The most intriguing piece of evidence for a dollar shortage is the tangled trio of prices in five-year TIPS, gold, and ten-year Treasury notes. TIPS stands for Treasury Inflation Protected Securities, a special type of Treasury note where the principal is indexed to inflation. This means the TIPS yield is a real yield; there is no need to add an inflation premium to a nominal yield because principal is already protected against inflation. When an investor pays a premium over par to buy a TIPS, the resulting real yield to maturity is negative because the investor receives the inflation-adjusted principal minus the premium paid.
From 2006 to 2016, gold and five-year TIPS (measured by yield on an inverted scale) exhibited a powerful positive correlation. This makes sense. When bond yields are negative, gold is more attractive because gold has no yield. A greater negative yield on TIPS should correlate with a higher dollar price for gold, and it does. Negative real yields, and a higher dollar price of gold, are early warning signs of inflation. Given massive money creation by central banks around the world, higher inflation expectations are reasonable.
The odd man out in the trio is the ten-year Treasury note. Principal on these notes is not inflation protected, so investors seek higher coupons or buy notes at a discount in order to gain inflation protection. The yield to maturity on a ten-year note represents some combination of credit risk (typically low) and inflation risk (variable based on economic conditions). If gold and five-year TIPS signal inflation, yields on ten-year Treasury notes should be rising, and prices falling. The opposite occurred. The yield on ten-year Treasury notes collapsed from 5.2 percent on July 6, 2007, to 1.3 percent on July 8, 2016, one of the greatest bond market rallies in history. Hedge funds and institutions lost billions shorting a presumed bond market bubble, while yields kept dropping and prices kept rising to new heights. This price action is a powerful sign of expected deflation and weak economic growth, even depression.
Gold and TIPS prices presage inflation. Ten-year Treasuries signal deflation. Which is it? To an efficient-markets economist, markets are never wrong, yet how could these markets be right if they signal opposite outcomes? The answer is that inflationary and deflationary forces coexist today in an unstable dynamic tension with the capacity to snap in either direction like a fault line in an earthquake, and produce a price shock for which most investors are ill prepared.
The nuanced way to reconcile prices of gold, TIPS, and ten-year notes is to understand this as a bizarre price triangle of fear. An investor who fears inflation buys TIPS and gold. An investor who fears deflation buys ten-year notes. Wise investors buy all three because inflation and deflation are both in play. The likely path is short-term deflation and recession due to debt, deleveraging, demographics, and technology, followed closely by inflation due to the central bank and fiscal authority policy response to deflation. Physicists find this back-and-forth behavior familiar, an example of a complex system on the edge of chaos that goes wobbly just before it spins totally out of control. Inflation must win in the end; governments require it and always find a way. Yet deflation will persist in the short run until government grasps its potency and resorts to stronger remedies such as debt monetization.
This uncertain landscape in which deflation and inflation compete in a tug-of-war is amplified by the dollar shortage in which inflationary central bank money printing and debt creation is offset by recessionary debt default. Today’s dollar shortage is a replay of the 1950s dollar shortage. In the aftermath of the Second World War, U.S. industrial capacity as a percentage of global capacity and U.S. gold reserves were both at all-time highs. Meanwhile, European and Japanese productive capacity were destroyed by the war and their reserves were depleted. Europeans and Japanese simply could not buy what America offered because they lacked dollars to do so. The first part of the solution was for the United States to give the world dollars through the Marshall Plan and Korean War spending. The second part of the solution was for the United States to supply dollars by running massive trade and budget deficits. This took time, but it worked. By the late 1960s, the dollar shortage had become a dollar glut. As inflation took over, trading partners did not want dollars and redeemed dollars for gold, leading to the closing of the U.S. gold window.
The sequence from the 1950s dollar shortage to the 1960s dollar glut is a succinct illustration of Triffin’s dilemma, named for Belgian economist Robert Triffin, who first articulated the theory in 1960. Triffin correctly forecast that the United States would have to run persistent trade deficits with the rest of the world in order to supply the world with sufficient dollars to finance global trade and banking. The dilemma was that if the United States ran these deficits indefinitely, the country would eventually go bankrupt. By 2016, the United States approached the point Triffin had astutely predicted sixty years earlier. This constrained its ability to continue to supply the world with dollars. Still, because the world depended on dollars, the resulting dollar shortage threatened to destabilize global capital markets. The real dilemma was that no widely agreed, widely held substitute for the dollar had yet emerged. The SDR is waiting in the wings to pick up the dollar’s crown, but the transition takes time, unless accelerated by crisis.
The world is a minefield of bad debt waiting to detonate into a generalized dollar liquidity crisis. It’s just a question of which landmine explodes first. More than $5.4 trillion of energy-related debt was created from 2009 to 2015, most of it in the fracking industry. The sustainability of that debt was based on oil prices at $70 per barrel or higher. With oil below $60 from late 2014 through 2016, default rates on energy debt started to soar. Equally threatening is emerging markets’ corporate dollar-denominated debt, estimated by BIS at more than $9 trillion. This is not sovereign debt of the type that caused crises in Dubai in 2009 and Greece in 2011, but rather corporate debt issued by local manufacturers, and commodity producers from Russia to Brazil, Mexico, Indonesia, Turkey, and beyond.
Sovereign debt can be serviced by the issuer’s hard currency reserves supplemented by IMF loans, currency swaps, and central bank purchases if needed. Corporate debt is more vulnerable. Corporate issuers might earn dollars from exports, yet many do not. The recent strong dollar means even exporting firms earn fewer dollars in relation to debt, which makes the debt more burdensome to repay. Corporations might get access to hard currency reserves from their home country central banks, but there is no assurance of that, especially if precious reserves, as in Russia, are needed to service sovereign debt.
The default ratio on this energy and emerging markets debt could be as low as 10 percent and still cause more than a trillion dollars in loan losses, with even greater losses in linked derivatives. The world is once again vulnerable to a major debt shock, as it was in 2007.
The source of this new debt shock shows central bankers are no better than generals fighting the last war. In 1998, the global crisis came from emerging markets’ sovereign debt and the hedge fund LTCM. Regulators then ordered bankers to scrutinize hedge funds more closely while emerging markets built up precautionary reserve positions in dollars. The 2008 crisis came from an unexpected direction: mortgages. Regulators then tightened mortgage lending standards, increasing down payments and improving underwriting standards. Now this new crisis comes from another unexpected direction: corporate debt.
A Chinese credit crisis is also in the cards. From 2009 to 2016, more than $10 trillion of Chinese investment was wasted on white elephant infrastructure, ghost cities, and corruption. This spending was financed in part by small savers investing in Ponzi wealth management products, Chinese banks, and foreign lenders eager to participate in the spurious Chinese growth story. This situation is being finessed by the People’s Bank of China through interest rate and reserve requirement levers, while the bad debt problem grows worse. Regulators persistently solve the last problem and are blind to the next one. This is because the real problem is not the existence of bad debt, but the easy money policies that create debt in the
first place. Market participants are more ingenious than central banks (although the bar is low) at finding ways to create debt and derivatives. That was Jeremy Stein’s insight and dismay.
Deflation is another pernicious threat. Even as fiscal deficits decline in developed nations, debt-to-GDP ratios keep rising because nominal growth is so low. The deflation conundrum is that it permits positive real growth with negative nominal growth. An economy can decline in the dollar value of goods and services produced, while growing in real terms if each nominal dollar is worth more due to deflation. This is fine for living standards, yet is nightmarish in terms of debt sustainability because debt is always nominal. If each dollar is worth more, the debt burden goes up even as the deficit goes down. Such is the strange, through-the-looking-glass world of deflation.
Currency wars led one central bank after another to lower rates in an effort to cheapen their currencies relative to those of trading partners. For Japan, Switzerland, and the European Central Bank among others, policy rates are negative. In other sovereign debt markets bonds offer negative total returns. Negative rates offer temporary relief for slow global growth, but where will ease come from in the next panic? Central banks assumed they could normalize rates before the next panic struck. The time to normalize rates was late 2009. Now it’s too late. The next crisis will come before the current easing cycle has been reversed. Central banks will be defenseless except through the use of massive new quantitative easing programs. This new money creation binge will test the outer limits of confidence in central bank money.
In addition to this list of catalysts from gold, debt, deflation, and default, there are exogenous threats that emerge in geopolitical space and spill over quickly into financial panics. These threats include conventional wars, cyberwars, assassinations, prominent suicides, power grid outages, and terror attacks.
Finally there are natural disasters such as earthquakes, volcanic eruptions, tsunamis, category five hurricanes, and deadly epidemics.
Skeptics say that wars, earthquakes, disease, and the rest have always been with us. The world managed to survive and even prosper in their wake. That is true. Still, the world has never been so in debt. Societies with low debt burdens are robust to disaster. They can mobilize capital, raise taxes, increase spending, and rebuild when the damage is done. Heavily indebted societies are more brittle. Panicked creditors demand repayment that causes distressed sales of assets, falling markets, and default. This climate of panic is not conducive to capital formation. Stretched budgets cannot be stretched further to support emergency spending. Burdened taxpayers cannot bear more taxation. Policymakers can push buttons and pull levers, but the transmission is broken. Indebted societies do not recover, they fail.
Earthquake 2018
Metaphors made of earthquakes and avalanches are useful to convey the dynamics of financial collapse, yet these dynamics are more than metaphors. The complex system dynamics and mathematical models used to describe both natural and financial disasters are substantially the same. In considering these system metaphors, allowance must be made for timescales. Nuclear explosions occur in nanoseconds. Earthquakes play out in seconds. Tsunamis unfold over hours. Hurricanes emerge and wreak their havoc over days, sometimes weeks. These timescales vary due to the system scale in which the dynamic occurs, and the tempo of reaction functions among constituent parts of the system. A financial collapse is a supernova—a momentous event that can last for years, or, in a real supernova, millennia. This is not because the event is less dynamic, but because system scale is more vast.
A currency collapse that moved in what seemed slow motion was the fall of sterling and the rise of the U.S. dollar as the dominant global reserve currency. Ratification of the Final Act of the Bretton Woods conference on December 27, 1945, is seen as a convenient date to mark the moment the dollar officially eclipsed sterling. This was based on the new world monetary order agreed at Bretton Woods in July 1944 that defined the special role of the dollar anchored to gold with other currencies tied to the dollar, and limited scope for devaluation under IMF supervision.
But the currency eclipse took place thirty years earlier, in November 1914. That was when gold flows between the United States and the United Kingdom began flowing back to the United States. Large flows to the United Kingdom began on July 29, 1914, as Britain liquidated investments for gold to finance the First World War. The United States had no choice but to ship the gold to honor its obligations under the rules of the game. This gold flow from the United States was deftly handled by Jack Morgan and his partners at J. P. Morgan & Company.
By November 1914, the liquidation phase was complete, and the market for short-term trade paper was stable. Now the balance of trade, rather than capital flows, came to dominate. The United Kingdom desperately needed U.S. exports of food, cotton, and war matériel. Once wartime insurance and shipping impediments were resolved, goods were sent from the United States in massive quantities. Under the rules of the game, the resulting balance of trade in favor of the United States had to be settled in gold. This was the beginning of massive gold accumulation by the newly formed Federal Reserve and its private bank owners.
Sterling’s role from 1914 to 1944 was a façade. The fact that London remained a financial center, and sterling remained a reserve currency, had more to do with Britain’s captive market in the British Empire, and the sufferance of anglophile bankers at J. P. Morgan, than with intrinsic strength. Scholar Barry Eichengreen brilliantly laid out this transition and the seesaw struggle between the dollar and sterling for the global reserve currency crown in the interwar years in his book Golden Fetters.
Sterling lost reserve status de facto in 1914, yet the world did not see the denouement until 1944. Thirty years is not a nanosecond. Still, sterling’s collapse was an unstoppable dynamic process. Insiders at J. P. Morgan knew the score; they handled gold on a daily basis and saw the global flows. Perhaps today’s dollar has already lost its dominant status, a fact seen by certain insiders, yet not known to investors because of the façade of empire the United States still projects. The eclipse of the dollar may not be a dramatic, earth-shattering event that waits in our future; it may already be at hand. In “The Hollow Men,” T. S. Eliot wrote, “This is the way the world ends / Not with a bang but a whimper.” Most cannot hear the whimper.
Future historians may look back at September 18, 2008, as the day the dollar died. The Fed furiously printed money to put out fires at Lehman, AIG, and Goldman Sachs. At the same time, China began to orchestrate massive inflows of gold, not under a gold standard, but rather stealth purchases using secret agents and intelligence tradecraft. The mirage of dollar strength continues. Still, the ground under the dollar has shifted.
While it is possible to pinpoint a climax in hindsight, that is not how financial decline appears in real time. Collapse comes in stages, over years, and includes quiet phases when an all-clear siren is sounded and investors emerge from their shelters, then are bombed again more intensely.
Complexity in a system breeds the seeds of that system’s own collapse. Why did European civilization not experience a general collapse in the thousand years from the fall of Rome to the Renaissance? The answer is there was no Europe in the systemic sense. European lands were a thinly connected patchwork of small kingdoms, principalities, and Viking raiding cultures. There were wars, conquests, culture, religion, and fine art, yet there was no highly scaled European system.
Only with the rise of concentrated political entities such as France, Sweden, Russia, and England in the sixteenth century did large-scale system dynamics appear. Increased density functions led to three great systemic collapses—the Thirty Years’ War, the Napoleonic Wars, and the twentieth-century world wars. Each collapse was followed by a concerted effort to stabilize the system with agreed rules of the game. The solution to the Thirty Years’ War was the 1648 Peace of Westphalia, which established the modern sovereign state system and enshrined raison
d’état as a guide to statecraft in place of religion and the divine right of kings. The resolution of the Napoleonic Wars led to the Final Act of the Congress of Vienna on June 9, 1815. The Final Act reduced French power, yet was not overly punitive toward France. The Congress of Vienna laid the foundation for modern diplomacy and the practice of the balance of power in international relations. The relatively stable, peaceful, and prosperous period after the Congress of Vienna was called the Concert of Europe.
The aftermath of the First World War did not produce a stable system as occurred in 1648 and 1815. The Treaty of Peace signed at Versailles on June 28, 1919, was politically punitive to a defeated Germany and economically unsound. The treaty contributed to hyperinflation and global depression and was a proximate cause of the Second World War. Only at the end of that war, in a series of agreements in 1944 and 1945, including Bretton Woods and the United Nations Charter, did stability reemerge in a hegemonic new world order led by the United States and the Soviet Union.
The contrast between the thousand years from AD 500 to 1500, and the five hundred years since 1500, illustrates the importance of systemic scale. Kingdoms came and went in the Middle Ages, yet there was no catastrophic breakdown. Political fragmentation served as watertight compartments on a ship, and low network density was resistant to political and economic contagion. Since 1500, increasing scale and density in Europe have led to exponentially larger breakdowns, exactly what complexity theory predicts.
The Concert of Europe collapsed in stages about sixty years after Vienna. German and Italian unification, completed in 1871, signaled a sharp increase in European network density and systemic scale. This political density was amplified by economic networks forged by invention or expansion of telephones, train travel, steamships, electricity, and other innovations. As complexity increased, more intricate and acute crises ensued. Decline of the Ottoman Empire, the 1905 Russo-Japanese War, and the 1912 Balkan Crisis were of a piece, leading to the destruction of Europe and the collapse of empires from 1914 to 1945. The First and Second World Wars are best viewed, and will be viewed by future historians, as a single, large-scale systemic collapse of Europe, Japan, China, and the British Empire. Complexity kills.
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