How to Break the Bank

The heads of state of the G-8 economically largest countries must be feeling very good about themselves. Last year they rescued a banking system that was coming apart at the seams; this year, the grey suit drama has been replaced by bread and butter banking. Those banks that survived are going back to basics. The G-8 central banks succeeded.

The heads of state put on their show in Italy last week. But the important players are the backroom bankers who meet before and after the politicians’ event: these are the meetings the financial press does not report. Now that all the secret meetings between the G-8’s boring bankers are over, it’s time to wonder what really caused the near collapse of the world’s banking system in 2008. We all know the cover story: the US sub-prime mortgage fiasco, billions of mortgages had been packaged and sold to bankers all over the world, mortgage loans that American homeowners couldn’t pay back. But, what was the real story? What was the real problem that took the world’s banking system to the brink?

We think the real story is in this 10-year chart:

[sorry - this blog site will not reproduce the chart I included in this article. I hope you can visualize it by reading the text. KN]

This chart measures the US dollar by comparing it to units of a basket of major currencies: the euro, yen, British pound, Swiss franc, and many others, including our Canadian dollar. As you can see, the US dollar peaked in 2001/2002, at 120 units. It went down for six years and finally bottomed in spring of 2008 at 71 units. That’s a 40% devaluation of the US dollar!

Why is this decline the real reason for the world banking crisis of 2008? It’s because the US dollar is the reserve currency of the world. And when the US dollar is devalued by 40%, the world’s banks’ reserves drop by an average of 40%. Yes, it is true that the American sub-prime mortgages contributed to the banking bust, but the real problem began six years earlier, when the US dollar peaked in 2001/2002. The fact that all those now-worthless sub-junk mortgages were also denominated in US dollars added fuel to a fire that was already burning.

Was it the Bush Republicans’ policy that depreciated the US dollar and brought the world’s banking system to the brink? Was it free market currency trading that drove the US dollar down? We may never know. But it is clear that the 2008 G-8 secret meetings produced a stronger US dollar.

Look again at the chart: the US dollar bottomed at a price of 71 currency basket units. Then, in the last half of 2008 it rallied to 88 units, dropped to 78, surged back up to 89 and dropped back down to 79: all this in one year.

It’s not hard to guess what the G-8 back room bankers decided in 2008 – they needed the US dollar to go up. And it did. And the world’s banking system did stabilize. Their plan worked. Can we guess what they might have decided at last week’s G-8 meeting in Italy? Their common goal would have been continued stability in the banking system. American officials would like stability at a low US dollar so as to help US exports in a weak economy. Other nations’ officials would like stability at a higher US dollar so as to help their exports in a weak economy. And, by now, a week after the high profile G-8 meeting, the back-room bankers will have reached a compromise.

We will see what that secret compromise was over the next few months. Will they let the US dollar decline and risk the banking system again? We doubt it. Will the Americans allow a big up surge in the US dollar and pressure their already weak economy? We doubt that too. It seems most likely that they will allow the US dollar to fluctuate in a narrow band of, say 80 units to 90 units.

What does all this mean to the average investor? What effect would stability have on the stock markets and bond markets? Last year the stock market crash ruined many Canadian’s retirement plans. Will a stable US dollar help us make our money back? Will it help us get our jobs back?

I’m afraid not. This is why:

Just as the six-year long devaluation of the US dollar hurt the banks, it helped Canada. No only did the US dollar go down when measured by the basket of currencies, it also went down when measured against a basket of commodities. Another way of saying that is: commodities went UP against the US dollar. The six-year decline in the US dollar was a six-year rise in energy prices, in raw materials prices and in food prices. Rising energy prices worked wonders in Alberta. Rising metals prices worked wonders in northern Canada. Rising grain prices worked wonders in the prairies. It was six years of boom time for Canada and six years of boom time for the Canadian Stock Market. Remember what happened in the last half of 2008 when the US dollar went up? Energy and materials prices went down. The Canadian stock market collapsed. Canadian pension plans lost billions. A strong US dollar doesn’t work for Canada.

If the US dollar stays at the same value it is now, does that mean energy and metals prices will stabilize too? Does it mean the Canadian stock market will stabilize at these levels? Will your RRSP stabilize? Will company pension plans stabilize? Will the price of your home stabilize?

If the world’s economy experiences an outbreak of stability, it will give us all a chance to re-evaluate our lives and get back to basics. Instead of scrambling to buy a bigger house with a bigger mortgage so as to increase our exposure to a red-hot real estate market, perhaps we can find the house that matches our family’s needs. Instead of ploughing more and more money into a red hot stock market in hopes of ballooning our RRSPs, we can choose a more balanced portfolio of more conservative investments. Instead of getting rich in a fast bucks bubble economy, we can focus on bread and butter living. As the world’s banking system stabilizes, we can stabilize too. Back to basics.