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This is part one of a two-part series. Part two will appear next week.
U.K. pension funds are being bailed out. The Bank of Japan uses excessive monetary policy to protect its currency and cap interest rates. China encourages its banks to buy stocks. The dollar is on a tear, interest rates are surging, and the financial world is fracturing.
The dollar, unlike any other currency, drives the global economy and financial markets. Because of its status as the world's reserve currency, the Fed's monetary policy actions play a critical role in steering the U.S. economy and all global economies and financial markets.
To foresee what crisis might be next, it is vital to understand the dollar's role in global finance and economics and the resulting role that the Fed plays in influencing global monetary policy. To do so, I start with insight from Triffin Warned Us, an article I published in 2018.
The "cliff notes" for the article lay the groundwork for part 2, which discusses the risks investors face as the Fed attempts to quell inflation.
The Bretton Woods agreement
In 1944, the United States and many nations forged a significant financial arrangement in Bretton Woods, New Hampshire. The agreement has paid enormous economic dividends to the United States. However, it has a incongruity that is manifesting itself now.
Per the terms of the 1944 Bretton Woods agreement, the dollar supplanted the British pound to become the world's reserve currency. The agreement assured a large majority of global trade would occur in U.S. dollars, regardless of whether the United States was participating in such trade. Additionally, it set up a system whereby other nations would peg their currency to the dollar. This arrangement is akin to the global currency concept made popular by John Maynard Keynes and his idea for a ”bancor,” a supranational currency.
Within the terms of the agreement was a supposed remedy for one of the abuses that countries with reserve currency status typically commit, running continual trade and fiscal deficits. The pact discouraged such behavior by allowing participating nations to exchange dollars for gold. In this way, other countries that were accumulating too many dollars, the side effect of American trade deficits, could exchange their excess dollars for U.S.-held gold. A rising price of gold, indicative of a devaluing U.S. dollar, would be a telltale sign that America was abusing her privilege.
London gold pool
The agreement started fraying shortly after it was made. In 1961, the world's leading nations established the London gold pool. The objective was to fix the price of gold at $35 an ounce. This was an attempt to maintain the Bretton Woods status quo. By manipulating the price of gold, an important gauge of the size of U.S. trade deficits was broken. Accordingly, the incentive to swap dollars for gold was diminished.
Seven years later, France broke ranks. It withdrew from the gold pool and demanded large amounts of gold in exchange for dollars. In 1971, President Richard Nixon, fearing the U.S. would lose its gold if others followed France's lead, suspended the convertibility of dollars into gold.
From that point forward, the U.S. dollar was a floating currency. There was no longer the discipline imposed upon it by gold convertibility. Nixon's actions essentially annulled the Bretton Woods agreement.
The following decade saw double-digit inflation, persistent trade deficits, and weak economic growth. These were signs that America was abusing its privilege as the reserve currency. The first graph below shows that, like clockwork, the U.S. began running annual trade deficits in 1971. The second graph highlights how inflation picked up markedly after 1971.
By the late-1970s, Fed Chair Paul Volcker raised interest rates from 5.875% to nearly 20.00% to arrest inflation decisively. While economically painful, Volcker's actions not only ended 10 years of persistently high inflation and restored economic stability but, more importantly, satisfied America's trade partners. The now floating rate dollar regained the integrity required to be the world's reserve currency despite lacking the checks and balances imposed upon it by the Bretton Woods agreement and the gold standard.
As an aside, my article The Fifteenth of August discusses how Nixon's "suspension" of the gold window unleashed the Federal Reserve to take full advantage of the dollar's reserve currency status.
Enter Dr. Triffin
In 1960, 11 years before Nixon's suspension of gold convertibility and the effective demise of the Bretton Woods agreement, Robert Tiffin foresaw this inevitable problem in his book Gold and the Dollar Crisis: The Future of Convertibility. According to his logic, the privilege of becoming the world's reserve currency would eventually carry a heavy penalty for the U.S.
Triffin's thesis was given little consideration at the time, but he was invited to a congressional hearing of the Joint Economic Committee in December of the same year.
What he described in his book and Congressional testimony became known as Triffin's paradox. Events have played out primarily as he envisioned.
He argued the reserve status forces a good percentage of global trade to occur in U.S. dollars. For trade and global economies to grow under such a system, the U.S. must supply the world with dollars.
To supply the world with dollars, the United States must run a trade deficit whereby the dollar amount of imports exceeds the dollar amount of exports. Running persistent deficits, the United States would become a debtor nation.
Foreign creditors enable U.S. deficits
Foreign nations accumulate and spend dollars through trade. They keep extra dollars on hand to manage their economies and limit financial shocks. These dollars, known as excess reserves, are invested primarily in U.S.-denominated investments ranging from bank deposits to U.S. Treasury securities and a wide range of other financial securities. As the global economy expanded and more trade occurred, additional dollars were needed. As a result, foreign dollar reserves grew and were lent back to the U.S. economy.
Making the world even more dependent on the dollar, many foreign countries and companies borrow in U.S. dollars to better facilitate trade and take advantage of America's liquid capital markets.
The arrangement benefits all parties involved. The U.S. purchases imports with dollars lent to it by the same nations that sold the goods. Additionally, the need for foreign countries to hold dollars and invest them in the U.S. results in lower U.S. interest rates, further encouraging consumption and providing relative support for the dollar.
For their part, foreign nations benefit as manufacturing shifted away from the United States to their countries. As this occurred, increased demand for their products supported employment and income growth, thus raising the prosperity of their respective citizens.
A win-win or a Ponzi scheme?
While it may appear the post-Bretton Woods covenant is a win-win pact, there is a massive cost accruing to everyone involved.
The U.S. is grossly over-indebted. As such, it has become increasingly dependent on low-interest rates to spur debt-driven consumption further and to roll over existing debt.
Lower-than-appropriate interest rates lead to unproductive debt, as can be seen with debt outstanding rising at a much faster pace than GDP.
Summary
Triffin's paradox states that with the benefits of the reserve currency also comes an inevitable tipping point or failure.
As we see with the current instance of rising interest rates and inflation, that point of failure is closing in on the U.S. and the rest of the world.
Part 2 of this article will focus on the dollar and Fed monetary policy and what it may mean as the Fed continues to push interest rates higher.
Michael Lebowitz has been involved in trading, portfolio construction, and risk management involving some of the largest and most active portfolios in the world. In addition to broad institutional experience, he also built a successful independent RIA allowing him to further extend his experience into the realm of investment management for individuals and family offices. Grounded in logic and common sense, he blends vast trading and investment expertise with economic viewpoints that delivers pragmatic and actionable thought leadership to clients.
Join our website today for a look behind the data at what is really going on with the markets and your money. www.realinvestmentadvice.com.
Contact him at [email protected].
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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
