History was never among my favorite subjects in school. Yet, as I have come to realize over the years, history has an uncanny ability to repeat itself and past experience holds important lessons for the future.
The current macroeconomic environment bears strong resemblance (albeit not as acute) to what existed in theGerman Weimar Republic
between 1921-24. During this period Germany experienced a period of
extreme inflation caused by the unchecked printing of currency. This ultimately
resulted in the death of the local currency (the Papiermark) and the rise of
Hitler. Adam Fergusson’s book “When Money Dies” chronicled this tumultuous period
and concluded that what really broke Germany was the adoption of soft
political options over sound economic policy. We are yet again in the midst of
a similar battle between politics and economics – one that has already claimed
9 European governments (France, Greece ,
Ireland , Italy , Netherlands ,
Portugal , Spain , Slovakia ,
Slovenia ).
Sadly, little has changed in a 100 years and politics once again has the upper
hand.
In order to understand why this is the case, it is important to first understand the origin of the modern financial system and recognize that it did not evolve out of sound economic theory but through a history of chance events. As a result it is just as susceptible to a collapse as were the previous monetary regimes.
The current macroeconomic environment bears strong resemblance (albeit not as acute) to what existed in the
In order to understand why this is the case, it is important to first understand the origin of the modern financial system and recognize that it did not evolve out of sound economic theory but through a history of chance events. As a result it is just as susceptible to a collapse as were the previous monetary regimes.
Emergence of the Dollar
as the International Reserve Currency
In the aftermath of the Second World War, Bretton Woods was
the location of a landmark international conference held in July 1944 to
discuss post-war reconstruction of Europe and establishment
of a new global monetary order. The United States offered to back the
Dollar through its vast stockpile of Gold in order to promote its acceptance as
the new international reserve. This coupled with the overwhelming political and
economic strength of the US
(which had benefitted from the war as both the arms supplier and bread basket
to Europe) resulted in the acceptance of the US proposal and the Dollar emerged
as the dominant international reserve currency.
This system worked well while the US maintained large trade
surpluses. However due to costs associated with the Vietnam war and increased
domestic spend, the US
started running a deficit by the early 1970s. It funded this deficit by simply
printing more Dollars prompting the belligerent Charles De Gaulle of France to denounce ‘Ze Imbeciles’ in Washington for exporting
inflation and debasing the Dollar. De Gaulle and other European nations however
did more than grumble about this and started swapping Dollars for as much Gold as
they could get their hands on. They could do this because at that point all they
had to do was show up at the US Fed to swap Dollars for Gold. A run on US gold
reserves ultimately resulted, prompting Nixon to unilaterally close the Fed
Gold Window in August 1971. The Dollar thus became a Fiat currency backed by a
promise to pay back nothing.
Clearly at this point everyone should have started moving
away from the Dollar. However, in one of the greatest economic coups in history
the US signed the JECOR
agreement with Saudi Arabia
in 1974. Under this agreement the US
promised to modernise Saudi Arabia
and to support the House of Saud (the ruling family of Saudi Arabia )
both economically and politically. In return, Saudi Arabia through its
considerable weight in the OPEC ensured that it sold oil only in Dollars. Since
Oil comprised the bulk of imports for most countries, they were forced to suck
up and accept the fiat Dollar as fait accompli. The dominance of the Dollar was thus
complete and continues till date.
America’s Exorbitant
Privilege
Having an international reserve currency is core to the
political and economic might of the US . While all countries need to
earn Dollars, the US
just needs some paper and ink, making the Dollar its chief (and highly
profitable) export. The end of the gold peg removed any last hurdles in printing unlimited currency. The US
government has therefore been able to finance its expenses (eg military spends) using
simple financial sorcery. But this isn’t all - in addition to a blank cheque
the Dollar is also a potent political tool as was demonstrated this March when SWIFT
(the dominant international mechanism for inter-bank money transfer) payments
to Iran were shut down under
pressure from the US .
The Big Printing
Press
Over the years, the Dollar’s ‘Exorbitant Privilege’ has been used to fund extravagant expenditures and
satisfy domestic constituencies in the US. This deficit spending is financed by borrowing
money (through the issuance of Treasury Securities) from other countries or
from the Fed. It is this latter component that is financed by printing money (politely
referred to as Quantitative Easing or QE). These borrowings comprise the total
US National debt which today stands at a little over $15 trillion. Include off
balance sheet liabilities (such as pensions) and this exceeds $55 trillion,
increasing at over $1 trillion a year. To put this into perspective, the GDP of
the United States
in 2011 was $15 trillion and Total Federal Revenues were $2.3 trillion.
Of the total US
federal government expenditure, mandatory entitlements (Social Security,
Medicare, Retirement programs etc) comprise a massive 87% of total revenues. Such has also been the case in Europe and as
the merry-go-round of governments there shows, it is difficult to take away such benefits from a public used to government largesse. There
is therefore little chance of curtailing this deficit spending let alone pay
any of the accumulated debt back. This
rising debt isn’t being supported by a rising tax base for not only is
unemployment increasing in the US ,
but with baby boomers going out of the workforce demographics are deteriorating
rapidly as well. The only way out then is to print more money to fill this hole
of interest payments, debt payback and pension liabilities. This was again demonstrated last night when Ben Bernanke promised to buy $40bn dollars of bonds every month.
It is therefore a given that QE will be extended indefinitely, further debasing the Dollar. Also likely is a protracted period of low dollar interest rates for any increase will increase the cost of servicingUS
federal debt (already at $250bn a year at the prevailing low interest rates)
and blow an even bigger hole in the budget. While the post above largely covers the US dollar, the same can equally be said of other major currencies such as the Euro. The US dollar's reserve status however permits QE at a much larger scale than is possible with other currencies.
The next post covers what this means for individual savings and the overall monetary structure.
It is therefore a given that QE will be extended indefinitely, further debasing the Dollar. Also likely is a protracted period of low dollar interest rates for any increase will increase the cost of servicing
The next post covers what this means for individual savings and the overall monetary structure.