Tuesday, October 16, 2018

Humpty-Dumpty’s Fateful Choice

According to the English nursery rhyme, “Humpty Dumpty sat on a wall, Humpty Dumpty had a great fall. All the king's horses and all the king's men couldn't put Humpty together again.” It is often presented as a riddle, and children are prompted to guess that Humpty was an egg. This is, of course, the wrong answer: the right answer, as all up-to-date children should know, is that Dumpty is the US dollar.

But back to the nursery rhyme: why would all of king’s men attempt to put together a broken egg, and why would horses be sent in to help? In fact, Dumpty was not an egg but a large cannon that accidentally fell from a castle wall during the English Civil War of 1642-49 and smashed into pieces. Another nursery rhyme, “Ring a ring o’ roses,” is about the Great Plague of 1665. Nursery rhymes aren’t about childish things; they are about serious things, like civil wars, pandemics… and currency collapses.

One of the most impactful events of the early 21st century is the US dollar's undoing as the world’s main reserve currency. Since many people will immediately demand to know when exactly this will happen, let me rush to supply them with the correct answer: this will happen early in the 21st century. As to how exactly it will happen—well, that’s the interesting part.

How is the US dollar like Humpty Dumpty? It’s all in the nursery rhyme: it’s fragile, it’s going to fall and crack, and no amount of energy (“king’s horses”) or military power (“king’s men”) will be able to make it whole again. There is an additional dimension to this falling-off-the-wall business. Wall-sitting is not so common, but the term “fence-sitting” is often used to indicate indecision.

This brings forth one important aspect of falling off a wall that we ignore at our peril: there are two ways to fall off a wall, and the decision as to which one is rarely without consequence. Walls and fences share a fundamental feature: they serve to separate the inside from the outside. Had Humpty fallen to the outside, the king’s men would have had to muster a sortie and sally forth, braving great dangers, to retrieve its mighty wreckage.

What are the two sides of the wall from which the US dollar shall fall, and how are they different. We’ll get to that question in due course, but first we have to spell out some basics. In order for a currency to serve as a global reserve currency there has to be lots of it available. There are three basic ways that a country can proliferate its currency: by lending it into existence; by borrowing it into existence; and by printing it and just handing it out no strings attached.

Lending it into existence is, of course, preferable: other countries then pay you interest, which you can reinvest in the project of making other countries pay you interest on your own money. But this only works if other countries absolutely must buy your currency in order to then use it to buy something they absolutely need, such as Saudi Arabian oil (which for a long time could only be purchased with US dollars, based on a deal between Saudi Arabia and the US). It also only works until lots of countries that you’ve bled dry start defaulting on their loans, leaving you with giant gaping holes in your banking system that can only be fixed by just printing money and stuffing it into those holes.

The trick of making others pay you to use your money is nice, but it doesn’t always work, and then the alternative—to pay others to use your money—comes into play. This is most easily accomplished by running trade and budget deficits and papering them over by issuing government debt. The reason it doesn’t always work is simple: what were the Saudis supposed to do with all those dollars they were getting for their oil (other than squandering them on useless American weapons which they promptly buried in the sand)? Why, lend them back to the Americans, of course! For a while, this scheme, called “petrodollar recycling,” worked like a charm: Americans lent out dollars at a higher rate, then borrowed them back from the Saudis at a lower rate.

But like all good things, this something-for-nothing scheme eventually stopped working. Trade and budget deficits grew into a truly gigantic pile of debt that had to keep growing all the time, and there just weren’t enough borrowers in the world who could be relied on to recycle all that money. Instead, the US has relied more and more on paying people to use its money—borrowing it into existence and paying others to use the US dollar, that is. The problem with doing this is that it eventually becomes impossible to keep the economy going because the capital it needs keeps getting eaten up by the ever-growing debt monster in the form of interest payments.

The solution to this problem—since it’s your own currency and you do whatever you want—is to drop interest rates to zero and start lending money at zero percent interest. Now, suddenly, there are plenty of takers! This is not exactly the same as just printing money and handing it out, since there are strings attached: when the loans come due, they have to be either paid off (fat chance!) or rolled over into new loans, still at 0% interest, one would hope. But since the only ones who can belly up to the 0% feeding trough are major corporations and financial institutions, the free money doesn’t filter out to consumers and stimulate demand, making it a bad idea to invest it in anything productive.

Instead, it is used to fuel speculative investments: companies inflate their share prices by buying up their own shares; financial institutions inflate real estate prices and other asset prices. This keeps federal dollars flowing and the financial system from collapsing. It also makes the rich feel even richer, but it is hardly a virtuous cycle for the economy as a whole: inflated asset prices for necessities such as housing depress consumer spending and shrink rather than grow the real economy of consumer goods and services. Nevertheless, you may currently be hearing lots of nonsensical statements such as the following: “…asset inflation has been the prime driver of growth in the developed world since the global financial crisis 10 years ago…” Look what a huge, beautiful economic tumor we grew by eating nothing but financial high-fructose corn syrup!

But we didn’t need to wait for speculative investors to get nosebleeds from stratospherically inflated asset prices or for the consumer economy to crater from asset inflation-imposed austerity, because soon enough foreign debt buyers started politely asking about getting a bit more than 0% for their troubles. Interest rates on federal debt rates then had to move up in order for the market to absorb the new debt without hurting the value of US debt. The rates on US government borrowing are now above the magic 3% level at which things are thought to start unraveling.

Beyond a certain point higher interest rates will trigger a recession/depression. But even if they don’t, foreign borrowers will eventually begin to realize that high interest rates are as bad as 0% interest rates if your creditor happens to be a deadbeat. We’ve been led down this garden path once before: prior to the Russian government’s default in 1998, interest rates on Russian government debt shot up to 100%. It was at that point that international investors decided that this wasn’t funny any more and walked away. Thus, there is no “right” level of interest rates to pick from while spiraling down into a debt hole.

Are there any alternatives to spiraling down into a debt hole? Some possibilities were opened up in this regard with the election of Donald Trump. He has all of the macroeconomic intellectual acumen of a casino and hotel magnate cross-bred with a beauty pageant organizer and a reality show host—none at all—but his megalomaniacal character makes him incapable of sensing his intellectual limitations. Add to this the fact that he has been deprived of all avenues of action except for just a few: giving tax breaks to corporations and the ultra-rich; increasing defense spending; and imposing unilateral sanctions on anyone he doesn’t happen to like. The latter is turning out to be quite lethal with regard to the US dollar’s status as an international reserve currency. If one’s ability to use the US dollar in foreign exchange reserves or in international settlements can be impaired without warning based on presidential whim, then this makes the US dollar rather unattractive. This development has turbocharged the effort, already underway, to shift away from the US dollar in international trade.

There are two effects to expect from this development. One is that the global demand for US dollars will drop as other countries find ways to trade with each other in their own currencies or using barter, bypassing the US dollar. The other that the supply of US dollars will increase, as foreign holders of US dollars unload their holdings. As a result, the US will not be able to continue borrowing internationally to continue to finance its gigantic trade and budget deficits. On the other hand, the US will be awash in dollars pouring in from abroad, and the US still has lots of assets to sell. We should expect much of the US to end up under new, foreign ownership. We should also expect anything that isn’t nailed down to be crated up and exported, much of it to China.

What can we make of Humpty’s fateful choice? Should Dumpty topple head over heels or heels over head? By tipping forward, toward higher interest rates, Dumpty would keep free money rolling in, for the time being, while bankrupting the numerous corporations that are being kept out of bankruptcy by ultra-low interest rates, triggering a severe recession/depression and a full-blown financial collapse. By tipping backward and keeping interest rates low the dollar would fall in value, driving up inflation and making it difficult for the US to continue financing its deficits. Unable to either lend or borrow money into existence, it would be forced to resort to Plan C: just print dollars and hand them out, no strings attached. But this leads to hyperinflation and a full-blown financial collapse too.

Perhaps Dumpty’s choice is just a matter of style, because the eventual result will be the same. Nor will it be a rational choice: the policymakers in the US have long given up on any realistic measures of such thing as unemployment rate, inflation or GDP growth. Their models might as well be based on tea leaves or goat entrails. But we should still be able to determine which way Dumpty got dumped by what we will observe first. If we see a deflationary collapse, Dumpty aimed high and fell backward; if we see an inflationary collapse, Dumpty aimed low and went head over heels.


MarkC said...

The Chinese gave us Iron smelting, gunpowder, alcohol and the compass.

America gave us peanut Butter, hot dogs and monster truck racing.

I know who my money is going to be on.

forrest said...

The traditional defacto solution to continually mounting debts, as Michael Hudson said in a piece on the long-term effects of compound interest, has been periods widespread bankruptcy. This achieves the necessary goal of effectively writing off unpayable debts, without the embarrassing need to do so explicitly & systematically.

the blame-e said...

Very nice article.

A lot of "very good writers" only give you a taste of the real thing and that's it. You, on the other hand, take your time to develop your argument fully, and you discuss complex matters while taking your time to say what needs to be said. As a result, this reader gets a full course meal of prime thought on important matters. I need that, more and more these days.

Here are my concerns. Since the Crash of '08 - '09 rules don't apply and consequences no longer matter (there just aren't any). Perhaps they were all out-sourced with the U.S. economy, too.

When Hank Paulson went to former President George W. Bush as Secretary of the Treasury, and said that without a bailout there would be rioting in the streets and Martial Law inside a week if the banks were not bailed out he was doubling down on the new financialization of the American economy.

Operating with the immense powers of financial extortion, the way Paulson put it, the president and the government was led to believe that it would be the banks and Wall Street rioting in streets and burning the country to the ground if a bailout wasn't forth-coming; not the American People who, having just lost between 40- and 50-percent of their retirement savings (mainly because the banks and Wall Street had exposed their old age nest eggs to risk) had every right to burn the place to the ground.

It was not the American People who were bailed out.

By the time of the Crash of '08 - '09, we had seen this kind of extortion before. The hollowing out of the American economy beginning in the 1970s was carried out with the corporate oligarchs offering the American People a non-choice, between keeping tens of millions of American jobs in the U.S., and tens of thousands of American manufacturing plants operating in the US. The American People could either pay more for goods and services by continuing having things "Made In USA" or they could pay less to have everything "Made Someplace Else." Nothing was mentioned about the end result: the death of the Middle Class. If that is not extortion then I don't know what is.

Since the Crash, extortions have been replaced with sanctions. "Believe our lies or else." The American People long ago had a bellyful with the whole mess, but have stood by and done nothing. Now the world has had enough, and it is doing something about it.

You would think that with "[t]he rates on US government borrowing . . . now above the magic 3% level at which things are thought to start unraveling," that the increasing cost (up to 37-percent with interest rates above 3-percent), of keeping the whole sorry mess going, that we would start seeing consequences -- but that was a long time ago, when consequences mattered.

Even the idea that soon the cost of paying interest on the debt will exceed the U.S. defense budget (which is greater than the next seven (7) countries combined), doesn't seem to bother these people. But what are you supposed to do?

Like most "rational economic thinkers," Kyle Bass has been using the old economic logic to bet against Japan and then China. They are both in pretty much the same debt boat the U.S. is. He has lost both times. It was one thing when he was just betting against the housing market back in 2007, but betting against governments is another thing. The old ways don't work, the old rules don't apply, and the old beliefs just don't matter. The US government's attitude is: "We're not playing by your rules anymore."

We have seen what happens with extortion. We are waiting to see what happens with sanctions. What comes next is on everybody's mind.

ZundapMan said...

And... who has called himself the "bankruptcy king?" It seems to me we have heard this from DJT repeatedly.

Chris said...

I've read this book. It's Crash Proof: How to Profit From the Coming Economic Collapse by Peter Schiff. Notice that it came out a few months before the Subprime Mortgage bubble burst and Lehman Brothers collapsed. It was incredibly prescient at the time. Schiff actually makes mostly the same arguments as Dmitry does in this essay. It almost came to pass, but then eventually, it didn't after all. Is it just the fed kicking the can down the road? Maybe, but I think this global petrodollar system may still have more life in it still, than most people can imagine.

Anselmo said...

According with this post of Mikhail Khazin, Trump is pushing to Humpy-Dumpty, because he needs tho destroy the Breton Woods order.

Vierotchka said...

This is my little paraphrase:

Highly Likely sat on a wall
Highly Likely had a great fall
All T May's horses and
All T May's men
Couldn't put Highly
Together again!

Unknown said...

I heard an interview with Michael Lewis (the Big Short, the fifth risk) his prediction is that Trump will call out a country, say China, make accusations, and then default.

justwondering said...

Great article, and in language that I can understand; however like Chris I think there's some legs left in the status quo yet. Especially when the alternatives are almost certainly very very unpleasant

Jayhawk said...

I have paid attention to the view of economists on the national debt for some sixty years. When I first became aware of the issue it was said that a debt up to equality with federal revenue was sustainable.

When US debt exceeded its revenue, it began to be said by economists that debt up to equality with national GDP was sustainable. This was a huge jump, but no explanation was ever given for the change.

Now that US debt is in excess of its GDP, economists are saying that national debt is irrelevant, not because the nation can print money, but because the Federal Reserve can buy excess debt, thereby erasing it from the national treasury. They do not say where the Federal Reserve will get the money is uses to buy the national debt. I find this theory astonishing. It is one step beyond the self licking ice cream cone.

Taxes, they now claim, are not necessary to sustain the operation of the government. That, the story now goes, can be done by borrowing and increasing the national debt without limit. Taxes, we are now told, are necessary only to reduce consumer spending and thereby control inflation.

forrest said...

To work in some capacity for the government, an "Economist" must be either an orthodox believer [in Economism, of course] of the the Chicago School of Economics -- or else a visiting operative of Wall Street invoking whatever bastardized Keynesianism they can conjure to justify whatever they want to do to us.

The people over at Kansas City [ http://neweconomicperspectives.org/ ] however, do seem to be objectively studying what happens in an actual economy.

At first they may sound, to some readers, as if they were coming from Oz -- but only because what typically passes for common sense in economics is as far removed from actuality as the ancient astronomical observation that "We're standing still and everything else goes around us."

Money seems to have a reality of its own, but it's a social creation. Ancient priests and governments could always conjure it up; and they didn't have to borrow it from anybody to make it good. (This was a custom that allowed the authorities to buy what they wanted as needed, rather than having to take their taxes in live chickens and rotting fruit.) Yes, the metal they used was worth something in its own right, but the value of the money still came down to what you could do with it.

People think the problem is that you could manufacture more money than things to buy with it. We've already done that, and it's no worse than having too many chips at a poker table. The real problem: These chips represent claims on real goods and services; and there are so many concentrated at the far end of the table that most of us are dealt out of the game.

If you think of money as ~"social permission to get what you need and do what you want," this concentration represents a severe restriction of liberty on the 99.9999...%. Those who benefit from that arrangement like it, and don't like us thinking about alternatives. But under stress, that sort of third world pyramid could turn out dangerously unstable.

Silly Me said...

My impression is that the US government will reassume the right of issuing its own currency, bankrupt the current dollar by issuing money to pay its debt, and return the right to the Federal Reserve, a private bank usurping the right since 1913.

Anselmo said...

Sorry, the link that I wrote in my last commentary is wrong.

You'll find the post in the web "khazin. ru", and the translation of his title is "on the rol and importance of Bretton Woods' system".

It was published in 03/06/2018

Unknown said...

What happened to your cluborlov.blogspot.com rss feed? I thought you had stopped writing until someone posted a link to your latest post. And there you are alive and well and writing.


Dmitry Orlov said...

I shut off the RSS feed a long time ago, when I found that it provided unscrupulous people an easy way to steal my content by reposting it without permission or attribution.