Tuesday, October 16, 2018
Humpty-Dumpty’s Fateful Choice
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.