A tale of two currencies

Mar 31, 2016·Alasdair Macleod

There is a widespread and growing feeling that financial markets are slipping towards another crisis of some sort.

In this article I argue that we are in the eye of a financial storm, that it will blow again from the direction of the advanced economies, and that this time it will uproot the purchasing power of major currencies.

The problems we face have been created by the major central banks. I shall assume, for the purpose of this article, that a second financial and monetary crisis will not have its origin in the collapse of China's credit bubble, nor that Japan's situation destabilises. These are additional risks, the first of which in particular is widely expected, but are subject to the control of a command economy. They obscure problems closer to home. Instead I shall concentrate on two old-school economies, that of the US and the Eurozone, where I believe the real dangers lie.

While the Fed has made some progress in making US banks reduce their balance sheet leverage, the Eurozone's banking ratios have remained stubbornly high. Of course, new regulations have been introduced, but banks still game the system, and monetary policy has continued to blow financial bubbles. The message to large bank depositors, typically those with more than the insured $250,000 or €100,000 at risk, is that little has changed for the better.

All central banks in the advanced economies have tried to make their banking systems water-tight since Lehman, instead of addressing the underlying issues. After the banking crisis of 2007-08, the G-20 commissioned the Financial Stability Board to come up with recommendations to help prevent governments from picking up the tab on future banking failures. The terms of reference simply omitted to address the underlying issues. The result was agreement on bail-ins to deal with future insolvencies, and all G-20 member states undertook to introduce legislation to permit their central banks to override the normal creditor pecking-order in a bank failure.

Bail-ins put big deposits at greater risk than bail-outs, because they are swapped for equity that is usually worthless, instead of having a central bank guarantee behind them. However, in a future systemic crisis, bail-outs are still more likely than bail-ins, because the priority for the authorities will always be to keep money functioning as normally as possible. Whichever way this issue is dealt with, the larger depositors are bound to be considerably more sensitive to losses in the run-up to a banking crisis today than they were in the wake of the last crisis, because of the bail-in question. And there is always the fact that no two crises are the same, so the Fed's rescue plan, which saved the world the first time, might not work so well the second time.

An obvious variance from 2007 is that the bubbles today are different, and they are also far larger. But the authorities are still fighting the last financial war. For example, the UK Government is currently obsessed with preventing another property boom, and is discouraging investment in buy-to-let residential property. Part of the stress-testing on mortgage lending is to establish affordability of a 5½% interest rate. It may well be a bubble in the making, but there is no attempt to restrict credit supply for all the other asset classes. No one seems to have thought through the consequences of how an interest rate rise of that magnitude would affect them and the banking system itself.

On the contrary, monetary policy is specifically designed to inflate financial assets, under the guise of promoting economic activity. Stimulating the economy has demonstrably failed in all advanced economies, so instead monetary policy is now solely about keeping the current crop of bubbles from deflating, such as government bonds, equity markets and the lending of cheap credit for over-indebted businesses and individuals. And that is why, with no economic benefit in prospect, monetary policy has become very frightening.

Monetary policy is dragging us into a second credit-induced global crisis. During the first one, there was an initial flight into money, or an increased preference for holding it relative to buying goods. Prices fell, in some cases dramatically. The motor industry, so important to a wide range of component suppliers and service industries, was supported by cash-for-clunkers in the US, and similar schemes in Germany and Britain. Prices generally were also supported by the inflationary actions of the Fed and the Bank of England, which flooded their respective economies with money as part of their plan to save the banks. It worked, prices recovered and stability returned. The gold price fell and then rose strongly, tracking the rise and then the fall in the dollar's purchasing power.

A second credit crisis is unlikely to play out in the same way. The most important difference is that among large depositors, preferences in favour of money over goods have already increased substantially. Total checking accounts and savings deposits were $4,464.5bn at end-2007, and today they are $9,973.4bn, an increase of 123%. The private sector is already awash with money, so we must question any crisis response that depends on yet more money being issued.

At a time of subdued price inflation, the unprecedented increase in bank deposits since the last crisis suggests that the non-financial private sector has already increased its preference for holding money relative to spending it, to unprecedented peace-time levels. The absorption of extra money through changing preferences is the reason the purchasing power of the dollar has so far remained relatively stable, at a time when the quantity of money in circulation has increased so dramatically. This is an important point to grasp, because it only takes a marginal shift in overall money-to-goods preferences to dramatically alter the general price level.

In the event of a second crisis, the Fed can be expected to use the same monetary tools that succeeded last time. The expansion of raw money in favour of the banks through quantitative easing worked well from the Fed's point of view, without generating price inflation. It becomes a precedent for future action, instead of an inflationary concern. Only this time, with the private sector already overstocked with money, the public's reaction will most likely not be to further increase checking and deposit account balances. But what do they do with this additional excess of money?

They buy other things, and pass the money-headache to someone else. Tangible assets, such as precious metals and commodities, will be sought by foreigners and Americans alike, to the extent they don't switch bank deposits into other currencies. But if the dollar, as the reserve currency is losing purchasing power, there will be no hiding place in other fiat currencies either. The only way exposure to bank accounts can be reduced on a net basis is to pay down debt. And with the currency's purchasing power falling, that will not make much sense to debtors, when they realise what is happening to money's purchasing power.

Under these circumstances, reducing excess liquidity becomes a game of pass the money-parcel. There will be some contraction of outstanding bank credit, particularly in the early stages of the crisis. It will be evidenced in falling, or stagnating, GDP numbers. But once a tipping-point is reached, the price effect of a general fall in preference for money can be expected to be dramatic, self-feeding, and extremely hard to stop.

It will result in stubborn, vicious, stagflation.

The situation in the Eurozone is somewhat different. Here, the increase in bank deposits has been modest in comparison, with private sector non-financial deposits growing by only 30% over the last eight years. So the public's preference for holding money in the Eurozone, particularly when price inflation is taken into account, has increased relatively little.

This is in marked contrast with the dollar, suggesting that the euro is likely to be less vulnerable to shifts in preference. But the euro has other problems: a very fragile banking system, the ever-present revolt against austerity, and the threat of Brexit.
The euro's inherent risks might be the source of the next global financial crisis, and it should be noted that any central bank, whose monetary policy introduced negative interest rates to inflate asset bubbles, has upped the risk of future monetary chaos. The ECB's monetary policy favours short-term survival at the cost of future destruction. It is a cover-up to ensure the public are unaware of the euro-system's undoubted systemic fragility.

But changes in currency purchasing power are mostly a dollar problem, and a little chaos in Europe, which is becoming increasingly likely by the day, risks developing into a catastrophe for the dollar, transmitted through the banking system. And once US monetary preferences begin to slide and the prices of goods and services begin to rise, the only way it can be stopped is for the Fed to raise interest rates to a level where demand for money stabilises.

This brings a new list of problems, which can be laid firmly before the door of the last seven years' monetary policies. There is an awful lot of excess liquidity to be discarded by the public, and nowhere for it to go. Cash held outside the banking system is discouraged under the guise of anti-money laundering regulations. The tendency of bank credit to contract will be a major strain on the banking system, which will require more money from the Fed to prevent a cascade of bank insolvencies. And how does an issuing central bank, whose balance sheet is already loaded with interest-rate sensitive assets, itself survive a rise in interest rates, when its own balance sheet is geared over fifty times?

Now is the calm before the storm, a storm which in the absence of a good grasp of price theory, central banks are simply not equipped to weather. The only shelter for individuals is sound money, money that cannot be expanded by governments and their licenced banks, which is gold and silver.

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