In a recent article[i] I postulated that the dollar could lose all its purchasing power with a rapidity that will come as an unpleasant bombshell, even to those who already see inflation as society’s greatest problem in the future. The key to understanding why this may be so lies in human reactions to the monetary consequences of the next credit crisis. The undermining of the dollar as a currency affects all other fiat currencies, because it is the reserve currency and all financial markets use it as the pricing medium for commodities and for much of international trade.
A comprehensible analysis of currency exchange dynamics must therefore concentrate on the dollar, only bringing in the broader picture when appropriate. In this article’s context, currency exchange dynamics refers primarily to events that lead to a change in the dollar’s purchasing power.
The dollar has suffered monetary inflation ever since the Federal Reserve Board was created, both in terms of the expansion of base money and of bank credit. The effect in terms of loss of purchasing power has so far come in two shifts. The first was in 1934, when the dollar was devalued against gold by 40%, and the second following the collapse of the London gold pool in the late 1960s, since when the dollar has lost a further 97.4%.
The precedent has therefore been set for a continuing trend, that will eventually conclude with the destruction of the current monetary system. We know this because monetary regimes come and go, leaving gold and silver as the only solid forms of money throughout human history. Therefore, the end of the dollar, along with the whole fiat currency system, just like the end of empires, is one of the monetary certainties. But only a small minority of analysts are conscious this is so and appear to assume the current monetary state will continue indefinitely.
This article argues the end of the current monetary regime could be much closer than even the uber-bears think. If so, it will be due in part to the extraordinary circumstances currently evolving.
Gold and silver, in terms of their purchasing power, are and always have been a safe haven from state-induced inflation and historically have remained relatively stable measured against other commodities, except in times of escalating financial violence when a credit crisis occurs. However, the quantities of fiat currencies relative to the available monetary gold are now far too large for this relative stability to continue even ahead of the next credit crisis, with gold and silver’s values having the potential to increase significantly, measured against both fiat currencies and commodities.
Potentially, fiat currencies face a perfect storm from an upcoming credit crisis, from the consequences of central banks’ misguided attempts to make the banking system catastrophe-proof, and from the spontaneous development of an alternative asset system in cryptocurrencies.
The prospects for the dollar are already deteriorating. The US budget deficit is escalating at the most inappropriate stage of the credit cycle, leading in turn to increasing US trade deficits, and therefore net selling of yet more dollars on the foreign exchanges. Government funding through Treasury issues is set to accelerate at a time when overseas ownership of US dollar-denominated bonds, which increased while the dollar was strong, are likely to sold, now the dollar is weakening. A falling dollar means rising commodity prices on the exchanges, rising domestic inflation and a sliding bond market. The Fed, having an eye on the risks to both private sector and government debt, is likely to be too slow to counter these negative forces.
Within the credit cycle, it is always rising prices, the consequence of earlier credit expansion, that lead into the final crisis stage. To combat rising price inflation in excess of their 2% targets, central banks will be forced to increase their deposit rates, while the time-preference on loans and bonds increases at the behest of markets.
These increases only end when the cost of financing and refinancing commercial projects exceeds the return on them, and malinvestments are revealed. At that point, escalating losses on bank loans force banks to retrench, particularly on loans for working capital. And without working capital, business failures quickly escalate.
Consumer debt is now a major factor
The sequence of events in the classic definition of a credit induced business cycle has gradually changed in one important respect. Instead of bank credit being taken up by businesses seeking to satisfy consumer demand arising from the discouragement to saving from low interest rates, marginal consumer demand has itself been bolstered by increasing levels of borrowing. This is because the wealth transfer due to monetary inflation is now severely taxing American consumers, who have abandoned savings habits and instead are borrowing to maintain their standard of living. Therefore, swings in savings rates, an important signal to businesses in the past, are not so relevant as they used to be.
When the credit crisis arrives, the composition of all that consumer debt also becomes important. At the end of 2017, US household debt stood at $13.15 trillion, and was comprised of $9.33 trillion of mortgage debt and £3.82 trillion of non-housing debt.[ii] Most of the mortgage debt is held by government agencies, taken into conservatorship by the US Treasury during the last credit crisis. We can safely assume government policy will discourage foreclosures on delinquent mortgages. That leaves non-housing debt, which is mostly not collateralised.
Therefore, when a credit crisis hits, in addition to a rapid reduction in interest rates and an expansion of base money through quantitative easing to rescue the wider economy, consumer finance companies will also need a backstop. The difference today from the last crisis is there is no reason to suppose there will be a significant collapse in residential property prices, though they may or may not be undermined to some degree by higher interest rates before the crisis arrives. That being the case and even allowing for the negative effects of losses in financial markets to consumer wealth, consumer credit seems unlikely to contract by very much, as it threatened to do at the height of the last credit crisis. Certainly, it will be the Fed’s policy to maintain consumer confidence at all times.
A further dampener is potential job losses. But here again, the Fed will almost certainly support the banks, on the understanding they don’t exacerbate the crisis by foreclosing on businesses in the general sense. After all, the Fed succeeded in stopping a financial and systemic crisis in 2008 by doing just that and is likely to feel confident today that policy is the most practical solution in a future credit crisis. Therefore, we can conclude that consumers, who are also employees, will see in aggregate little reason to reduce their spending significantly, and consumer finance companies will be encouraged to continue to offer credit. An important consequence is price inflation will continue.
Of course, we must not make light of the dangers. Unemployment will rise, as will personal bankruptcies. Banks will stop offering credit for working capital purposes for smaller businesses. That’s what happens in every credit crisis. But the point at issue is the scale of the initial effects of the crisis stage of the credit cycle, which may not be as disastrous as the mountain of outstanding debt to be unwound implies. What happens after that is another matter.
Perhaps this Panglossian view of how the next credit crisis might commence without a systemic crash will surprise bearish commentators. However, an analysis of bank lending and bank balance sheets in the Eurozone reveals similar trends towards consumer lending, though obviously they vary between member states. Thanks to the ECB’s aggressive and continuing QE policies, banks appear to have reduced their exposure to government debt as a proportion of their total assets, which casts the ECB’s continuing policy on QE in a different light. Eurozone banks have at least made some constructive moves to reduce their exposure to sovereign debt, while decreasing their capital ratios.[iii]
Accordingly, between the world’s two largest economic entities, bank risk appears to be less compared with the position at the time of the last credit crisis. This is not to suggest that systemic risk in the banks has been banished, only that it is almost certainly less than it was. The character of the next credit crisis is bound to be different from the last for this reason. Furthermore, the steps taken by the Financial Stability Board, the Bank for International Settlements and individual central banks to prevent a financial crisis occurring again are bound to have reduced the systemic risk of multiple bank failures.
However, the credit crisis will still occur, because it is baked in the cake of the credit cycle itself. In the interests of preserving banks from the uncertainties of free markets, other potentially far more serious errors have been committed by regulating how money is used and by suppressing symptoms of financial and currency risk.
