Will the Next Reserve Currency Evolve In the Direction of Sound Money?
The dollar's precarious role as an international reserve currency seems more pressing to investors than political economists. The international standing of currencies is a vital part of the global monetary order, affecting many economic relationships.
"It is important here first to distinguish between the need for some 'lender of last resort and the organization of banking on the 'national reserve' principle. ... It is far less obvious why all the banking institutions in a particular area or country should rely on a single national reserve. This is certainly not a system that anybody would have deliberately devised on rational grounds. It grew up as an accidental by-product of a policy concerned with different problems. The rational choice would seem to lie between either a system of 'free banking,' which not only gives all banks the right of note issue and at the same time makes it necessary for them to rely on their own reserves but also leaves them free to choose their field of operation and their correspondents without regard to national boundaries, and on the other hand, an international central bank. I need not add that both of these ideals seem utterly impracticable in the world as we know it. But I am not certain whether the compromise we have chosen, that of national central banks which have no direct power over the bulk of the national circulation but which hold as the sole ultimate reserve a comparatively small amount of gold, is not one of the most unstable arrangements imaginable." (F. A. Hayek, Monetary Nationalism and International Stability, (Graduate Institute of International Studies, Geneva, 1937; Good Money, Part II, The Standard, The Collected Works of F. A. Hayek, Volume 6, Liberty Fund, 2008, p. 88.))
The precarious role of the dollar as the international reserve currency is an issue that has seemed of more pressing importance to investors than political economists. The international standing of currencies forms a principal feature of the global monetary order, influencing a wide range of economic relationships. It is obvious why investors take an interest. And investment returns.
Despite the great impact of international currencies, however, political economists—with the notable exception of F. A. Hayek—have tended to neglect them. Perhaps this is because currencies are traded in high volumes twenty-four hours a day, in view of which economists have found it wise to shy away from making heroic comments about the dollar's value because of the nontrivial prospect of embarrassment by market movements.
This potential for embarrassment has been illustrated in the wake of the COVID pandemic as the dollar rallied sharply despite many forecasts that it was destined to depreciate or collapse as the decay of U.S. economic preponderance accelerated. Year-over-year, as I write, the Dollar Index has rallied by 13.69%.
Looking back as far as the 1960s, a flurry of investment commentary anticipating the dollar's demise has seemed to provide a perverse trading signal. Whenever economists and investment commentators have raised alarms that the dollar was about to lose a lot of value, jeopardizing its status as the world reserve currency, the dollar has tended to rally sharply.
Among the volumes that expressed alarm about "The Death of the Dollar" were The Collapse of the Dollar and How to Profit from It: Make a Fortune by Investing in Gold and Other Hard Assets, by James Turk and John Rubino, 2008. The Money Bubble: What to Do Before it Pops, also by Rubiino and Turk 2014, Crashed: The Death of the Dollar, a novel by William Cooper, 2014.The Collapse of Western Civilization by Naomi Orestes and Erik Conway, 2014, The Death of Money: The Coming Collapse of the International Monetary System, By James Rickard 2014. The Dollar Crisis: Causes, Consequences and Cures, by Richard Duncan, 2005.
You can see that 2014 was a banner year for warnings of the dollar's early demise. In January 2014, the U.S. Dollar Index traded at 86. The Dollar Index promptly rallied almost straight up, trading above 100 for much of the rest of the decade.
William F. Rickenbacker's 1969 book, Death of the Dollar, is the sole example among the more prominent works in this category to have been written before Richard Nixon repudiated the dollar's link to gold in 1971. Suppose you actually read this book, as I did almost half a century ago. In that case, you will be disappointed: it offers little insight into the current world monetary system and why it is flirting with collapse.
Rickenbacker made a name for himself by pointing out that the industrial uses for silver made the metal too valuable to permit its continued use in coins at the low rates the U.S. Treasury was willing to pay for it. Death of the Dollar was an extension of Rickenbacker's argument to gold, which he also found to be too valuable to permit its price to remain set at thirty-five dollars an ounce (as contemplated by the Bretton Woods agreements that spelled out the ground rules of U.S. hegemony at the end of World War II).
Rickenbacker pointed out that the annual industrial consumption of gold had tripled from 1.46 million ounces in 1957 to 6.1 million ounces in 1966. By the end of the 1960s, industrial consumption was four times the annual U.S. gold production. Therefore, Rickenbacker's conventional argument was that trends in supply and demand would make it difficult to achieve a sufficient deflation to preserve the dollar/gold peg at thirty-five dollars to the ounce,
In that sense, Death of the Dollar was a very different kind of book than later volumes with similar titles; While Rickenbacker was writing it, during the final years of "The Great Prosperity," the signal crisis of U.S. hegemony was still to come. Unlike today, the United States was still the world's greatest creditor nation. You may recall that the signal crisis of hegemony begins with an adverse judgment by capitalizing on the possibility of continuing to profit from reinvestment in the material expansion of the economy. This isn't because they are pessimists but because they respond rationally to falling returns.
Return on U.S. Capital Stock Plunges During the Late '60s
A crucial feature of the prelude to financialization in the 1970s was a 40 percent plunge in the rate of return on the capital stock of U.S. manufacturers between 1965 and 1973, as reported by Giovanni Arrighi in Adam Smith in Beijing.
When Eisenhower left the White House, only a decade before Richard Nixon repudiated the dollar's link to gold, total U.S. business investment was just a shade less than 50 percent of GDP, stronger even than what we have seen recently in China (41.6 percent in 2021) but without the artificial stimulus from a credit bubble. Eisenhower was no friend of easy money.
Even in the wake of unprecedented monetary stimulus since 2008, U.S. business investment has been at the bottom of the tables in recent years. The U.S. Capital investment as a percent of GDP, 1970 - 2020 averaged 22 percent: with a minimum of 17.8 percent in 2009 and a maximum of 25.11 percent in 1979. The latest value from 2020 is 21.09 percent. For comparison, the world average in 2020 based on 151 countries is 23.76 percent.
A key feature of the decline of U.S. hegemony was a sharp drop in the percentage of profits earned in manufacturing. That fell from over 50 percent in the early 1950s to just about 10 percent by 2001. Meanwhile, the percentage of profits accounted for by financial returns among so-called FIRE (finance, insurance, and real estate) companies rose from about 10 percent to about 45 percent.
Equally startling, the ratio of financial revenues to operating cash flow for nonfinancial American firms rose from around 10 percent in 1950 to a five-year moving average of 50 percent by the turn of the century. The largest component of financial revenues was interest, reflecting the growing saturation of the U.S. economy with debt while real income growth petered out.
The signal crisis represents the turn away from the capital commitment to business assets in favor of financialization. As such, it is the prestige of a worsening crisis and the eventual collapse of the dominant regime in the terminal crisis of hegemony.
Growth of Financial Assets Vastly Outstrips Economic Growth
It should not be surprising that long-term investment in the United States fell off a cliff as financial assets proliferated. London-based financial analyst Paul Mylchreest of ADM Investor Services reported in March 2015 that "the stock of globally traded financial assets had increased from the U.S. $7 trillion in 1980 to something approaching U.S. $200 trillion." This huge proliferation of financial claims growing at a compound annual rate of about 10 percent over thirty-five years, while the economy's nominal growth was poking along at barely half that rate (5.33 percent), hints at a greater crisis to come.
Indeed, recent computations by the Bank for International Settlements show that total global debt was almost three times greater than the whole world economy at the end of 2020. More precisely, total debt stood at 290.8 percent of global GDP.
A little-noted feature of the hypertrophy of debt in the fiat money system, where almost all our money is borrowed into existence as debt, is that the more money is borrowed, the stronger the deflationary trap that is poised to snap shut. For one thing, debt drives production. Capitalists whose investments are financed by debt have incentives to continue expanding production, even at lower prices, to meet fixed debt payment obligations.
Furthermore, when central banks encourage credit demand by slashing interest rates to invisibility, they stimulate a "cross-border carry trade" in which borrowers operating in countries with higher interest rates are tempted to borrow dollars at low-interest rates. As the borrowers are obliged to buy dollars to repay their debt, the effect is equivalent to a short squeeze in currency markets. As of Q4 of 2021, according to the Federal Reserve Bank of St. Louis, Chinese "nonfinancial" companies alone had collectively borrowed $38.539 trillion as of Q4 2021. This is tantamount to a multi-trillion-dollar short position against the dollar.
With the Federal Reserve embarked on a vigorous tightening program again, rising interest rates in the United States can be expected to compound a self-reinforcing rally in the dollar. This will shrink demand for key commodities priced in dollars. Price collapses for a whole range of dollar-denominated commodities can be expected to undermine both cash flow and collateral, thus jeopardizing the ability of debtors to repay.
Also, note that the ability of the real economy to support rapidly compounding financial claims (most of the financial assets are debt instruments) is exaggerated by looking at compound growth since 1980. Remember, from 1992 through 2000, reported US GDP growth only fell below 3 percent twice—in 1993 when it was 2.7 percent and in 1995 when it was 2.5 percent. But those days are past. More recent figures show that even by official growth accounts, it has dwindled to a standstill.
As David Stockman pointed out in his May 2015 article, "Wake-Up Call for B-Dud and the New York Fed Staff—This Isn't 'Transitory,'" April 2015's number for manufacturing production represented a 0.33 percent annual growth rate since December 2007. Hardly robust enough to support debt growth of about 18% annually.
Debt and Money Destined to Be "Destroyed on a Truly Enormous Scale
In other words, financial claims have been multiplying more than thirty times faster than industrial production since the onset of the last recession. This underscores Tim Morgan's thesis in his 2013 book, Life After Growth. Morgan states that "the total of financial claims has become vastly larger than anything that the real economy can deliver.…This divergence between real potential output and the scale of monetary claims helps explain why the world is mired in debts that cannot be repaid. It also explains why the process of the destruction of the value of money is inevitable and is starting to gather pace." Morgan concludes, "What it means is the that financial and real economies can be reconciled only if financial claims (meaning both debt and money) are destroyed on a "truly enormous scale." Spiraling financial claims on a stagnant real economy implies an enormous wipeout of financial claims—hence my expectation of a coming "terminal crisis" of U.S. hegemony.
The U.S. government has become the world's greatest purveyor of economic lies since the Soviet Union. The government remorselessly overstates economic growth and exaggerates the strength of the employment market. As pointed out by Zero Hedge in the May 2015 article "The Big Lie: Serial Downward Revisions Hide Ugly Truth," the level of U.S. retail sales has been chronically exaggerated. Between 2010 and 2015, over 20 percent of the initial gains in retail sales were removed by serial downward revisions in later months. According to the article, "For over 65 percent of the time, a 'good' number prints, stocks rally, the everything-is-awesome meme is confirmed, and then a month later (or more) retail sales data is downwardly revised." (Along the same lines, the unemployment rate for April 2015, officially reported at 5.4 percent, is really 23 percent, as reported by Shadow Government Statistics, computed as Statistics Canada computes the unemployment rate in Canada.)
Then there is the dramatic 25 percent dollar rally that began around May 2014, which was triggered, in part, by the response of traders to statistical factoids that exaggerated the strength of the U.S. economy. A stronger dollar, in turn, contributed to the systemic price reversal that cratered the price of oil and other economically sensitive commodities. These were second-order effects of China's monumental credit bubble.
The current monetary system is unsustainable; It is bound to collapse. There has been no lack of alarm about the fact that we are dependent on paper money that could quickly lose value—or perhaps suck your livelihood and fortune into a deflationary vortex. Let's take a step back to get a better perspective on this. The U.S. dollar and the world monetary system need to be understood in the broader context of fading U.S. hegemony.
Rules from America's Days At the Summit of the World
The United States wrote the rules of the world economy when we were far away from the world's most prosperous and powerful economy. Today, our luster has faded. One of the puzzles we must decipher as investors are how and under what conditions the U.S. dollar's role as a reserve currency is likely to end. Also, the current system should be understood as the culmination of a centuries-long process in the evolution of money and credit, as shaped by successive hegemonies. As Hayek pointed out in New Studies in Philosophy, Politics, Economics and the History of Ideas, the institutions of the moment are the latest attempt to cope with the demand for more and cheaper credit—a centuries-long tradition of our civilization.
A review of the last stages of hegemony shows several points to bear in mind now:
1. Banking has never been a genuinely free market activity. During each of the successive stages of hegemony over the past five centuries, the predominant power has sponsored an official or quasi-official bank that has determined the role of money and credit during that stage of the world's economic development.
2. As the scale of government has grown, there has been a loosening of restrictions that commodity-based money imposed on credit expansion, creating a general tendency for credit to become easier.
3. Debt crises have a way of coming to the fore during the twilight of hegemony. No matter the institutional framework of banking, the phase of financialization that follows the signal crisis of hegemony culminates in a terminal crisis of debt distress, often aggravated by the ruinous expenses of war.
4. Money and banking have evolved over the past half-millennium to permit a more promiscuous extension of credit. The U.S. system of pure fiat money reflects the unprecedented scale of the U.S. government as the largest the world has ever seen and the declining marginal returns (accelerating inefficiency) of a system that cannot pay its way. In this light, easy credit at an unprecedented scale is the monetary reflection of scale diseconomies. The government needs to create trillions of dollars out of "thin air" to pay its otherwise unaffordable operating expenses. The terminal crisis of U.S. hegemony may well prove to be the end of fiat money and fractional reserve banking, as the unstable fiat system collapses and money and banking devolve to a smaller and more efficient scale.
5. Hegemonic transitions always involve crucial ways of re-configuring the reserve currency. How will the next reserve currency differ from the dollar? That is a tough call. On current evidence, it seems as likely as not that metapolitical conditions will favor a declining scale of sovereignty. Perhaps some alliance of mini-sovereignties and city-states, more akin to the Hanseatic league than the United States, will emerge to sponsor a new reserve currency — backed by a high-tech military coalition. I admit that is hard to imagine; there is the precedent of the Wendish Monetary Union, formed in 1379 to maintain the currency for the Hanseatic League of merchants and city-states. The union struck a silver coin equivalent to the Lubeck mark, containing 18 grams of fine silver. The Encyclopedia of Money comments:” Unlike many feudal governments, the merchants of the Hanseatic League never sought to profit from currency debasement. Often governments dominated by merchant princes or commercial classes displayed a strong commitment to currency integrity, perhaps to help attract commercial activity. Living on an empire of trade and finance, Venice maintained the value of the ducat for over 500 years. In the nineteenth century, England became the staunch defender of the gold standard against bimetallism, which would have allowed debtors to substitute silver for gold to repay debts.”
So sound money is not unprecedented. And it remains challenging to imagine how the institution of money can evolve from here to permit an even more promiscuous extension of credit. The pendulum may have swung too far toward meeting the demand for more and cheaper money—with the consequence that the next reserve currency may prove harder to debase than the dollar did. I suppose the crucial issue for you to ponder is how far the eclipse of democracy now in view will permit creditors to shift the terms of borrowing in their favor?
In Strategic Investment, I only provide an impartial viewpoint. I studied philosophy at Oxford, which the University claims helped me think clearly. Even so, you have the same ability that I have. So only believe what makes sense to you.