Money and debt are essential for the functioning of a healthy economy and international trade but history, going back to Roman times, warns that their abuse can lead to the downfall of states and empires. We will focus on the last fifty years and use of the fiat US Dollar as reserve currency, starting in 1971. Some see this as an “exorbitant privilege” while others describe it as a curse.
The “Nixon Shock”
In August 1971, President Richard Nixon suspended convertibility of the US Dollar to gold, effectively ending the Bretton Woods monetary system. The post-WWII fixed exchange rate system under Bretton Woods was backed by the US Dollar, as reserve currency, which in turn was convertible to gold at a fixed rate of $35 per troy ounce.
West Germany left the Bretton Woods system in April 1971, rather than devalue the Deutsche Mark, followed by Switzerland in early August. Rising inflation and increased calls for redemption of Dollars into gold left the US contemplating devaluation to prevent depletion of their gold reserves. Instead Nixon and his advisors — Treasury Secretary John Connally, Fed chairman Arthur Burns, and then Undersecretary for International Monetary Affairs (later Fed Chairman) Paul Volcker — opted to suspend convertibility to gold.
A general revaluation of G10 currencies followed but, by March 1973, the fixed exchange rate system had lapsed fully into a floating exchange rate system.
Stagflation
Widely considered a political success, suspension of the gold standard was an economic disaster, starting with stagflation in the 1970s.
Inflation soared. The price of Gold spiked from $35 to $675 per ounce, within 10 years, while crude oil increased more than tenfold, from $3.56 to $39.50 per barrel.
An “exorbitant privilege”
The French complained that the Dollar as reserve currency afforded Americans an “exorbitant privilege”. Barry Eichengreen describes it as an “asymmetric financial system, supporting American living standards and subsidizing American multinationals”.
Global trade and international borrowing grew, driving up demand for Dollars — and US Treasuries to bolster reserves — and driving down interest rates.
The US financial system had a monopoly on printing the reserve currency and access to cheap money. Inflation further eroded the cost of borrowing.
Released from the fiscal discipline of the gold standard, the US government ran larger federal deficits.
Wall Street
Financialization refers to the increase in size of a country’s financial sector relative to its overall economy; normally accompanied by a shift away from manufacturing, as a result of globalization.
The financial sector, in the past four decades, has made out like Donkey Kong. Market capitalization grew three times faster than their Main Street compatriots.
Twin deficits
To maintain the Dollar’s status as reserve currency, the US had to provide enough Dollars to meet the insatiable demand from burgeoning international trade. They were able to achieve this by running larger and larger current account deficits (red line below) — to inject Dollars into the global economy — while recycling the money through capital account inflows into US Treasury investments (purple).
Running twin deficits plugged the gap in the income equation, offsetting net imports (the current account deficit) with a fiscal deficit (government transfers > taxes). Corporate profits soared after China’s admission to the World Trade Organization (WTO) in 2002, climbing to more than 10% of GDP.
But burgeoning Wall Street profits blinded policymakers to the corrosive effect that the twin deficits were having on the manufacturing sector. Capital account inflows — balancing current account outflows — strengthened the Dollar exchange rate to the point that US manufacturers could no longer compete against foreign manufacturers in export markets, nor against foreign imports in domestic markets.
The manufacturing sector started to lose jobs (gray below). The trickle turned into a flood after China’s admission to the WTO, with manufacturing employment falling to below 12 million in 2010.
Net International Investment Position
The US lapsed from being the world’s largest creditor to being its biggest debtor, with net borrowings of $16 trillion.
Household Debt
Before World War II, people rarely took out mortgages to buy homes. They saved their money, and when they had enough, they bought one. The same was true of other asset purchases, like automobiles, farm machinery or appliances.
Starting in the 1950s, banks created credit products that allowed people to buy before they earned. That’s been a key feature of the U.S. economy ever since.
Today, the financial sector’s contribution to GDP is more than twice what it was in the 1960s.
This increased “financialization” has made every asset market highly sensitive to changes in interest rates, because they affect the yield and financial value of those assets. (Ted Baumann, The Baumann Letter)
Household Net Worth
Falling interest rates drove up prices of equities and real estate, creating a wealth effect. When individuals feel wealthy, their propensity to spend and consume increases. Even if their incomes have not increased, they are more likely to increase debt or draw on savings.
The graph below shows how household net worth in the US has almost doubled relative to disposable personal income. People may feel wealthier — due to asset price inflation — but their incomes have not risen commensurately.
Rising Inequality
Low interest rates have a far more detrimental effect than just “fictitious” wealth. The benefits of low interest rates are skewed towards individuals with strong asset bases who have the ability to borrow at low rates and invest in real assets which benefit from the inevitable asset price inflation. Low income-earners, on the other hand, largely suffer from the negative effects of rising consumer prices.
The GINI coefficient below illustrates the rising inequality between income groups in the US. The higher the ratio, the greater the concentration of benefits in the hands of a few.
Higher income groups have a lower propensity to consume than low-income groups; so increased inequality is likely to lead to lower consumption. But the impact on consumption is marginal — it doesn’t really matter to overall GDP whether a rich family spends an extra Dollar or a poor family from the other side of the tracks.
The real damage is far more insidious.
Growing inequality has a polarizing effect in politics, with rising populism appealing to large swathes of the population who are angry over lost jobs, falling incomes and high inflation. Especially when the impacts and benefits of financialization/globalization are concentrated in separate geographic areas: the flyover states versus coastal elites.
The impacts go even deeper.
Demographics
Demographics of a nation are its destiny as Ben Wattenberg would say. Economic growth goes hand-in-hand with population growth.
When people feel oppressed or exploited, the birth rate falls. The fertility rate in the US — expected births per woman over her lifetime — has been falling sharply since the global financial crisis of 2008.
We hear a lot about the declining birth rate in China — where the fertility rate is 1.699 births per woman (2021) — but the 2021 US fertility rate of 1.781 is not much better. Russia is similar, at 1.823, while Japan faces the largest decline in working age population, with a 2021 fertility rate of 1.368. Declining birth rates warn of a shrinking workforce in the next generation and even slower growth.
Another trend that has been evident is a declining male employment rate, from 78% in the late 1960s to 65% today. Participants who feel exploited tend to drop out of formal employment, shrinking the workforce even faster.
The demographic impact of falling male participation was offset by a sharp rise in employment amongst women — from 41% in 1970 to 58% in 2000 — but that is now also declining, to around 54% today.
Declining male and female employment rates since 2000 have accelerated the slow-down of economic growth.
The Debt Trap
The US has run into the inescapable problem of debt-fueled growth: diminishing marginal returns on investment. The low-hanging fruit have been picked and opportunities for productive investment grow increasingly scarce.
The graph below compares GDP to total corporate and household debt. The amount of GDP produced per Dollar of debt has almost halved since the 1970s and is likely to fall even lower.
Cheap money also encourages malinvestment in nonproductive areas, dressed up to look attractive through massive leverage and artificially low interest rates. The wealthy invest in real assets, as a hedge against inflation, but these are often not productive assets. Investment in speculative assets — such as gold, precious metals, jewellery, artworks and other collectibles, high-end real estate, or cryptocurrencies — seldom produces much in the way of real income, with the speculator relying on asset price inflation and low interest rates to make a profit. Many so-called “growth stocks” — with negative earnings — fall in the same category.
Falling GDP growth means less opportunities for investment. Capital formation by non-financial business regularly peaked at 5% of GDP in the 1960s to early 1980s. But, apart from the Dotcom bubble, peaks have struggled to reach 3% of GDP since the mid-1980s. Now we have a disturbing new trend, where post-pandemic capital formation (?) is struggling to reach 2%.
Falling investment leads to lower growth which in turn leads to lower consumption and GDP growth — as well as lower participation rates and birth rates — creating a self-reinforcing downward spiral.
The End Game
Federal debt at 120% of GDP is unsustainable.
Extensive research of highly indebted economies by Carmen Reinhart and Ken Rogoff (This Time is Different, 2008) found that economic growth was significantly diminished once they become highly over-indebted. Further research, in 2014, by Dr Cristina Checherita and Dr Philip Rother, for the ECB, suggests that the negative growth rate effect of high debt may start from levels as low as 70-80% of GDP.
Increased monetization of federal debt, post 2008, with expanding Fed purchases of Treasury and mortgage-backed (MBS) securities, has discouraged foreign investors from buying federal debt. The Fed has been forced to raise purchases to support increased Treasury issuance.
Massive current account deficits, with matching capital account inflows are supporting the Dollar at an uncompetitive, high exchange rate.
Capital inflows are no longer flowing into Treasuries but into equities and higher-risk securities. This could have a destabilizing effect on the Dollar, with any form of risk-off event precipitating capital outflows rather than inflows.
Powell’s Dilemma
Fed Chairman Jay Powell is in a difficult position. With the consumer price index growing at the highest annual rate (7.0%) in almost 40 years, the Fed needs to raise interest rates to prevent the economy from overheating.
The real Fed funds rate (the overnight rate adjusted for inflation) is way behind the curve — at the lowest level in more than 60 years.
But a sharp rise in interest rates would crash both the stock market and the bond market. The bond market is the deepest and most liquid market in the world but any indication that the US federal budget is on an unsustainable path would cause panic. With federal debt at $29.8 trillion, a 2.4% increase in the cost of funding would equal the entire defense budget (2021: $718 bn).
Conclusion
A fiat US Dollar as reserve currency has long been considered an “exorbitant privilege” — providing the US Treasury and corporations with cheap international funding. But overuse of cheap debt has led to unproductive investment, declining growth, and rising inequality. Twin deficits — on current account and a fiscal deficit — have supported an inordinately strong Dollar, eroding the competitiveness of US manufacturers and destroying more than a third of US manufacturing jobs. Falling investment and declining employment growth have also created social, demographic and political upheaval that will be difficult to correct.
Federal debt has climbed to an unsustainable 120% of GDP. Default is unlikely — as is fiscal austerity, where the government cuts spending in order to generate a surplus and repay debt — leaving inflation as the only viable option. Rising inflation would lift GDP relative to federal debt, eroding the real value of the debt. We expect sustained inflation and negative real interest rates to reduce the ratio of federal debt to GDP to a sustainable 60% to 70% of GDP over the next five to ten years.
The strong Dollar is expected to weaken as inflation soars and the current account deficit shrinks. A shrinking current account deficit would also bring the Dollar’s status as reserve currency into question, creating an international Dollar shortage. There is no ready replacement for the US Dollar as reserve currency, however, and it is likely to continue for the foreseeable future — until the US decides that it can no longer afford the “exorbitant privilege”.
Acknowledgements
- Dr Lacey Hunt, Hoisington Asset Management, Quarterly Reviews
- Neil Howe, The Fourth Turning
- Steph Pomboy, Macro Mavens
- Lyn Alden, The Fraying of the Petro-Dollar System
- Luke Gromen, FFTT
- Michael Pettis & Matthew Klein, Trade Wars are Class Wars