In this post I want to mention the problem behind the American currency and its difficult problem that requires an analysis from various points of view. In part 1, I refer to the current situation from an economic theory point of view and in part 2 I will explain the current dollar predicament.
Part 1: The Austrian Vision
The Austrian school of economics is a branch of economics not very appreciated by Keynesian’s, Friedman’s Chicago boys and their nemesis, the Marxist school. Its called Austrian because its concepts were laid out in the university of Vienna in the late 19th century, but its development was mainly in the United States in the 20th century thanks to Austrian exiles from World War 2. The most know names of the Austrian school are:
- Carl Menger
- Eugen Bohm Bawerk
- Friedrich Hayek
- Ludwing Von Mises
- Murray Rothbard
Without further details on the school, their most important concept is that “the market is a process of human interaction”.
The market moves between phases of equilibrium and disequilibrium, and it is in this process that humans look for lucrative opportunities. Before advancing further, it is important to state that this concept is not about capitalism or liberal economics. The concept is as old as commerce, and commerce was the expansive force of civilization. In layman’s terms: to take advantage of a situation, a product or someone.
For example, the classical commercial example would be buying merchandise in an economical place and selling it at a more expensive location for a better price.
When we move the example to capital and capital formation, the concept would be:
Where do I assign my saved capital? That question is the basis of capitalism.
Should I spend it now and enjoy it, or should I invest it so that I can enjoy it in another moment?
Capital grows when the second road is chosen. It is a longer road and instead of taking my profits, I reinvest them to assure the expansion and existence of my business or someone else’s business therefore delaying gratification in exchange for more capital in the future. Capital formation is not a regular process, it is a process similar to the growth of a tree, where the inner rings tell a story of good and bad years. So is capital growth, the sum of good and bad years.
The history of humanity is a cycle of booms and busts, also known as the normal business cycle.
The cycle gets interrupted
To this natural cycle of human interactions, a distortion is added. This distortion is the role of central banks in manipulating the offer and the demand of the cost of money (interest rates). Let’s not forget that central banks are recent inventions in humanity’s long story. The Federal Reserve was created in 1913.
The FED’s interventions begin to change the business cycle, and the role of central banks as a bank of banks, a clearinghouse and a facility for printing paper bills and forging coins got lost. Since 1987 after the back Monday stock crash, Alan Greenspan declared publicly that the FED will act as a source of liquidity and support for the financial and economic system. These declarations have been known since then as the Greenspan Put and in reality, mean that the FED will not let asset prices go down. This declaration is the beginning of our world of massive bubbles and explosive market crashes.
The Greenspan Put basically creates a culture of instant gratification, where like a two-year-old toddler, if the gratification does not occur, the market goes in to a tantrum. This short-term culture makes trading a more attractive business than long term capital growth and investment and it showed the world that short-term beat long term, contrary to all capital growth theories.
The Greenspan Put declaration was repeated in:
- Tech bubble of 2001
- Subprime crisis of 2008
- Demand and offer shock of COVID-19 in 2020
- In April 2020, the worst economic indicators since the great depression came out, with 30 million unemployed persons, and still the S&P 500 Index keeps rising, not as a result that companies are doing great but that the FED acts as buyer of last resort always and will not let asset prices (stock prices) fall.
The Greenspan Put addiction
There is no more need of fundamental P/E ratio analysis
Technical analysis with its curious geometry does not say anything
All market momentum is based of the FED’s promise that it will print the money necessary to sustain markets. The Greenspan Put became an addiction.
The “market process” as the Austrian School of Economics would know it is completely broken. A market that will only go up and will accept no corrections thanks to the massive central bank distortion, creates an irresponsible and irrational short-term vision that is used by company executives who instead of investing in their core business, have become dedicated to playing financiers by buying back their own stock with very cheap debt and now have no excess cash to face the economic crisis. The bases of capitalism are at play.
Being Too big to fail became the most successful business plan in Wall Street, as the FED will always play last-minute hero and save the day. This vision has created asymmetric risks where executives take their salaries, bonuses and golden parachutes to a retirement in Florida’s golf courses and leave the problem to the FED. This is what is known as Moral Hazard.
The fat that investing in anything without risk consideration is now something normal, explains why Argentina’s 100-year bonds where oversold in 2017-2018. At the moment, they are now at default, again.
The fact that the dollar is the worlds reserve currency is generating a global problem with huge implications, since in the last 10 years, close to 10 trillion dollars of dollar denominated debt has been issued around non-dollar countries and corporations. These debts must be repaid and there is where you find the dollar problem amplified by the FED’s manipulations.
Part 2: The dollar problem
The dollar has been the world reserve currency since Bretton Woods assigned it this role, discarding other proposals such as Keynes’s world reserve currency the Bancor. The fact that the dollar has no competition makes it the standard currency for commerce but also for finance.
In bad times, it is a refugee of value and capitals rush to this currency in what is known as a flight to safety.
Other currencies have a certain sense of security, such as the British pound and the Japanese Yen, but none have a global role. The Euro, which was supposed to be an answer to the dollar, has not consolidated successfully after 20 years. The international commerce of the eurozone is mostly in dollars and there are massive fiscal differences between north and south.
The Euro problem
Recently, the Dutch have blocked new massive financial aids to Italy and Spain, since it did not want to lend more money to countries that are not fiscally responsible. Southern European countries rebelled since they will not accept another repeat of the 2008 scene of forced austerity. A Spanish minister said that the EU is not a club just to buy Volkswagen cars. The logic behind this argument was given by Yanis Varoufakis who expressed that Northern Europe’s huge trade surplus exists thanks to the big fiscal deficits of its poorer southern neighbors who keep the Euro cheap. Without a cheap Euro, northern European countries would have expensive currencies that would not make them competitive exporters. Imagine the world with a strong Deutsche Mark as a refuge currency, where would German exports be? Discussions in Europe still have a long road ahead of them, but the fact is that as Yanis Varoufakis explains, the EU has no surplus recycling mechanism and this is leaving a 2-time EU, in which northern countries gain more than what they lose. Southern countries will not take any longer puritanical economic lessons from Holland, Lichtenstein or the UK, whom they consider fiscal black holes where their tax revenues magically disappear.
During a good part of the year, the DXY index which measures dollar strength has been rising strongly, since it has been acting as a refugee currency. This creates 2 problems for the USA.
Since the dollar is getting stronger, US exports become less competitive. That is the easy problem to understand. The second problem is not that easy to understand.
There are close to 11 trillion dollars of outstanding dollar denominated debt by the rest of the world, and every debtor must buy dollars to repay and pay their coupons. This is what drives a massive demand for dollars worldwide.
Why is so much debt issued in dollars?
The answer has two parts, the first can be resumed in the statement printed on the dollar bill “in god we trust”, which means, the American economy is so strong it withstands anything. The second, is because no one trusts Putin, Erdongan, Xi Jinping, Modhi, the Kitchner’s, the Chavez’s, the African dictators and the Brazilian populists.
There is very little appetite for the debt in those currencies where politicians try to play as if they were the FED, printing money without real value. Those countries have no economical liberty or respect for laws. Time after time they have proven recipes for disaster.
A dollar that is too strong will result in a global financial threat.
The emerging market menace
If the dollar becomes to expensive, many countries might say: I have the will to pay, but I just cannot buy dollars at those rates. This would create massive bankruptcies and liquidations. Devaluation against the dollar has been between 20-30% for emerging markets this year.
All this situation is compounded by a terrible year on commodity prices on which most emerging markets depend. A few weeks back we saw the negative oil episode.
The perspective is very bad, and the problem is not only for the debtor but for the creditor as well.
To stabilize the demand for dollars, the FED has established swap lines with 13 new central banks who can now use mechanisms to supply their local markets with dollars and keep local currencies from devaluating.
Swap lines played stabilizing roles in the 2008 crisis, when only the UE, Japan, UK and Canada had them.
Countries not aligned politically with Washington have not received Swap lines from the FED. These include China, Russia and Iran.
Dollar and Geopolitics
Since dollar access has become a geopolitical issue, the idea of a global reserve currency has been floated again once more. Proposals range from Bancor ideas to really giving IMF drawing rights real use.
Meanwhile, gold keeps rising for one simple reason: the worry on central banks and their handling of their currencies. Everything that gets distorted becomes dangerous, and gold still provides a semblance of a non-distorted asset.
Since I began working in 2006, the FED’s balance sheet has expanded from 800 billion dollars to close to an estimated 10 trillion by the end of 2020. We live in a distorted world in which defying the law of physics, things expand but don’t contract. Even stars expand and contract. As you can see in the graph, the problem the dollar faces is not small.
Everyone is a Keynesian at the present moment
In my first economics class in high school, my teacher thought me the concept of There is No such Thing as a Free Lunch
Who will pay this bill?
Will millennials accept this load without rebelling?
How long will the dollar defy the laws of physics?