Currency exchange value dynamicsMar 1, 2018·Alasdair Macleod
In a recent article[i] I postulated that the dollar could lose all its purchasing power with a rapidity that will come as an unpleasant bombshell, even to those who already see inflation as society’s greatest problem in the future. The key to understanding why this may be so lies in human reactions to the monetary consequences of the next credit crisis. The undermining of the dollar as a currency affects all other fiat currencies, because it is the reserve currency and all financial markets use it as the pricing medium for commodities and for much of international trade.
A comprehensible analysis of currency exchange dynamics must therefore concentrate on the dollar, only bringing in the broader picture when appropriate. In this article’s context, currency exchange dynamics refers primarily to events that lead to a change in the dollar’s purchasing power.
The dollar has suffered monetary inflation ever since the Federal Reserve Board was created, both in terms of the expansion of base money and of bank credit. The effect in terms of loss of purchasing power has so far come in two shifts. The first was in 1934, when the dollar was devalued against gold by 40%, and the second following the collapse of the London gold pool in the late 1960s, since when the dollar has lost a further 97.4%.
The precedent has therefore been set for a continuing trend, that will eventually conclude with the destruction of the current monetary system. We know this because monetary regimes come and go, leaving gold and silver as the only solid forms of money throughout human history. Therefore, the end of the dollar, along with the whole fiat currency system, just like the end of empires, is one of the monetary certainties. But only a small minority of analysts are conscious this is so and appear to assume the current monetary state will continue indefinitely.
This article argues the end of the current monetary regime could be much closer than even the uber-bears think. If so, it will be due in part to the extraordinary circumstances currently evolving.
Gold and silver, in terms of their purchasing power, are and always have been a safe haven from state-induced inflation and historically have remained relatively stable measured against other commodities, except in times of escalating financial violence when a credit crisis occurs. However, the quantities of fiat currencies relative to the available monetary gold are now far too large for this relative stability to continue even ahead of the next credit crisis, with gold and silver’s values having the potential to increase significantly, measured against both fiat currencies and commodities.
Potentially, fiat currencies face a perfect storm from an upcoming credit crisis, from the consequences of central banks’ misguided attempts to make the banking system catastrophe-proof, and from the spontaneous development of an alternative asset system in cryptocurrencies.
The prospects for the dollar are already deteriorating. The US budget deficit is escalating at the most inappropriate stage of the credit cycle, leading in turn to increasing US trade deficits, and therefore net selling of yet more dollars on the foreign exchanges. Government funding through Treasury issues is set to accelerate at a time when overseas ownership of US dollar-denominated bonds, which increased while the dollar was strong, are likely to sold, now the dollar is weakening. A falling dollar means rising commodity prices on the exchanges, rising domestic inflation and a sliding bond market. The Fed, having an eye on the risks to both private sector and government debt, is likely to be too slow to counter these negative forces.
Within the credit cycle, it is always rising prices, the consequence of earlier credit expansion, that lead into the final crisis stage. To combat rising price inflation in excess of their 2% targets, central banks will be forced to increase their deposit rates, while the time-preference on loans and bonds increases at the behest of markets.
These increases only end when the cost of financing and refinancing commercial projects exceeds the return on them, and malinvestments are revealed. At that point, escalating losses on bank loans force banks to retrench, particularly on loans for working capital. And without working capital, business failures quickly escalate.
Consumer debt is now a major factor
The sequence of events in the classic definition of a credit induced business cycle has gradually changed in one important respect. Instead of bank credit being taken up by businesses seeking to satisfy consumer demand arising from the discouragement to saving from low interest rates, marginal consumer demand has itself been bolstered by increasing levels of borrowing. This is because the wealth transfer due to monetary inflation is now severely taxing American consumers, who have abandoned savings habits and instead are borrowing to maintain their standard of living. Therefore, swings in savings rates, an important signal to businesses in the past, are not so relevant as they used to be.
When the credit crisis arrives, the composition of all that consumer debt also becomes important. At the end of 2017, US household debt stood at $13.15 trillion, and was comprised of $9.33 trillion of mortgage debt and £3.82 trillion of non-housing debt.[ii] Most of the mortgage debt is held by government agencies, taken into conservatorship by the US Treasury during the last credit crisis. We can safely assume government policy will discourage foreclosures on delinquent mortgages. That leaves non-housing debt, which is mostly not collateralised.
Therefore, when a credit crisis hits, in addition to a rapid reduction in interest rates and an expansion of base money through quantitative easing to rescue the wider economy, consumer finance companies will also need a backstop. The difference today from the last crisis is there is no reason to suppose there will be a significant collapse in residential property prices, though they may or may not be undermined to some degree by higher interest rates before the crisis arrives. That being the case and even allowing for the negative effects of losses in financial markets to consumer wealth, consumer credit seems unlikely to contract by very much, as it threatened to do at the height of the last credit crisis. Certainly, it will be the Fed’s policy to maintain consumer confidence at all times.
A further dampener is potential job losses. But here again, the Fed will almost certainly support the banks, on the understanding they don’t exacerbate the crisis by foreclosing on businesses in the general sense. After all, the Fed succeeded in stopping a financial and systemic crisis in 2008 by doing just that and is likely to feel confident today that policy is the most practical solution in a future credit crisis. Therefore, we can conclude that consumers, who are also employees, will see in aggregate little reason to reduce their spending significantly, and consumer finance companies will be encouraged to continue to offer credit. An important consequence is price inflation will continue.
Of course, we must not make light of the dangers. Unemployment will rise, as will personal bankruptcies. Banks will stop offering credit for working capital purposes for smaller businesses. That’s what happens in every credit crisis. But the point at issue is the scale of the initial effects of the crisis stage of the credit cycle, which may not be as disastrous as the mountain of outstanding debt to be unwound implies. What happens after that is another matter.
Perhaps this Panglossian view of how the next credit crisis might commence without a systemic crash will surprise bearish commentators. However, an analysis of bank lending and bank balance sheets in the Eurozone reveals similar trends towards consumer lending, though obviously they vary between member states. Thanks to the ECB’s aggressive and continuing QE policies, banks appear to have reduced their exposure to government debt as a proportion of their total assets, which casts the ECB’s continuing policy on QE in a different light. Eurozone banks have at least made some constructive moves to reduce their exposure to sovereign debt, while decreasing their capital ratios.[iii]
Accordingly, between the world’s two largest economic entities, bank risk appears to be less compared with the position at the time of the last credit crisis. This is not to suggest that systemic risk in the banks has been banished, only that it is almost certainly less than it was. The character of the next credit crisis is bound to be different from the last for this reason. Furthermore, the steps taken by the Financial Stability Board, the Bank for International Settlements and individual central banks to prevent a financial crisis occurring again are bound to have reduced the systemic risk of multiple bank failures.
However, the credit crisis will still occur, because it is baked in the cake of the credit cycle itself. In the interests of preserving banks from the uncertainties of free markets, other potentially far more serious errors have been committed by regulating how money is used and by suppressing symptoms of financial and currency risk.
Central bank policy errors
The first policy error has been to synchronise monetary policy between the major central banks through forums such as the G20. Inevitably, as is gradually becoming apparent today, this leads to a globally synchronised inflation-fed increase in demand for limited resources, semi-manufactured goods and consumer goods. Unless someone like Elon Musk comes up with a credible plan to immediately import the necessary stuff from the moon or Mars, the consequence is bound to be an increase in prices, which not even hedonic adjustments can hide.
It is for this reason that it seems certain that price inflation will accelerate sooner and faster than currently discounted in financial markets. The effect of synchronising monetary policy globally is to bring the increase in interest rates and bond yields forward in time, as well as the credit crisis that follows. Partly for this reason, and partly because of the implied cap imposed on interest rate increases by the overhang of record levels of debt, the expansionary period of the credit cycle seems unlikely to last much beyond the year-end.
We must now turn our attention to the credit crisis that follows this expansionary phase, and the dynamics behind it.
By not permitting the unwinding of past malinvestments, central banks have stored up financial and economic distortions that threaten to imperil the global economy and ultimately state-issued currencies. Prevention of these forces being unleashed has had the effect of suppressing economic potential, which becomes obvious when you cut through misleading state statistics. Take hedonic adjustments out of official price inflation statistics, and you can immediately see that a true GDP deflator would have the US economy still in recession from the last crisis. And why the 2% inflation target adopted by all central banks? As even a child understands, you do not stimulate consumers into buying extra things by a policy of raising prices. No, what you achieve is the ability of a welfare state to fund itself cheaply through the transfer of wealth from ordinary folk to government coffers by way of monetary inflation.
Therefore, the principal victim of monetary policy is an unwitting public, with statistical deception for cover. But having established the primacy of misleading statistics, central banks have moved on. An objective for some time now, in the name of anti-money laundering and tackling tax evasion, is to do away with cash. While this ultimate objective is still a pipe-dream, cash withdrawals are already severely restricted in practice by bank regulations and made impractical for all but small amounts. The truth is central banks do not want depositors to have the option of owning their own currency, because if just some of them decide to increase their cash, they disrupt the banking system, and potentially cause liquidity problems for individual banks as well.
The unintended consequences could become apparent in the next credit crisis. Instead of withdrawing physical cash, depositors will be forced to pass-the-cash-parcel by buying substitutes. The pressure valve, which allows people to retain fiat currency in cash through a credit and financial crisis, has effectively been sealed off, and they are forced to dispose of it bank deposits entirely. All it takes is a moderate increase in the quantity of currency deposits being dumped onto unwilling buyers, sellers of assets and goods aware that currency is losing value, for a currency’s value to begin to collapse.
Central banks have therefore transferred banking risk to currency risk by limiting encashment of deposits. Furthermore, increases in interest rates to stabilise the purchasing power of currencies will no longer be a sure-fire solution, because they merely spring debt traps, not least on governments themselves, further destabilising fiat currencies by undermining ‘the full faith and credit’ of the issuers. The option of a Volcker solution as a final backstop to stopping hyperinflation of prices developing appears to be no longer available.[iv]
The rise and rise of currency alternativesWe can draw some important conclusions from our analysis so far. The next credit crisis will be unlike the last, and doubtless the central banks from all their analysing have prepared well thought out solutions to a general banking crisis. Therefore, banks are less likely to be a systemic threat to the extent they were in 2008/09, when a crisis was wholly unexpected. That does not mean depositors will be complacent, and at the margin, they are likely to seek alternatives to holding bank balances during the crisis.
The question then arises as to what alternatives to depreciating currencies might be available to bank depositors. Precious metals, widely accepted as true money, are likely to be in strong demand, as they always have been when currencies begin to lose their value and credibility. But we have a new, disruptive force in cryptocurrencies.
Cryptocurrencies have enjoyed a wave of popularity, driving bitcoin from virtually nothing to nearly $20,000 in mid-December. Since then, there has been an unwinding of excessive public speculation, at a time when regulated institutions have begun to get involved. While retail banks are wary of the losses their customers might suffer, investment banks are investing in this new business line, and regulated products are sure to follow.
The legitimisation of cryptocurrencies as an alternative to cash, if the trend continues, is going to have intense implications for the course of the credit crisis, and the eventual value of fiat currencies. The difference between the restricted issue of an individual cryptocurrency and the potentially infinite issue of fiat currency will not be lost on savvy members of the wider public. And we are not talking of the population of only one country, but over most of the globe. The potential for the purchasing power of fiat currencies to collapse, measured against both traditional metallic money and the new cryptocurrencies, is enormously important, and can be expected to hasten the end of the fiat currency era.
The next credit crisis is likely to be a two-stage affair, with the initial crisis developing as it always does, out of rising prices and rising interest rates in the expansionary phase of the credit cycle. However, we can reasonably assume that this time, central banks will be ready to implement previously devised plans to ensure the financial system is supported.
In transferring systemic risk into currency risk by blocking off bank depositors’ escape routes, the initial crisis could soon be followed by the rapid destruction of fiat currencies, beginning with them being sold for alternatives, particularly precious metals and cryptocurrencies. Growing numbers of the general public will begin to realise that commodity prices and everything derived from them will continue to rise, and that therefore cash deposits will buy less and less.
No one wants to think this might be true, and severe inflations always have to overcome a high degree of resistance to the thought that the currency people have been using for decades, even generations, might finally be worthless. Not even central banks will be prepared for this possibility. Of course, it is in their power to do something about it: all they need do is reduce the currency outstanding, absorbing all that is loose. Governments would have to balance their budgets by cutting their spending aggressively and wean themselves off currency seigniorage. But that requires an understanding of economics that is diametrically opposed to the supposed benefits of inflationism, and a contrary embrace of the virtues of sound money and deflation.
The groupthink that inflation is good for us all is too ingrained in the establishment and its epigones for anyone regard a return to an anti-inflation monetary and economic policy as a possibility. Therefore, at this point, we enter the realms of true hyperinflation. As more and more people try to abandon their legally-mandated fiat currencies, the fact that they can only do so by selling them to other increasingly disillusioned holders leads rapidly to a situation where, in terms of goods, there is no bid for fiat currencies.
The collapse could therefore be rapid, considerably faster than, say, the collapse of the German mark in 1923.[v] The speed of the mark’s final collapse was to a degree hampered by the rate at which circulating notes were printed. And who in these times draws a cheque on a bank, taking days to clear? Nowadays, exchanging currency for goods is almost always electronic and instantaneous.
Will anyone escape? That remains to be seen, but Russia, which is rapidly accumulating gold and has reformed her banking system, could do so by offering gold convertibility for the rouble. China could also escape, but because she has relied on bank credit expansion to an enormous extent in recent years, she will have to reveal substantial hidden gold reserves to back the yuan. Both these nations could stabilise their currencies through the issue of undated bonds with a modest coupon, convertible into gold on demand, but only at far higher gold prices.
Both Russia and China appear to have some understanding of the role of gold in stabilising a currency, which must be why these two nations are taking the lead in accumulating physical gold. For the rest of us, unfortunately we are the victims of government hubris about how they can control everything, and the outlook is one of fiat currency destruction, sooner perhaps than almost anyone thinks is likely, or even possible.
[i] See https://www.goldmoney.com/research/goldmoney-insights/a-roman-lesson-on-inflation
[ii] Mortgage debt includes $444bn of home equity lines of credit (HELOC). Data from Federal Reserve Bank of New York.
[iii] See the ECB’s Supervisory Banking Statistics for Third Quarter 2017 Table T02.03.2 for bank asset composition by country.
[iv] Paul Volcker was Chairman of the Fed in 1980-81, when the Fed raised the Fed Funds Rate to over 20% in 1981 tp break the inflation spiral.
[v] Until early 1923, there was a general belief variously in the foreign exchanges and the domestic economy that the mark was bound to recover. Thereafter, the public began to abandon all hope, and the mark’s final collapse took about six months.
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