world wanted dollars. Because of that, the US ran persistent demand-driven current account deficits—for a long, strange period in the 1960s, the US was receiving net inflows of capital from Europe, and using that capital to, among other things, buy out European companies. By 1960, the value of outstanding dollars exceeded the value of American gold backing them, but demand for dollars persisted.
The US didn’t want to back out of the system (dollar flows are addictive, and tight integration with European economies was a Cold War imperative), so there was a long period where patching up the system was a key foreign policy concern. That’s not an exaggeration: JFK said that the current account deficit was one of two things he was afraid of (the other was nuclear war); LBJ said it was one of his two biggest problems (the other was Vietnam). The need to keep other countries using dollars, not converting them into gold, and not devaluing their currencies led to all kinds of odd political permutations:
- Since ground troops were expensive (the current account deficit was very close to the cost of keeping US soldiers deployed in Germany), maintaining the Bretton Woods agreements actually encouraged the US to pursue nuclear deterrence.
- The exchange rate for the Yen was chosen at a somewhat arbitrary value, which turned out to undervalue it. This was fine with Japanese policymakers, since this acted as a subsidy for their export-driven growth model, but it meant that protectionism for US textile workers in the South risked Japanese cooperation with the overall system. Arguably, the South’s flip from solidly Democratic to solidly Republican was at least in part caused by strenuous efforts to keep the dollar strong. (Japan eventually agreed to export restraint, but only in 1972, after the US suspended dollar convertibility into gold.)
- During the Suez Crisis, the US lent Britain money to avert a balance-of-payments problem, on the condition that Britain withdraw troops from Egypt.
- France under de Gaulle threw periodic fits over US defense and foreign policy decisions, and either threatened to convert dollars to gold or actually did so. This gave France a partial veto over US foreign policy, especially in the late 60s.
There were essentially no global macro investors in the 1950s and 60s. There were macro investors, who looked at things like demographics and scrap rates to time the auto cycle. And there were global investors, like John Templeton, who was buying Japanese equities at 2-3x earnings in the mid-60s. Global macro didn’t make sense because national governments and central banks coordinated to keep volatility low. Trends, imbalances, sudden reversals—all of these existed, but they were happening at the Bank of International Settlements, the Banque de France, and the New York Fed, not on trading floors. In fact, while there was no money to be made, the world of global macro was far more entertaining in this period than it is today. Sure, currency crises are interesting, but in 1960 Eisenhower asked his advisors to look into switching the dollar’s backing from gold to uranium. Global macro was serene on the surface, but frantic underneath.
There are odd echoes of this today. Post-crisis, macro funds' returns have been weak. (HFRI has macro returning 23 basis points annualized over the last five years.) There’s been excitement, for sure: the near-collapse of Europe; the rise and slowdown of China; Brexit, Trump, Covid-19. But central banks and policymakers have moved vigorously enough to counteract extreme moves.
In a sense, they’re defending a modern reincarnation of Bretton Woods, where the dollar is backed not by gold but by borrowing, specifically the borrowing of countries and companies that produce tradable goods. It’s not so much that the dollar can buy oil, copper, and iPhones; it’s that companies that own and produce such products are systematically short dollars, and demand dollars to cover their short positions. Because of the peculiarities of corporate taxation, some of America’s most competitive exports—software and pharmaceuticals—aren’t part of the tax base (although the wages of the people who make them certainly are).
This view contrasts with the simpler model that a currency is backed by the fact that income earned in that currency is subject to taxation. In that model, an economic crisis in the US should lead to a lower dollar: fiscal policy is countercyclical by default (in a recession, taxes go down, while welfare spending rises), and the expected net present value of future taxes also declines (every recession increases the variance of tax revenue, and retroactively reveals that some recent economic activity was not as valuable as it looked, so the expected stream of future tax cash flows should be lower and the discount rate higher). In practice, recent recessions have been good for the dollar, because the most salient effect is that demand for dollars rises.
Financial markets exercise a sort of conservation of volatility. Under fixed exchange rates, events that should have changed the value of the dollar had to change the US’s behavior with respect to allies instead. A system of floating exchange rates and capital mobility creates more visibly weird results (like a Russian default indirectly destabilizing Long Term Capital Management, and threatening the entire US financial system, even though LTCM didn’t own any Russian debt—or credit problems in US housing causing funding problems at European banks). But foreign policy connects the world just as much as financial markets. You just can’t pull up the latest quote on Bloomberg.
But all this points to an interesting fact about the dollar: the more a currency is a reserve asset, the less control the issuer has over its value. Under the Bretton Woods system, the US could exercise some agency with respect to the dollar, but generally in response to exogenous threats. Normally, a country would want its currency to depreciate during a recession, in order to subsidize exports and inflate away debts. The US has traded the exorbitant privilege of printing a reserve currency for the duty to have a currency outside its own control.
This system sounds about as unsustainable as the old status quo. Demand for dollars basically forces the US to behave in a way that reduces the ultimate value of those dollars. But unsustainable systems can last a long, long time. If you’d been thinking in macro terms, you might have looked for ways to short the dollar in 1960, when dollars outstanding exceeded the US gold supply backing them. But you would have waited over a decade; inflation eventually picked up, but the proximate cause wasn’t an overvalued dollar; it was deficit spending due to Vietnam and the Great Society.
Britain in the 20s through 40s is another case study in just how durable a currency can be: even though Britain’s economy had peaked in relevance at the start of the twentieth century, and declined steadily since then, the pound was still neck-and-neck with the dollar as a reserve currency until the late 40s. Sterling had high market share because Australia, Canada, and India all defaulted to it. And none of them could afford to defect. The US’s monetary relationship with the Middle East is an echo of this: if they sell a product priced in dollars and have few domestic investment opportunities, they need to save primarily in dollars, and their savings get recycled back to the US, which makes the US financial system bigger and more liquid, improving the dollar’s network effect.
So one view of the financial system is that buying dollars is a bet on China. On the margin, China converts rich-world demand for consumer goods into emerging market demand for raw materials. China’s exports to the US are priced in dollars, and their imports tend to be, too, so China drove higher dollar demand even independent of their accumulation of reserves from 2000-2014.
There are three scenarios that count for China:
- Dominance: as China grows, it convinces more countries to settle trade in RMB instead of USD, and chips away at the dollar.
- A steady state: China remains a large economic player, but doesn’t try to reach global hegemony.
But interestingly enough, every one of these scenarios has a mostly dollar-positive outcome: generally, countries with an invest-and-export model are very reluctant to let other countries get involved in their currency, since they give up control over important policy levers. In the steady state, China keeps doing what it already does: buying dollar-denominated materials, selling dollar-denominated products, and further dollarizing global trade. And a collapse would be a macro shock—of the sort that makes every borrower panic and scramble for dollars.
The Bretton Woods agreements set up a system where the dollar was guaranteed to collapse. Gradually, then suddenly. In the current system, the dollar can teeter pretty much indefinitely. It looks strange from the outside, and it’s historically strange, too, but the different weird elements roughly cancel out.
This writeup is mostly the result of a deep dive into Bretton Woods and monetary history.The Bretton Woods Agreements is a great overview.How Global Currencies Work is great for historical information, especially about Sterling (in the early twentieth century) and the Yen, Euro, and RMB more recently. AndDollars, Gold, and Power is a phenomenal look at how dollar convertibility played into Cold War politics.
Facebook has acquired gif search engine Giphy for $400m. The best first-order explanation is that it’s a way to track usage of competing apps. As it turns out, the product is designed to make this doable:
When embedded into third-party apps, Giphy can track each keystroke that’s searched using Giphy tools. Developers who install Giphy tools into their apps are required to give the service access to the device’s tracking ID. Such access allows Giphy (and now, Facebook) to better match the identity of a user across the apps they use on their phone.
Facebook has a history of getting exceptional competitive intelligence and using it to make strategic acquisitions and launch clones. With their data, they can buy based on expected viral coefficient and long-term user growth rather than more nebulous assumptions (as a consequence, any early-stage consumer app investment is either in a company that rejected an FB offer or a company that FB rejected).
Another interesting possibility is that Facebook is testing the waters for a larger deal. $400m is an expensive way to do that, but spending 7bps of market cap to see whether or not acquisitions get regulatory/PR approval is cheap if Facebook is planning a bigger one soon.
(In an interview, Giphy investor John Borthwick says the negotiations started in late March.)
Africa and Covid-19
Several pieces recently (The New Yorker, The Economist) have noted that Covid-19 appears to be spreading more slowly in Africa, and that this is probably not just due to lower testing. Several African countries shut down travel early in the epidemic, and quickly rolled out other responses. That’s especially interesting if Africa starts to receive more foreign direct investment as companies diversify supply chains.
Africa is infrastructure-constrained: there are some ports but few roads, and trade between African countries is difficult. I wrote a few months ago about the many natural investors in African infrastructure, especially power and ports. The next few years will be an interesting test of whether or not this was wise.
A few days after the US announced a new TSMC-owned fab in Arizona, Chinese state-backed funds invested $2.2bn in a Chinese fab. Autarky in a high capital cost, high-margin business is very good news for capital equipment manufacturers, who may be even harder to catch up to than the fab companies themselves. If the US and China are both building their own copies of a global supply chain, everything needs to get rebuilt—twice.
(Given China’s struggles with domestic chip fabrication over the last two decades, I’m not especially optimistic that this plan will succeed. But even failure has a large budget.)
Italy Doesn’t Plan to Miss Tourist Season
Italy intends to reopen their border on June 3rd, in what they describe as a “calculated risk.” I’m not optimistic that the constraint on inbound visitation to Italy is quarantines, rather than caseload. Ryanair, for example, plans to operate at 1% of capacity through the end of June, and 40% through the end of September. The aggressive timing indicates that Italy is thinking about the summer tourism risk I wrote up two weeks ago.
The sample size for second-wave infections is limited at present, but in countries where there’s been another wave (most notably Singapore and South Korea), the government’s response has been a swift reimplementation of lockdowns.
The Economist suggests “travel bubbles,” groups of similar countries that can open their borders to one another while still quarantining new arrivals from elsewhere.
One conception of the “nation state” is that the transaction costs for having a group of people under the same set of laws is lower when they all have the same norms. When most relationships are local, language and social beliefs are the main centers of gravity. But in a globalized world, you can have different nation-style groupings for different kinds of activities. The EU is not the Eurozone; free trade agreements, currency zones, and military alliances overlap imperfectly. Since Covid-19 creates a new tail risk from travel and immigration, it makes sense that countries could group together, both based on common levels of risk and common levels of risk-tolerance.