The dollar – King Rat of failing currenciesMar 7, 2019·Alasdair Macleod
The explanation for the sudden halt in global economic growth is found in the coincidence of peak credit combining with trade protectionism. The history of economic downturns points to a rerun of the 1929-32 period, but with fiat currencies substituted for a gold standard. Government finances are in far worse shape today, and markets have yet to appreciate the consequences of just a moderate contraction in global trade. Between new issues and liquidation by foreigners, domestic buyers will need to absorb $2 trillion of US Treasuries in the coming year, so QE is bound to return with a vengeance, the last hurrah for fiat currencies. However, China and Russia have the means to escape this fate, assuming they have the gumption to do so.
It may be too early to say the world is entering a significant economic downturn, but even ardent bulls must admit to it as an increasing possibility. Financial analysts, both bovine and ursine, face a complex matrix of factors when judging the future effect of any downturn on currencies, and of the prospects for the dollar in particular.
Some will take the view that a global downturn will continue to drive foreign currencies to be sold for dollars, because dollars are perceived to be less risky and required to repay debt. Some will point to the tension in the euro from the extra twist an economic downturn gives to the debt crisis forced on Italy and the other three PIGS, compared with the relative stability of the Hanseatic nations. Some analysts will expect China to get her come-uppance when her debt-fuelled economy implodes into crisis.
As a recession progresses, it is conventional to think of the dollar as a safe-haven. For a brief time, relative to other currencies this might be true. But what then?
Those that succeed in their analysis beyond the short-term will do so by discarding all bias. They could then observe that in the event an economic downturn gathers pace a split could emerge in relative outcomes between East and West. The effect of a downturn on the Asian bloc, led by China, Russia and now joined by India, is likely to differ from the effect on America and Europe. It is the new versus the old, Asian mercantile states that provide minimal welfare, differing from the more mature welfare-heavy nations.
When we consider these two groups, we tend to analyse the situation through the lens of our own prejudices. Remove this predisposition, and it should become clear that whatever the starting point in terms of debt to GDP and other metrics, the prospects for welfare-light nations are considerably better in a global economic downturn than they are for nations burdened by extensive welfare obligations. China and other Asian states will not face the same degree of debt escalation as America, Japan, the UK and the European nations. Furthermore, Asia has far more dynamic economies with the potential for a continuing industrial revolution.
Government finances will be central to outcomes. Given that all government finances deteriorate during economic downturns, the starting point and the pace of debt escalation are what should concern us. China’s overall debt to GDP ratio at approximately 260% compares with that of the US which is around 360%, so on that score China’s total debt is significantly less. The US Government’s debt to GDP stands at over 100%, while China’s is estimated to be under 45%. Yet, Western analysts perceive China to be in a weaker debt position than the US.
America’s principal strength, which everyone cites, is the reserve role of her currency. Everyone needs dollars. All countries without sophisticated financial markets in their own currencies borrow in dollars, which must eventually be repaid. Everything from commodity prices to global financial markets is referenced in dollars. The dollar has also become weaponised, the means of enforcing America’s foreign policy. It is the King Rat of the currency world.
So long as the world enjoys continual economic growth, the dollar is difficult to challenge. When the economic tide turns, everything becomes different. In this article I explain why the global economy is heading for a crisis which could be similar in scale to the great depression. If this analysis is correct, then the dollar’s prospects as the global reserve currency, even its continuing existence, will be threatened and must be reassessed in that light.
Peak credit is coinciding with trade protection
In a previous article I pointed out the catastrophic danger of combining trade protectionism with the top of the credit cycle. This combination was devastating when the Smoot-Hawley Tariff Act was passed by Congress in October 1929, particularly when compared with the relatively minor consequences of the Fordney-McCumber tariffs of 1922. The difference was Fordney-McCumber was introduced early in the credit cycle, and Smoot-Hawley at its peak. This dissimilarity was the principal driver behind the viciousness of the Wall Street crash and the subsequent global depression.
We have a situation today so similar to Smoot-Hawley and its coincidence with the top of the credit cycle in 1929 that we should be deeply concerned. What is particularly alarming is that international trade appears to have already stopped expanding, almost as if it has run into a brick wall. A comparison with the 1929 experience suggests this result as extremely likely. That precedent warns us today’s international trade may be rapidly sliding from expansion into severe contraction, with dire consequences for the whole global economy. Smoot-Hawley and the top of the credit cycle in 1929 combined into the motive force that made the great depression unnecessarily deep, global and intractable.
The impact on government debt funding will be immense
The question then arises as to how a top-of-the-credit-cycle event combined with an escalation of trade protectionism will impact the US economy today, particularly with regard to funding an increasing budget deficit when Americans have become used to foreigners buying the bulk of new Treasury bonds.
To appreciate the full implications, we must revisit the connection between trade and budget deficits under the recessionary assumption that the budget deficit will rise, while trade volumes contract. But before examining the consequences, we must set the scene by explaining why and how the twin deficits are linked. The easiest way to do so is to imagine a world of sound money, where the total of money and credit is fixed and the preference for holding money relative to goods does not alter.
If the quantity of money and credit is constant, all imports must be paid for by exports. In other words, trade imbalances cannot arise if there are no changes in the total of circulating money. If credit is extended to an importer, it must be sourced from savers prepared to defer their spending, instead of being created out of thin air, as is the case with fractional reserve banking. At the same time, the government can only finance its spending by raising taxes and borrowing from private individuals. The banking system in our sound-money example can only act as intermediaries and cannot increase the quantity of money or credit to pay for government spending, nor can it expand credit to finance trade.
Therefore, the sound money condition that makes a trade imbalance impossible is the same one that makes a budget deficit impossible. It follows from this that if the quantities of money and credit are allowed to expand, imbalances develop for trade or government budgets, or both. One deficit does not have to lead to the other, but to the extent it does not, then the difference must be reflected in a change in the savings rate. Savings must be spent in order to increase the consumption that leads to trade deficits. Alternatively, they must be invested, or spending deferred, in order to reduce them.
If a government spends more than it receives in taxes and the resulting budget deficit is not reflected in a similar deficit on the balance of trade, it is because individuals defer their spending and increase their savings by buying government bonds. Their spending on consumer items thereby becomes curtailed, restricting demand for imported consumer goods. Obviously, there are other investment media, such as corporate bonds and new issues which attract savings, which is why the twin deficits will never be exactly equal. But generally, if there is no change in the savings rate, both trade and budget deficits will approximate with each other.
In today’s world of fiat currencies, a budget deficit still has to be financed in the absence of an increase in savings. The two sources of non-saver finance are the purchase of government debt by the banking system and the reinvestment of surplus dollars accumulating in foreign hands, mainly as a result of the trade deficit. So long as foreigners are willing to reinvest their dollar surpluses instead of selling them, the twin deficits are not destabilising. The trouble comes when that condition ceases, which is most likely to happen when the credit cycle turns, and tariffs are imposed or threatened.
Furthermore, government finances deteriorate rapidly when an economic slump develops. Table 1 below is an idealised illustration of how the government funding requirement increases during a relatively minor recession, due to a changing combination of the twin deficits. Our starting point is the US fiscal year to October just ended.
US residents and banks would only have had to find $184bn in Fiscal 2018 to fill the Federal Government’s funding gap. This is the domestic funding requirement. Assuming the changes listed in the notes to Table 1 apply to fiscal 2019, the domestic funding requirement rises to over a trillion dollars, an increase of more than fivefold. Crucially, this assumes capital surpluses accumulating in foreign hands from the US’s trade deficit are fully recycled into Treasury bonds.
An escalation of domestic funding requirements will be repeated in all other countries that habitually run trade deficits and face rising welfare obligations. These dynamics are certainly not factored into market expectations, because bond yields have yet to reflect the increase in supply, and the price of gold has not suggested the inflationary implications of the quantitative easing certain to be reintroduced in all the advanced economies.
Returning to our analysis of the US position, the increase in the domestic funding requirement implies capital imports would have to rise sharply even in a moderate recession if a funding crisis is to be avoided. That is unlikely to happen.
Assuming that global trade is beginning to contract as our thesis suggests, it is more likely foreigners will be repatriating funds into their own currencies instead of investing them in dollars. Earlier bullish assumptions by foreign corporations about trade expansion will inevitably lead to a downwards reassessment of their dollar requirements. Rising budget deficits and the emergence of malinvestments in their own jurisdictions will require funding as well. The potential for a government funding crisis to go global is very real.
Until only recently, foreign investors have continually increased their investments in US Treasury bonds, expecting uninterrupted growth in cross-border trade. This has changed with America’s new protectionist policies and the Chinese and European responses to them. We saw evidence of this in the US Treasury’s TIC data for December, when foreigners were recorded as net sellers to the tune of $91.4bn, representing nearly twice the previous month’s trade deficit.
This may be early evidence that capital flows are already reversing out of US dollars. Without capital inflows, it will be the American banking system and private investors that will have to fund the whole budget deficit and absorb further dollar liquidation from abroad. Just to be clear, Table 1 above tells us the domestic funding requirement will switch from $184bn last year to financing the whole budget deficit of over $1,500bn if foreigners stop buying. Additionally, there is the prospect of extra capital outflows, if December’s TIC figures are any guide. At that rate, foreigners will liquidate a significant portion of their existing dollar investments, which includes the disposal of Treasury bonds.
These dollar sales are likely to be significant and could easily take total required purchases of US Treasuries by domestic sources to well over $2,000bn. Foreigners have accumulated substantial dollar investments over the years and at the last date of record (end-June 2018) they totalled $19.4 trillion, to which we can add cash funds held through correspondent banks and short-term money instruments totalling a further $5.2 trillion as at last December. At over 110% of GDP, the total of $24.6 trillion in investments and cash is the highest dollar exposure ever recorded in foreign hands.
We must also mention the feedback of contracting international trade on other economies, because that will undermine US exports even more, as well as their import/export trade with each other.
Countries with an exporting surplus will therefore take a hit on their trade from a general contraction. But as countries such as Japan and Germany have consistently proved, the savings habit which is part and parcel of their trade surpluses will otherwise limit their difficulties to considerably less than those faced by the welfare spendthrifts who have euthanised their savers.[i] Britain, France and the Mediterranean states are at particular risk, and the prospects for currency dislocation from the additional strain on the euro-system can be expected to escalate into a European currency and banking crisis.
In a short time, the negative feedback from these chains of events is likely to further undermine state finances everywhere by deepening the trade contraction, reducing tax income and increasing welfare commitments. Table 1 above will reflect just the opening salvo in a deepening slump, an outcome that is likely to become impossible to avoid, with serious consequences for currencies as central banks respond with an increasing pace of monetary inflation.
The demise of unbacked fiat currencies
The coincidence of Smoot-Hawley tariffs and the top of the credit cycle in 1929 occurred under a gold standard. The mythology of that experience has left the gold standard blamed for the depression and fed into the inflationist policies we see today. In truth, it is a confusion of effect with the cause, and few economists appreciate the destructive role tariffs played at the peak of the credit cycle. Nevertheless, everyone knows what the policy response from central bankers this time will be: they will fund their governments’ deficits in conjunction with increasing the reserves of the commercial banks by the tested expedient of quantitative easing.
The precedent of QE for resolving difficulties of this type was the policy response to the great financial crisis. It is impossible for American and other savers, who are all but euthanised anyway, to fund escalating budget deficits when they are personally in debt, becoming unemployed, and their financial investments are suffering from vicious bear markets. The neo-Keynesian dictum is to encourage spending to the exclusion of saving, driven by the belief the great depression was exacerbated by a tendency to save. Instead, inflationism will replace savings, accelerating the destruction of personal wealth. In short, the central banks see no alternative to throwing the inflationary dice just one more time despite repeated failures to achieve anything positive in the past, other than their states’ survival.
While politically there appears to be no alternative to squeezing the last drops of blood from the productive private sector to support governments and the international banking system, the escalation of monetary inflation could finally destroy unbacked fiat currencies. Instead of repeating the gold-induced collapse of commodity and raw material prices in the 1930s, eventually prices will rise as fiat currencies sink, giving only a brief appearance of price stability. So, after an initial financial shock it is likely that residential property values, mining stocks and the share prices of businesses that can survive a currency collapse might begin to recover, measured in devaluing currency terms.
If so, it resolves nothing. The most pressing problem, besides the economic slump and the currency collapse, is the continuing crisis in government finances. It is commonly assumed that the devaluation of existing government obligations favours government. This naïve view does not take into account the cost escalation of future legally-mandated obligations on governments to provide continuing welfare and other services. It is difficult to envisage welfare-driven governments having the authority to reverse the socialising legislation of the last ninety years sufficiently in order to stabilise their finances.
However, an increase of the quantity of base currency by the central bank through QE and the accompanying expansion of bank reserves will continue to be seen as a practical monetary policy. It is only later the horrors for the general price level will become fully apparent. By then it will be too late, if it is not already, to address a growing loss of public trust in the currency’s purchasing power. In the case of the dollar, as soon as foreigners overexposed to it become aware of its trending direction, they are likely to accelerate their selling on the foreign exchanges, realising their losses on US Treasuries. This particularly applies to the Chinese and Japanese, America’s largest creditors, whose focus will have shifted from kowtowing to America’s trade policies to supporting their domestic economies.
With a falling dollar measured in yuan, yen and even euros (if that currency still exists by then) the general price level in America will begin to rise at an accelerating pace which can no longer be concealed through statistical management.
And so, the difference between the collapse that started in 1929 and the current hiatus is gold. Ninety years ago, through the medium of the dollar, prices were measured in gold at one ounce for $20.67. It led to a 40% devaluation of the dollar in January 1934. Today, while the actual tariffs proposed are less than those of Smoot-Hawley and not yet fully implemented, the monetary inflation behind the credit cycle has been considerably more extreme. If the combination of the two in 1929 remains a valid precedent for what is going to pass in the next year or two, today’s unbacked fiat dollars face a full-frontal challenge not only to financial asset values, but also to international and the American public’s faith in the dollar as a viable currency.
Escaping the fiat collapse
From the foregoing, it is clear that a series of events has now commenced that threatens to spark a worldwide cyclical credit crisis centred on that King Rat of currencies, the dollar. Other currencies face similar problems: twin deficits, a lack of savers, escalating government welfare commitments and a decline in tax income. These currencies are threatened with the same fate as the dollar, but perhaps not concurrently.
This will not come as a surprise to followers of Austrian business cycle theory. But Western central banks, vaguely understanding another credit crisis is likely, have tried to seal off the escape routes. They have largely persuaded their populations that gold is no longer money. They have instructed banks to limit cash withdrawals. They have protected their governments from a future systemic crisis by tightening regulations and enacting legislation for bail-ins to replace bail-outs. The effect of these measures in a crisis can only be guessed at. But they are likely to accelerate the destruction of a currency’s purchasing power, if, instead of encashing deposits (meaning people exit the banking system but not the currency), people are forced to exchange bank balances for physical goods and perhaps cryptocurrencies in order to escape systemic risk.
You might argue that small depositors are protected by deposit insurance, but it is not the small depositors that will start a stampede into alternatives to bank deposits. It will be larger depositors and holders of bank bonds who will protect themselves from bail-ins.
Currencies issued by nations which have retained a saving culture, and whose governments are not obligated to provide expensive welfare for their citizens, can survive if they take appropriate action. Undoubtedly, they will face persuasion by their own neo-Keynesian inflationists to keep their currencies “competitive”, at least initially. When this leads to escalating domestic interest rates, these policies are likely to be abandoned in favour of sound money in the form of gold backing, and the inflationists side-lined.
The currencies most likely to end up with gold backing are likely to be the Chinese yuan and Russian rouble. Both China and Russia have embraced gold as the time-honoured money, superior to ever-expanding fiat currencies. Besides stabilising the pan-Asian monetary situation for the benefit of Eurasian trade, a credible gold-exchange standard introduces monetary discipline and reduces interest rates towards those mutually agreed between lenders and borrowers of gold.
While we cannot forecast this outcome with certainty, we can see that the opportunity to escape currency destruction for Asia will be available. We can go even further, and say there will be no credible alternative, and that there are today specialists in the Russian and Chinese establishments far-sighted enough to understand the point. After all, Russia has already sold her dollars for gold, and China deliberately moved to control the global market for bullion. Furthermore, the last three months’ reports on the status of her reserves, show China appears to have stopped accumulating dollars and instead is selling them for gold. Importantly, now she does not mind advertising it.
China and Russia are in a similar position to Britain following the Napoleonic wars. Following the formal reintroduction of the gold standard in 1821 (the gold sovereign had been introduced in 1816) the value of government debt in private hands rose as interest rates fell and the government’s financial credibility improved. The wealth creation from this simple act of securing sound money was a major contributor to the success of the industrial revolution, which propelled Britain into her global pre-eminence. China has similar ambitions for the industrialisation of Asia. Furthermore, she understands it is only by allowing her citizens to accumulate personal wealth that her economic objectives can be achieved.
She would be stupid not to follow Britain’s nineteenth-century example.
[i] The term is Keynes’s, a desire he expressed in his General Theory.
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