Be Careful What You Wish For

In what I found to be a most interesting article, Jared Bernstein, a former Obama and Joe Biden economic adviser, wrote an op-ed in the New York Times advocating the removal of the U.S. dollar as the world’s reserve currency.

He claims that the balance of payment deficit engendered by the dollar’s reserve status is costing the U.S. jobs. These job losses are the result of foreign demand to hold the reserve currency, pushing the dollar too high relative to other currencies making production in the U.S. too costly. He reckons that the downside of losing reserve status for the dollar would be an increase of just 1% in the CPI rate of inflation.  This, he thought, would be an acceptable, low cost, trade off.

As someone who thinks that the U.S. would experience acute pain from seeing the dollar lose its reserve status, I thought that I should attempt to explain why I feel this way.

Let me start by referencing another article that I found to be most fascinating over at Mises.org.

Dante Bayona referenced an old tale about Salvador Dali:

There is a story about the great Catalan surrealist painter Salvador Dali. It is said that in the last years of his life, when he was already famous, he signed checks knowing that they would not be submitted to the bank for payment. Rather, after partying with his friends and consuming the most expensive items the restaurants had to offer, he would ask for the bill, pull out one of his checks, write the amount, and sign it. Before handing over the check, he quickly turned it around, made a drawing on the back and autographed it. Dali knew the owner of the restaurant would not cash the check but keep it,put it in a frame, and display it in the most prominent place in the restaurant: “An original Dali.”

It was a good deal for Dali: his checks never came back to the bank to be cashed, and he still enjoyed great banquets with all of his friends. Dali had a magic checkbook.

But what would have happened if one day art collectors concluded that Dali’s work really did not capture the essence of surrealism, and therefore that his art was not of great value? If that had happened, every autographed check would have come back to the bank (at least in theory), and Dali would have had to pay up. If Dali had not saved enough money, he would have had to find a job painting houses.

Bayona, in using this story, is  warning that the U.S. has been writing an excessive number of checks that it clearly believes will never be cashed. As long as the dollar remains the world’s reserve currency those dollar-based IOUs held overseas will remain there, uncashed.

But just what would happen if the dollar lost its reserve status and those checks had to be honored? I propose that we look at a similar situation that played out for the U.S. between the end of WW II and, roughly, 1980.

By way of quick background, in 1944 the world agreed to adopt the Bretton-Woods monetary system. Everyone agreed that both dollars and gold would be counted as reserves. The U.S., at the time possessing something on the order of 70% of the world’s monetary gold, would see its currency and IOUs held by foreigners, counted as official reserves. The U.S. also promised to honor a gold exchange ratio for foreigners of $35/oz. and currency ratios would all be fixed.

The one thing that no one counted on at Bretton-Woods was the idea that the U.S. could start to run balance of payment deficits. After all, the U.S. was going to emerge from WW II as the economic colossus of the globe. It was impossible to imagine the U.S. as an emerging debtor, but that is exactly what happened.

                          U.S.                                        U.S.

            Short Term Liabilities              Gold Stock

Year           to Foreigners            @$35/Oz.        Tonnes

1955             $11,895                    $21,753           19,331

1960             $18,701                    $17,804           15,822

1965             $25,551                    $13,806           12,268

1968             $31,717                    $10,892             9,679

1971 *          $55,417                    $10,206             9,069

1974 *          $95,000                    $11,803            10,489

($ in millions)

*      Bretton-Woods gold conversion was abandoned in 1968 and gold was then no longer fixed at $35/oz.

Source: The War on Gold, Anthony Sutton, 1977

As we can see above, the U.S. had managed to accumulate debts to foreigners of $18.7 billion by 1960, and this was after settling a further $3.5 billion in foreign claims by shipping 3,500 tonnes of gold overseas. That is, dollars were starting to flow back towards the U.S. The checks that the U.S. had written, never expecting them to be cashed, were being presented for payment.

The problem was that by 1960, the U.S. no longer had enough gold, if valued at $35/oz., to settle its debts to foreigners. The U.S. either had to revalue gold higher (a default), continue to ship gold overseas or adjust its economy so that is ceased allowing excessive money and credit growth so that the gold outflow was stemmed.

For a time, until 1968, the U.S. chose to stay the course, to continue to allow excessive money and credit growth and to cap the gold price at $35.

Foreigners during this period continued to send dollars back to the U.S. in exchange for gold even as dollar claims to foreigners continued to explode due to easy money policies in the U.S.

By 1968 it was clear to the U.S. that they were about to lose all of their gold and they defaulted on their obligations, refusing to honor the $35/oz. pledge of Bretton-Woods. By 1971, the fixed currency portion of Bretton-Woods was also ended, burying the Bretton-Woods system forever.

In 1960, the first year where U.S. obligations to foreigners exceeded its gold holdings, the U.S. GDP figure was $543 billion. The foreign obligations of the U.S. then amounted to just 3.4% of GDP. This was enough to destroy the monetary system of the day.

By 1974, with inflation picking up, U.S. GDP had nearly tripled to $1,548 billion and foreign liabilities had jumped to 6.1% of GDP.

Between 1955 and the end of the U.S. honoring its $35/oz. gold obligation, foreigners sent back well over $11 billion dollars to the U.S., and this clearly intensified inflationary pressures in the U.S.

In the following graph we can see that post WW II the velocity of money in the economy started to accelerate, particularly after 1955:

Part of the increase was initially driven by a normalization of the economy following the war, but the acceleration in velocity was increasingly driven, in my opinion, by the loss of confidence in the dollar's reserve status.

 As the dollar started to lose its reserve currency status and dollars that were expected to remain overseas permanently flowed back to the U.S., CPI inflation picked up dramatically as a consequence of the increase in velocity. From a sub 2% rate in the late 1950s, CPI inflation was over 6% by 1969 before completely exploding in the 1970s.

My point is that foreign obligations of somewhere between 3-6% of GDP created, in the end, massive CPI inflationary problems as many of the dollars flowed back to the U.S. Faith, of course, wasn’t just lost by foreigners, it merely kick started the process of a loss of confidence in the dollar inside the U.S. as well, forcing velocity and CPI inflation much higher.

I would stress that the imbalances of the Bretton-Woods period pale in comparison to the imbalances created by the reckless monetary policies of the Fed and other central banks of the past couple of decades.

The IMF’s Composition of Foreign Exchange report (COFER) alone details nearly  $12 trillion of foreign exchange reserves held by global monetary authorities. Perhaps 60% of this is held in U.S. dollars, roughly $7 trillion. This amounts to 40% of current GDP for the U.S. The Fed’s balance sheet now stands at 26% of GDP. These numbers dwarf the imbalances that kicked off a flow of overseas dollars back to the U.S. under Bretton-Woods, resulting in the start of CPI inflation in the 1960s.

More importantly, Russia and China appear to have been forced by U.S. actions in the form of inconsequential returns on their dollar based holdings and interference in their historical spheres of influence to push for a removal of the dollar from center of the global economy. This just may give Mr. Bernstein his wish, the removal of the dollar as the world’s reserve currency.

Unfortunately, unlike Salvador Dali’s experience, the checks that the U.S. has written over the years, checks they expected to never see cashed due to the dollar’s reserve status, will come home again. The result should be massively higher CPI inflation. Dali actually provided those who took his checks with something of great value in the form of his art. The U.S. cannot say the same as its current rate of savings and growth in output cannot hope to cover the number of checks it has been writing.

It won’t be pleasant as it happens, but such an outcome is a necessary precursor to returning to sustainable growth.

Disclaimer: Nothing on this site should be construed as investment advice. It is all merely the opinion of the author.

Tiger by the Tail

Ben Hunt of Salient Partners recently wrote:

I spent the past week in Switzerland, meeting with old friends and making some new ones, and just like my recent travels in the US there was one overwhelming sentiment. No one doubts the omnipotence of central banks. No one doubts that market outcomes are fully determined by central bank policy. No one doubts that central banks are large and in charge. No one doubts that central banks can and will inflate financial asset prices. And everyone hates it.

Among those investors and allocators with the freedom to flee public markets, the interest in private market opportunities has never been greater. Among those investors and allocators trapped by mandate diktat in the Alice in Wonderland world of public markets, the resigned desperation has never been worse. It’s a quiet desperation in Zurich – a Teutonic stare at the floor and a wrinkling of the mouth – more obvious in Geneva with a Gallic shrug and a full-faced grimace. But’s it’s all the same emotional response to the Bizarro markets in this, the Golden Age of the Central Banker.

At this point in time, the dominant investment belief of our time is that central bankers are omnipotent and no one wants to fight them. The direction of markets is up, as ridiculous as this seems to every sentient being. Portfolio managers may not be happy about all of this as Mr. Hunt points out, but they will not fight it.  They will play the game and be fully invested.

I am quite sure that fund managers don’t understand the true implications of the omnipotent central banker meme, both for society and for themselves.

As far as society is concerned, central bankers have been able to pin interest rates at ridiculously low levels causing a collapse in the savings rate. Below, we can see that net savings in the U.S. has collapsed over the decades following the end of the Bretton-Woods monetary system and a move to pure fiat that central banks can create from thin air:

As we can see, net savings has averaged about 1% of gross national income for a decade. This is a negative savings rate in real terms. There is no way for a society to grow and become wealthier without savings and investment.
This lack of savings is certainly impacting capital spending. We can see from the following graph of industrial and construction capital spending from Goldman Sachs (via Zerohedge) that capital spending is going nowhere fast and is certainly declining in real terms in the U.S., Europe and 
Japan:



   
In short, corporate capital allocators have given up trying to grow their businesses. They are now starting to liquidate their firms because interest rates near zero limit their returns on investment to zero as well. Better to return the capital to shareholders and be done with it. Corporate America is now returning about 4% of the current equity market capitalization to shareholders in the form of share buybacks and dividends each year, and borrowing very heavily to do so.

If I were a professional fund manager I might look at this situation and assume that this is very bad for my profession. It is, after all, tough to be a professional capital allocator if the corporate world is giving up on capital allocation and returning the money to shareholders so that it can be consumed.

Nevertheless, I see some pretty stupid commentary from professional fund managers extolling the wonderful opportunity that we have to buy shares at these levels.  Morgan Stanley strategist Adam Parker even posits that the S&P 5oo could rally another 50% by 2020. All that this requires is a 6% year growth rate in earnings and a 17x P/E multiple in that year to make it so. Well, these companies are telling you that they are going to shrink in real terms if their capital spending plans are any indication. Additionally, if they continue to grow earnings it will be below the operating line and solely a function of financial arbitrage. No one should be dumb enough to pay 17x earnings for shrinking companies in liquidation mode. I wish Mr. Posen’s clients luck in their share buying endeavor. They will certainly need it.

Yes, the primary investment meme of our day is one of central bank omnipotence and that nothing can stop the march of rising asset prices. The cynicism drips heavily from my keyboard now as I am convinced that not only are the world’s central bankers not omnipotent, but they are nothing but a bumbling group of fools who have a tiger by the tail.

Central bank interest rate decisions of the past 15 years have created a situation where societal capital is liquidating itself while asset prices have been forced to levels that predict growth as far as they eye can see. They have created an environment ripe for a disaster.

Disclaimer: Nothing on this site should be construed as investment advice. It is all merely the opinion of the author.

Savings

Andy Lees in his very insightful Macro Strategy Partnership newsletter points out that Norway is having a little trouble making budgetary ends meet and will have to clip a little capital from the its oil industry:

Local currency non-oil tax income will no longer cover budget spending, forcing the government to dip into its oil and gas revenues. These revenues are in dollars, and some will have to be switched into crowns. “The taxes in Norwegian crowns will not be sufficient to cover the spending of petroleum reserves”.

Norway has been quite fortunate, they are a small country in terms of population with a very large oil and gas industry. Their ability to produce more than they have consumed has allowed them to pile up quite a large amount of net savings in the form of exported oil and gas. This appears to be changing.

While North Sea production has been falling for some time, I still think that this little anecdote reveals quite a bit about the financial system in the West. Savings rates are now very punk in the West and, as a consequence, capital investment is stagnant. This lack of capital formation is also crushing growth rates, employment and wage growth.

Overnight bank lending rates went negative recently in Europe for the first time. German Bund yields are negative out to four years now. Italian ten-year bond yields are now lower than those on ten year Treasury paper at around 2.35%. Of course, the level of savings is crashing as interest rates are pushed to an artificially low level. There is no longer any incentive to save in the West.

As these low rates destroy the incentive to create fresh capital via savings, real growth rates will shrink. When you force the system to consume its own seed corn, growth rates will suffer. In Norway, even booming asset prices and an oil price that has quintupled in the past 15 years aren’t generating sufficient economic growth and tax revenues to allow the system to build up its oil related savings any longer.

In the US, the net savings rate has averaged about 1% of GDP for the past decade and has run at just 2% year-to-date. This compares to about a 10% net savings rate in the 1950s and 1960s when real growth rates averaged 4%. The savings rate has continued to sink, pretty much in a straight line, ever since the US abandoned Bretton-Woods and the link to gold and the result has been a real growth rate of sub 2% for a decade now. 

Central bank interest rate policy is having an effect, but not the one intended.  Interest rate cuts were supposed to stimulate growth. Animal consumptive and investment spirits just needed a little push to get moving after the collapse of 2008, or so our Keynesian policy makers thought. Push rates down and watch the recovery blossom was their mantra. Unfortunately, the opposite is now occurring as consumption relative to savings is now very high, inhibiting a recovery in global growth, not an outcome the Keynesians would have thought possible.

Instead, the Austrian Business Cycle Theory seems to be offering the world a different, and more accurate, lens through which to view secular economic trends. Artificially drive rates down and you drive down capital formation and the attendant real rate of growth and real wealth creation.

Growth will not come roaring back until the previous malinvestment has been cleared from the system and interest rates are allowed to normalize so that the supply and demand for savings can meet. Present policies engender a lack of savings and capital formation as well as inflation in asset prices that is unjustified given the lack of savings and real growth to back them up. These interest rate policies also serve to lower employment and real wages. Without more capital in back of them, employees cannot become more productive and cannot see their wages increase. 

The world’s biggest savers, those in Asia, also appear to be less interested in saving in terms of Western fiat currencies. Also, as shown by the Norwegian example, when push comes to shove, with interest rates down at these levels the Chinese will, in my opinion, sell down their hoard of dollars and euros and consume. After all, why hold on to negative yielding paper?

The world is also very complacent about the threat of CPI inflation, but we may be very close to that point in time when the demand to hold the infinite amounts of non yielding paper that central bankers have created flips and becomes a desire to consume widgets before the next guy with a stack of Fed bucks beats you to it and drives the widget price into the stratosphere.

CPI inflation seems to me to be like the stored force behind a dam. Keynesian central bank policies have created a dam that is structurally unsound and ready to break.  More worrisome is the notion that central bankers around the world still seem intent on continually putting more proverbial water behind the dam and increasing the stored force there in the form of higher and higher asset prices. Time to move to higher ground.

Disclaimer: Nothing on this site should be construed as investment advice. It is all merely the opinion of the author.

Velocity

Sometimes you read something and think, only a Fed economist could come up with something that ridiculous. This paper put out by the Federal Reserve of St. Louis postulates that money hoarding is causing the velocity of money to collapse in the US economy.

In the paper they utilize the quantity theory of money equation as follows:

MV = PQ

In this equation:

• M stands for money.
• V stands for the velocity of money (or the rate at which people spend money).
• P stands for the general price level.
• Q stands for the quantity of goods and services produced.

Based on this equation, holding the money velocity constant, if the money supply (M) increases at a faster rate than real economic output (Q), the price level (P) must increase to make up the difference. According to this view, inflation in the U.S. should have been about 31 percent per year between 2008 and 2013, when the money supply grew at an average pace of 33 percent per year and output grew at an average pace just below 2 percent. Why, then, has inflation remained persistently low (below 2 percent) during this period?

Declining Velocity

The issue has to do with the velocity of money, which has never been constant, as can be seen in the figure below . If for some reason the money velocity declines rapidly during an expansionary monetary policy period, it can offset the increase in money supply and even lead to deflation instead of inflation.

They perform some algebra and show that Velocity equals nominal GDP/monetary base. Over time, this number has been falling. In their estimation, the recent gargantuan growth in the monetary base should have produced inflation. In their world, it has not. Their conclusion, people are hoarding money.

Ridiculous.

Nobody is hoarding money. These Fed economists think inflation is low because they are looking in the wrong place. We have phenomenal levels of inflation in the securities markets and in real estate. Household net worth is exploding, up nearly $10 trillion last year alone. Velocity in the financial markets is rocketing higher and there is clearly a race on to spend “money” as fast as possible.

Monetary debasement is creating copious amounts of inflation and a surging rate of velocity, or turnover of the monetary base, that only a Fed economist could miss. Of course, all of this inflation, unbacked by savings or incremental output, is the Austrian definition of malinvestment and wealth destruction. This is something missed by everyone at the Fed as well. 

 Disclaimer: Nothing on this site should be construed as investment advice. It is all merely the opinion of the author.

East is East and West is West

In my most recent post I recounted the story of John Law, the 18^th century central banker that set out to save France via a scheme that involved paper money and a stock market bubble, but that wound up in an inevitable state of collapse.

One of the more interesting aspects of that period was how Law acted as the bubble inflated. As the apparent wealth and power of France rose with the overvalued share price of the Mississippi Company, Law became more jingoistic and threatening toward France’s two major rivals, Britain and Holland.

Financial bubbles mislead not only investors into believing that they have far more wealth, power and influence than they actually do, but politicians as well.  And for politicians, power not utilized is power wasted.

As the US and the West seem to be on an apparent collision course with Russia over Ukraine, I can’t help but notice that today’s politicians in the West seem to be behaving as badly as did John Law with regard to threatening other countries. I will argue that while the causes of this current bellicosity may be many, the financial bubble in the West is surely one of the main drivers.

The West just flat out believes that its financial power and influence is so great that its wishes and demands cannot be refused by other nations. Russia must bend or be financially destroyed by sanctions, or worse. China, with their actions in the South China Sea also appears to be on Washington’s naughty list and they will certainly be targeted next. To the Austrian oriented analyst however, much of the West’s economic power is nothing but a mirage as decades of malinvestment fostered by central bank interference with market interest rates has created an economy that is far weaker and more vulnerable than most believe. 2008 was not a one-off event.

Here is where the tale gets interesting; Russia and China appear to have no interest in backing down, perhaps due to an understanding of the West’s inherent economic weakness.

As I recounted with the John Law story, the dissonant voice during bubbles gets silenced. In Law’s day, the primary loser was Britain’s ambassador to France, the Earl of Stair.

Stair saw through the smoke and mirrors of Law’s scheme and said so. British politicians thought it unwise to antagonize someone as powerful as Law and Stair was sacked.

Being right doesn’t help much in these instances, at least in the short term. Things are no different today. Reason and logic always take a back seat to fashion during a bubble, at least here in the West. While freedom of speech (generally) exists in the West, it can be powerfully silenced by fashion. Today, what is fashionable is to claim faith in the bubble.

While the West often clings to the fashionable, those in the East have learned a different lesson that they may be applying here. The lesson that Russia has learned from history is that when challenged by the Western powers you should give ground to your enemies until he is hopelessly overextended. Then you can counterattack and defeat them. This worked on Napoleon and Hitler.

Napoleon actually made it all the way to Moscow and captured what was then nothing but a burned out shell of a city. He was left there starving with his troops through a bleak Russian winter. He left France with 500,000 men under his command and returned with but 25,000. The Germans fared no better in WW II.

Today, infinite dollar creation has made the US supremely vulnerable to a dollar-selling counterattack.

The questions before us then are: Does Russia understand just how vulnerable the West has made itself economically via nearly infinite fiat money and credit creation? Are they willing to play the dollar card as a way to reduce the West’s ability to interfere in their traditional spheres of influence? Is China willing to go along with Russia here, recognizing that the West’s wrath will soon be directed its way?

While the following story appears to have been denied by Russia and China, Hank Paulson, US Treasury secretary in 2008, claims that China said that Russia had approached it about dumping US bonds during the crisis.

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=afbSjYv3v814

Perhaps Paulson was just looking to burnish his reputation as an economic firefighter, or perhaps the story is true, either way, it does highlight the very real potential for economic calamity should these two act in concert against the dollar.

To this analyst, the US appears to be acting in a fashion similar to that of John Law nearly three centuries ago during another financial bubble. Russia and China do not appear to be too afraid, however. Perhaps this is because they believe that they hold the ultimate card in this game of poker with the potential to create a dollar crisis.

Unfortunately, the US, clinging to the mirage of infinite economic power that has been engendered by the financial bubble has made itself acutely vulnerable here. What is worse, Washington’s actions towards Russia and China just may force these two powers to pull the pin on the dollar hand grenade.

Disclaimer: Nothing on this site should be construed as investment advice. It is all merely the opinion of the author.