Note: Forgive the absence last week. It was an extended birthday week-off. :)
My last post on Peter Zeihan explained how, post World War Two, the U.S. when setting up the global trading system made economic sacrifices in exchange for global security guarantees against the Russians.
Economic sacrifices? Isn’t free trade good for all people all the time? This is what I learned in school. Zeihan didn’t specify what economic sacrifices the U.S. was making, so I was confused about this….until I discovered Lyn Alden, Luke Gronen, and Brent Johnson, who I hosted on Clubhouse for a discussion on the topic the other week.
The punchline of their argument is that it looks like it’s inevitable that we’ll devalue the U.S. dollar and experience inflation in the next few years.
First, some history to set up the argument:
Post WWII, The U.S. signed the Bretton Woods Agreement which made us the first ever Global Reserve Currency (GRC).
The way it worked was that the U.S. backed the dollar with gold, and other countries pegged their currencies to ours. We held gold for others and acted as a creditor nation to others — our currency had value because there was something backing it.
This worked for over a decade until our gold reserves started to shrink, and people began to doubt the dollar’s power as the global reserve currency (GRC).
In 1971, as a result of all this, we moved to “The Petro Dollar system,” where we replaced gold backing with oil backing and made the dollar as good as gold for oil.
The arrangements with other countries were simple: They sent us stuff, we sent them money, they took the money and bought U.S. treasuries — which enabled more purchases of their stuff.
From 1973-2003, this arrangement worked well. Unable to maintain gold backing in the previous system, policymakers managed to give order to an all-fiat system.
But then it stopped working, as other countries stopped buying U.S. Treasuries while our trade deficits continued to rise even faster.
What changed? In 2008, the U.S. proved that it would going to print however much money it needed to take care of its interests first, everyone else be damned. In contrast to how Paul Volcker handled it a few decades earlier, this was a loss of confidence globally—it’s hard for other countries to rely on a currency that will inflate as needed.
This has only gotten worse in 2008, and other countries are refusing to foot the bill. The U.S. government increased its debt levels by $4.6 trillion from 2015 through 2019, but foreigners only bought $700 billion of that, and almost all was by private investors during a brief period in 2019. The pandemic only exacerbated everything of course, as almost a quarter of all money ever printed was printed in 2020.
We could have seen this debt spiral coming, as it’s an inevitable part of being the GRC. The “Triffin Dilemma” explains that the outcome of the GRC is a persistent demand for dollars which means there will be perpetual trade deficits to service the dollar supply. This results in a stronger U.S. dollar which means more importing power and less exporting power. Less exporting power means a hollowed out manufacturing & industrial base as it can no longer compete with other countries who are deliberately weakening their currency to increase their exporting power.
Indeed, the GRC incentivizes mercantilism. Various trade partners will want to maximize their exports and minimize their imports by manipulating their currencies to weak levels. As a result, the U.S is left fronting the bill with persistent trade deficits, and the petrodollar reinforces itself.
This is why the U.S., the most powerful country in the world, is begging China for face masks and ventilators — because we don't make them on our own anymore. Manufacturing in the 1970s was nearly 30% of U.S. GDP, and now it’s 11%. And industrial at large is 19% of U.S. GDP while the world average is 30%.
To be sure, there are advantages of being the GRC too, namely a higher standard of living and military dominance because you can print your own currency to buy commodities and other imports while other countries can't.
But the downsides are real: trade deficits don't last forever, and debt builds up until it becomes unmanageable. A strong dollar while running trade deficits may have elevated our standard of living, but has also shifted our supply chains overseas.
If we think about business cycles, debt accumulates until a recession, which forces deleveraging, and then debt accumulates again upon recovery. This is the short-term business cycle. But since the debt/GDP ratio doesn't get back to previous levels, interest rates fall to 0, then comes quantitative easing, and then more fiscal policy. At some point, you start to run out of ways to deleverage. That is the long-term business cycle.
This puts us in a position to have an inflationary outcome and possibly a currency devaluation, which often go hand in hand.
Low interest rates mean you can have a high debt/GDP ratio while still paying interest on that debt. But high debt levels create systemic economic fragility, to the point where mass-insolvency becomes a national security issue — a perfect example being the bankruptcy of small businesses during Covid.
It seems the only way out of this is via inflation: whenever sovereign debt to GDP has reached over 130%, 51 out of 52 times that debt was not paid back in real terms, meaning there was inflation.
Indeed: the only way to solve the debt problem is to print money, which undermines faith in our currency, and that’s why other countries haven’t been buying U.S treasuries anymore, which exacerbates the problem.
In other words, while there is significant foreign demand for dollars (especially to service the aforementioned dollar-denominated debts), there is not a big foreign demand for Treasuries, which is a problem considering our ever-increasing debt/GDP ratio.
Another problem is the lack of U.S. dollars in circulation. While we used to produce 40% of global GDP, we're now closer to ~15-20%. As China became the world's largest commodity importer, it made less sense to price goods in dollars, and as this shift towards decentralization continues—according to Alden and Gromen—we'll likely move to a multi-polar currency world where no country has a big enough money supply to be the GRC. Although the dollar will likely remain the biggest currency, it will play a smaller role in global trade. Remember, before WWII there was no GRC, so this GRC monetary regime has been anomalous in history.
On this topic, Luke Gromen thinks it's in the US's best interest to stop being the GRC, while Brent Johnson thinks the opposite. Luke says China is using the Euro Dollar system against us — they're borrowing our currency and lending it out at a spread to emerging markets. This, of course, increases China's economic and geopolitical influence, and getting dollars back helps their case. When the dollar gets too strong, emerging markets feel the pressure and either (a) default (in which case China gets hard asset collateral) or (b) the Fed comes in and gives everyone lines of credit — except for China. Since China is a creditor, the dollars end up in their pocket anyway.
So we're facing this period of de-dollarization — the behavior in which countries only trade in their native currency (ie. limiting their use of the U.S. dollar as the GRC). Rather than burning down foreign exchange reserves and devaluing their currency, other countries have shown a willingness to de-peg earlier on and take the inflationary pain to their economies.
It seems like the U.S. wants to have its cake and eat it too: they want to have a global reserve currency and weaponize the dollar, but they also want to bring jobs home and try to bring supply chains home.
But these two goals may be generally mutually exclusive.
In the 1980s, our middle class spent half their paycheck on essentials, but these days they can't even afford the bare necessities. Incomes failed to keep pace with the growth of essential goods.
But someone's supposed to buy the treasuries, and pensions aren't growing. So what do you do? The Federal Reserve basically just prints dollars to buy treasuries so they can shift to debt monetization, for lack of available buyers.
The main difference between the 2008 crisis, for example, and now is that this is no longer a private debt bubble, it's a public (sovereign) debt bubble — and monetary policy has run out of ammo. We need a new sugar daddy.
So the “endgame” for the current high-debt environment will likely involve a combination of high fiscal deficit spending (monetized by central banks), cash and Treasury yields held below the inflation rate, a trend shift from disinflation to inflation, and, subsequently, currency devaluation.
We’ve seen two dollar spikes in history: in 1980 Paul Volcker hiked up interest rates to double digits to stabilize the dollar and force deflation. Then the Plaza Accord was signed in 85 to devalue the dollar relative to the Yen and German Deutsche Mark.
This worked because debts were very low, so we could ramp up the interest rates without pain. But, in turn, these actions contributed to the Latin American debt crisis: emerging markets in Latin America were unable to pay dollar-denominated debts back, resulting in defaults, recessions, and currency crises.
Then there was a second dollar spike in the 90s during the tech bubble, and the same thing happened with South Asia and Russia.
This brings us to the present, where again we're seeing the highest debt-to-GDP ratio since World War II. Once there is a sufficient supply of dollars for those debts, the dollar’s value will likely decrease, just like the previous two dollar spikes.
Alden’s view is that this third dollar spike ends when the Federal Reserve expands its monetary base by trillions of dollars to fund U.S. government deficits over the next several years, for lack of sufficient foreign/private buying of that debt.
The federal debt of the United States is increasing by over $1 trillion per year, and any amount of this new debt that isn't purchased by foreign and private investors would need to be monetized by the Federal Reserve, meaning a greater supply of dollars.
This of course is an argument for hard assets. Bitcoin, Gold, etc—these commodities are products that derive their value from not changing. The same features that make poor tech products which is a strange concept in a tech world of constant iterations
Anyway. So that’s why we’ll have to devalue our currency over time—to inflate our debts away. Read Alden to learn more.
Read of the week: Chris Dixon on NFTs
Watch of the week: Perfection. I’ve seen this parody movie trailer too many times and I can’t stop laughing.
Listen of the week: Larry Summers with Bill Kristol
Until next week,