By Alasdair Macleod
June 21, 2020 "Information
Clearing House" - Dollar-denominated
financial markets appeared to suffer a dramatic change
on or about the 23 March. This article examines the
possibility that it marks the beginning of the end for
the Fed’s dollar.
At this stage of an evolving economic and financial
crisis, such thoughts are necessarily speculative. But
an imminent banking crisis is now a near certainty, with
most global systemically important banks in a weaker
position than at the time of the Lehman crisis. US
markets appear oblivious to this risk, though the
ratings of G-SIBs in other jurisdictions do reflect
specific banking risks rather than a systemic one at
this stage.
A banking collapse will be a game-changer for financial
markets, and we should then worry that the Fed has bound
the dollar’s future to their fortunes.
The dollar could fail completely by the end of this
year. Against that possibility a reset might be
implemented, perhaps by reintroducing the greenback,
which is not the same as the Fed’s dollar. Any reset is
likely to fail unless the US Government desists from
inflationary financing, which requires a radically
changed mindset, even harder to imagine in a
presidential election year.
Introduction
The most important mistake
economists and financial watchers make is to assume
events and prices tomorrow are simply projections of
those of today. It is the basis of all economic and
financial modelling. Yet despite the hard lessons of
experience economic forecasters persist with their
misleading models.
Nowhere is the failure of linear projection from the
past more important than in the lifeblood common to
everything. While knowing that state-issued currencies
change in their utility over time, almost no one expects
their demise, other perhaps at some point in the far
distant future. But what if this generally linear
expectation is as wrong as all other forecasting models?
What if the response to the current economic crisis is a
more rapid depreciation of currencies? And what happens
if they die altogether? And what are the consequences
for the ordinary person?
This article explores these what-ifs. It examines the
conditions that could lead to this outcome. History
gives us a guide, not through extrapolation, but by
telling us that every recorded currency collapse has
occurred to fiat currencies unbacked by gold or silver.
So, we know it will happen — eventually. Less understood
is that the pattern is always the same: a prolonged
period of falling purchasing power, followed by a sudden
collapse when a currency’s users finally reject it. In
terms of time the latter phase usually lasts
approximately six months.
Assessing the turning point
The early morning of Monday, 23 March was a
significant time, marking the top of the dollar’s
trade-weighted index. At the same time, gold, silver and
copper prices, having fallen in the weeks before turned
sharply higher. And while oil initially followed, it was
a month before it resumed its uptrend — delayed by the
delivery hiatus in the futures markets which briefly
drove the price negative. The S&P 500 rallied the
following day, ending a near 30% decline before
recovering all of it, and then some.
Something had changed. Either markets decided that
economic growth, both in the US and the rest of the
world was going to continue following lockdowns, and
growing demand for key commodities was going to be
resumed. Or, as the decline in the dollar’s TWI
indicated, the purchasing power of the dollar was going
to decline, and commodity prices were reflecting an
accelerating downtrend for the dollar’s purchasing
power.
The performance of the S&P 500 since 23 March, being
unhinged from any business conditions, gives us a clue:
the flood of money emanating from the Fed is fuelling
stock prices. It is also fuelling prices of all other
financial assets.
The turnaround in silver is a more subtle story, shown
in the chart as the reciprocal of the more usual
gold/silver ratio. Silver had been ignored, classed
solely as an industrial metal. Gold was seen by the
financial community as the only metallic hedge against
uncertainty in the financial system. That changed on 23
March when the gold/silver ratio peaked at 125 on the
previous business day. It is now beginning to outperform
gold with the gold/silver ratio currently down to 98. We
might look back and pinpoint this time as marking the
beginning of a return to some moneyness in silver.
The weeks before had seen the Fed ease monetary policy.
On 3 March, the Fed cut its funds rate from 1 ½% to 1%.
In the accompanying announcement the Fed said that the
fundamentals of the economy remained strong, but the
coronavirus posed evolving risks to the economy.
On 15 March, the Fed cut its funds rate again, this time
to zero, but the statement now said the coronavirus had
harmed communities and disrupted economic activity in
many countries, including the US. On a twelve-month
basis, overall price inflation and price increases for
other than food and energy were running at below 2%. The
Fed announced renewed quantitative easing of at least
$500bn of Treasury purchases and $200bn of
mortgage-backed securities “in the coming months”. It
was “prepared to use its full range of tools to support
the flow of credit to households and businesses and
thereby promote its maximum employment and price
stability goals.”
That day the Fed made two other announcements. The first
detailed arrangements for the encouragement of credit
expansion to support both consumers and businesses,
including the reduction of reserve ratios for all banks
to zero. The second concerned the reduction of costs in
drawing down USD swap lines at the other major central
banks. They were followed over the course of the week by
a series of announcements facilitating the availability
of credit.
Clearly, the Fed was engaging the ultimate in aggressive
monetary policies. And taking a phrase from the last
head of the ECB, the Fed had signalled it was prepared
to do whatever it takes without limitation. But the
response in the markets took a week to develop into an
inflection point, a normal pause before a new direction
is found.
Central bank inflation and bank
credit difficulties
Since the Fed is one step removed
from the non-financial economy it relies on commercial
banks to implement its monetary policy. But commercial
banks will only act as the Fed’s agents if they are
confident the rewards are greater than the risks
involved. If the current crisis is simply a matter of
the coronavirus being contained before everything
returns to normal, then bankers might be prepared to
take a punt on an increase of bank lending.
But as time passes, the losses mount. Business and
consumer defaults are increasing, and the prospects for
a rapid recovery appear to be receding. Furthermore,
liquidity strains in the banking system are resurfacing,
despite the massive injections of QE by the Fed. After
subsiding from the panicky days of last September,
overnight repos are on the increase again totalling
anything between $20—$100bn daily.
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It has been generally
forgotten that the global economy was already facing
a recession before the virus lockdowns. Trade wars
between America and China and bank credit expansion
having run for a decade were a repeat of the
conditions that led to the Wall Street Crash in
1929, when the Smoot-Hawley Tariff Act following the
roaring twenties was enacted, bank credit imploded,
and the 1930s depression followed. Similarly, banks
are now highly leveraged on their balance sheets and
fear of bad debts has taken over from lending greed.
The global banking cohort is increasingly desperate
to reduce balance sheet commitments at the same time
as the Fed and other central banks are frantic to
see them expanded.
It is no wonder that the Fed’s expansion has
remained bottled up in financial markets, driving
financial assets even further into dangerous
overvaluation territory. Consequently, without
liquidity flowing more freely into the non-financial
economy, bad debts can only deteriorate further,
with loan risk rapidly increasing for commercial
banks.
Systemic issues are being
ignored
When the coronavirus first became
an economic issue, there were mounting concerns over
payment failures in supply chains. In the US, these
payments are effectively the equivalent of gross output,
which at the end of last year was running at $38
trillion. While we regard gross output as the value of
products as they flow through their production stages,
the payments flow the other way, back down the chains.
Therefore, the $38 trillion figure can be taken as proxy
for the sum of all supply chain payments in the US, to
which must be added the dollar equivalents of supply
chain payments outside the US for semi-manufactured
imports.
Not all supply chains have been completely disrupted, so
the good news is payment disruptions onshore should be
significantly less than $38 trillion but could easily be
half that. But there is likely to be additional
disruption from abroad, a point addressed by the Fed
when it increased the number of central banks (but not
China) having access to its swap lines.
The risks to commercial banks are not so much from the
largest corporations, likely to be bailed out if in
trouble, but from lower tiers of borrowers. This affects
banks with exposure to collateralised loan obligations,
which are bundled loans to companies often unable to
raise funds any other way — today’s version of the
collateralised debt obligations that blew up the banking
system in 2008. Additionally, banks have direct loans
and revolving capital exposure on their balance sheets
with all businesses in the $38 trillion of onshore
supply chains.
The market capitalisation of the US’s G-SIBs — global
systemically important banks — is less than a trillion
dollars. Yet the supply chain failures that they are
expected to backstop are many trillions — multiple times
their market capitalisation, and even of their balance
sheet equity.
It seems hardly possible that the
US banking system will survive the current supply chain
disruption without help. The added bad news is that the
US G-SIBs are rated much more highly in stock markets
than their Chinese, Japanese, Eurozone, Swiss and UK
competitors, shown in Figure 1 above.[i]
It indicates that a systemic failure in
dollar-denominated financial markets is not widely
expected, given the generally higher market ratings
afforded to US G-SIBs than for those in other
jurisdictions. This probably explains why this topic is
not yet a significant issue for dollar investors, though
individual bank failures are more obviously an issue in
other jurisdictions, where some G-SIB price to book
ratios are below 30% while those of US G-SIBs average
93%.
The next significant event therefore will almost
certainly be the failure of a G-SIB, if not in America,
then elsewhere. Given the sheer scale of the problems in
supply chains in all currencies and the accumulating bad
debts attributable to lockdowns it could happen in a
matter of weeks. Presumably, failing banks will be taken
into public ownership with the Fed backstopping it with
yet more inflationary finance. The impact on the Fed’s
balance sheet, which has already grown to over $7
trillion will probably be several times its current
size. But that, on its own, may not be enough to destroy
the dollar.
A more direct danger is posed from monetary policies
aimed at supporting financial asset values. In common
with other major central banks the Fed has become
reliant on a policy of ultra-low interest rates to fund
its government’s deficit. At the same time, there has
been a longstanding belief, particularly in America,
that rising prices for financial assets, chiefly stocks,
have been vital to generate a wealth effect and
therefore maintain public confidence in the economic
outlook. In current markets, this overvaluation policy
has been taken to extremes with even teenagers
reportedly buying fractionalised stocks through
aggregating platforms, such as Robinhood, as if it is a
just another computer game.
The dollar’s inevitable descent
In more normal times the excessive
speculation in the markets seen today would encourage
the Fed to inject some caution into monetary policy; but
the Fed cannot backtrack for fear of triggering a
catastrophic collapse. Consequently, the future of the
dollar has become firmly tied to that of confidence in
financial markets.
With a rapidly escalating budget deficit the US
Government has a growing funding requirement, the cost
of which already absorbs $400bn in interest charges
annually. The Trump administration had increased its
deficit to record levels in the good times when tax
revenue was buoyant. And now the crisis has hit, higher
interest rates will expose the US Government to a debt
trap. This is a weapon the Fed cannot use.
As noted above, the next market shock is likely to be a
systemic failure in the banking system. It matters not
where that occurs, but when it does it makes bank
depositors autarkic. Not only do they withdraw funds
from banks they deem to be at risk thereby increasing
their problems, but they also reduce cross-border
currency exposure. The dollar is most exposed of all
currencies to the latter risk: on last known figures
foreigners owned about $25 trillion in securities,
short-term paper and bank deposits, while Americans held
roughly half that invested mainly in illiquid production
facilities abroad, limited portfolio exposure to listed
securities and with very little liquid foreign currency
exposure.
In our headline chart we noted that the dollar’s turning
point was 23 March and its subsequent downturn was part
of a bigger commodity picture with gold, silver, copper
and — belatedly — oil prices rising. In March, US TIC
data showed that foreigners reduced their dollar
exposure by $227.9bn, only offset by US residents’ net
sales of foreign securities of $133.3bn.[ii]
Here is the evidence that in troubled times money heads
for home. Additionally, that month saw a trade deficit
of $44.4bn suggesting total foreign-related dollar
selling amounted to $177.7bn. This is only part of a
bigger dollar picture, but it does appear foreigners
were reducing their dollar exposure at the time that the
dollar’s TWI peaked on 23 March.
This is important, because there are two market factors
that have always led to a fiat currency collapse. The
first is selling by foreigners, which appears to have
commenced, and in this respect the dollar is
particularly exposed. With some $25 trillion invested in
US securities etc., the potential destruction to the
dollar’s purchasing power from this source is
significant. As global trade shrinks further, not only
will foreigners be driven by the need to redeploy
dollars into their currencies of origin, but they will
stop funding the US Government, choosing to sell down
their US Treasury holdings, a process which has already
started. If the Fed is to successfully fund the growing
budget deficit it must absorb foreign sales of US
Treasuries as well as maintain sufficient levels of QE
to fund a rapidly increasing budget deficit.
Just imagine the consequences of a systemic failure. The
spell cast over financial assets will be broken. First,
investors and speculators are likely to turn their
attention to equities, being obviously the most
overvalued financial assets at a time of intensifying
crisis. Foreign investors will join, selling down their
portfolio exposure, repatriating some, if not all of the
proceeds by selling dollars as well. Next, with a
falling dollar and a growing sensitivity to the
political aspect of the crisis, market participants will
reassess the US Government’s funding requirements and
question the yield suppression policy of the Fed. Dollar
selling seems bound to intensify.
It will then become obvious to everyone that the Fed is
sacrificing the dollar in order to fund the government,
keep the banking system going and to support the economy
by attempting to provide the liquidity to defray supply
chain failures. It will already be demonstrably failing
to support financial asset prices, which has become the
visible manifestation of a successful monetary policy.
It would be a miracle if this failure, in Trump’s
election year with a socialistic president being lined
up by the Democrats, does not lead to a full-blown
financial and dollar crisis.
Unless the Fed can raise interest rates to the point
where it is too expensive for speculators to short the
dollar (which we can rule out), it will enter the second
phase of its collapse, driven by US residents realising
the dollar is losing purchasing power, rather than
prices rising. The purchasing power of any money depends
on the balance between money and goods maintained by its
users. If they collectively reject the money in favour
of goods, then money’s purchasing power declines,
potentially to zero. Following foreign selling, this is
the second phase of the destruction of a fiat currency,
which in past examples have taken roughly six months for
it to become worthless.
There are three factors that could shorten this
timescale even further: the replacement of cash and
cheques by digital payments, modern communications
leading to the rapid spread of information, and as a
consequence of the development of cryptocurrencies,
wider public foreknowledge of the weaknesses of unbacked
fiat currencies.
The case for fiat currency survival beyond 2020
The circumstantial evidence that
the dollar will collapse before the year-end is
mounting. Cassandra opened her casket, the evils
escaped, and only hope remains trapped.
Or so it seems. We cannot divine the future. We can only
sift the evidence, be aware of common fallacies and
avoid the temptation to wrongly extrapolate from
yesterday into the future. While our method may be
better than the macroeconomic forecasting beloved of the
establishment, a predicted outcome is never reality. And
it is possible the US Treasury might attempt a reset,
perhaps using Treasury dollars, otherwise known as
greenbacks, which were last issued in 1971. But without
axing government welfare commitments to the American
public, returning to balanced budgets and abandoning Fed
dollar denominated debt this sort of legerdemain is
unconvincing. Furthermore, the dollar’s reserve role for
other currencies would have to be abandoned because of
the monetary inflation involved in Triffin’s dilemma.
And other currencies tied to the Fed’s dollar held in
their reserves would still face their own collapse.
A reset abandoning the Fed’s dollar in favour of
greenbacks is possible. But history has shown that the
introduction of a replacement currency for one that has
collapsed fails unless government financing by monetary
expansion is demonstrably abandoned. Only time will tell
whether in a presidential election year the US
Government musters the clarity of purpose to implement a
new lasting dollar regime.
The US Treasury says it still has over 8,000 tonnes of
gold. If it is willing to drop its neo-Keynesian
economics and its long-standing denial of gold’s
monetary function, America could reintroduce gold
convertibility for the greenbacks. This would probably
be a last resort. It reneges on the Fed’s balance sheet
note — which in these conditions would be its only
significant asset, involves the abandonment of the
welfare state and America’s longstanding geopolitical
aims, and it allows China to gain potential advantage by
displacing the dollar with a more convincing gold
convertibility of its own.
China has deliberately cornered the gold bullion market
in plans that go back to the time of Deng. Almost
certainly, following the introduction of its
Regulations on the Control of Gold and Silver (1983),
the Chinese state accumulated sufficient gold for its
strategic purposes by the time it then permitted its
citizens to buy gold with the opening of the Shanghai
Gold Exchange in 2002. The gold acquired by the state at
that time is not declared as monetary gold and the
quantity is unknown, but after examining inward
investment flows net of trade deficits in the 1980s and
growing export surpluses subsequently, a ten per cent
allocation of foreign exchange gained into gold at
contemporary prices suggests a position of some 20,000
tonnes of bullion was likely to have been accumulated by
2002.
There is no way of establishing the facts, and therefore
statements about the Chinese state’s ownership of
bullion are necessarily speculative. But additional
evidence is compelling:
• China is now the largest gold mining nation by far,
extracting an estimated 4,200 tonnes since 2010, more
than any other nation. This has been driven by
government policy.
• The state controls all Chinese gold and silver
refining, taking in doré from abroad to add to Chinese
stocks. At the same time, virtually no Chinese refined
gold kilo bars are permitted to leave the country.
• In 2002, when the Shanghai Gold Exchange was set up by
the Peoples’ Bank of China the Chinese government
encouraged its nationals to acquire physical gold, even
advertising its attractions in state media. Since 2010
alone, 17,200 tonnes have been delivered into public
hands by the SGE. These figures were achieved by
importing bullion from the West in enormous quantities.
• Its allies in Asia, principally members of the
Shanghai Cooperation Organisation, have also been
acquiring gold. Russia has been particularly aggressive
in dumping dollars for gold.
• China now dominates physical gold markets and can be
said to control them.
Given all these verifiable facts,
it seems unlikely that a state which centrally plans
would not have acquired for its own use substantial
quantities of bullion ahead of the establishment of the
SGE. America knows it and continues to resist gold
having a monetary role. If America’s anti-gold policy
changed, it would restrict the dollar’s circulation
abroad. It would mark the end of dollar hegemony and a
gold-backed yuan would become the foreign currency of
choice throughout Asia, eastern Europe, the Middle East
and Africa.
Conclusions and consequences
A banking crisis in the coming
weeks is an increasingly likely event, given the scale
of disruption to supply chains. The escalation of
bankruptcies and of non-performing loans worldwide will
almost certainly take the banking system down. It will
be a watershed, a wake-up call to all those who expect a
return to normality after the coronavirus passes.
For the moment, central banks are throwing money at the
problem; money which remains stuck in financial assets,
inflating them even further, and not being transmitted
to the non-financial economy by banks already
over-leveraged to failing borrowers.
We can be certain central bankers and government
treasury departments are only now grasping the enormity
of these problems, but they are still behaving as if
chucking money at them is a viable solution. They will
only destroy their unbacked fiat currencies, and that
destruction, starting with the dollar, is already in
progress. The clock is ticking from 23 March. While
there may be attempts at a fiat money reset, without
clear legal commitments from central banks and treasury
departments to end inflationary financing, any reset
will only delay currency destruction by a matter of
months.
The consequences of such an outcome are always
devastating, the more so because all major westernised
central banks are committed to the same inflationary
policies at the same time. The political consequences do
not bear thinking about.
At some stage, hopefully sooner rather than later,
metallic money will regain circulation. And when prices
are set in gold or silver, perhaps through fully backed
substitutes, the stability they bring will end the
trappings of fiat currencies. All this destruction is
measured in current terms, nearly all from statistics
collected by the Bank for International Settlements.
Gone will be worldwide fiat currency debt, amounting to
some $250—$300 trillion. Gone will be all OTC
derivatives which settle in fiat, amounting to a further
$560 trillion. Gone will be listed derivatives, a
further $33 trillion. Gone will be options, a further
$65 trillion. All these, totalling over $900 trillion,
are only part of the destruction.
Global deposits held as bank balances totalling $60
trillion will evaporate. Worldwide equity markets
denominated in fiat are a further $70 trillion; anything
that does not migrate from fiat pricing disappears,
including most, if not all ETFs. Goodbye to hedge funds.
Goodbye to offshore financial centres. Goodbye to
onshore financial centres. Goodbye to $100 trillion of
fiat money.
Life will be very different, and those not prepared for
it, principally by retaining a store of non-fiat, sound
money, which can only be physical gold and silver until
credible substitutes arise, will face impoverishment.
Measured in real money, the value of non-financial
physical assets will collapse due to the preponderance
of desperate sellers to whom survival is most important,
even though priced in worthless fiat their prices will
have risen. The experience of inflationary collapses in
Germany and Austria in the early 1920s showed the way,
when country estates went for almost nothing in
gold-back dollars and $100 would buy a mansion in
Berlin.
None of this is expected. It may not happen, but the
chances of it happening appear to have increased
significantly from 23 March.
- "Source"
-
Notes
[i] Thanks go to Professor Kevin Dowd for help
in preparing the table in Figure 1.
[ii]
https://home.treasury.gov/news/press-releases/sm1009
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