Submitted by Paul Brodsky of Macro Allocation, Inc.
In part 2 of the "Man in the Moon" series we look at Paul Volcker’s roundtrip - monetary policies and their impacts from 1971 through the Great Leveraging to today. Part 1 can be found here.
If it Looks Like a Duck…
Prior to 1971, all global currencies were valued based on a fixed exchange rate system, commonly referred to as “Bretton Woods”. Each currency was directly linked to the US dollar’s fixed exchange rate to gold.
Bretton Woods effectively died in August 1971 (officially 1973) when the U.S. Treasury ceased exchanging dollars for gold in what became known as “The Nixon Shock”. Overnight, global money and credit became un-tethered to anything scarce. (The Man in the Moon is concerned only with understanding the value of money, not gold’s status as an economic, financial and political lightning rod.)
What followed from 1973 to 1982 in the West was a period of significant inflation coincident with economic stagnation (i.e., “stagflation”), a state of dis-equilibrium with which most global economists were unfamiliar. 1970s stagflation is now commonly blamed on two Middle East wars, in 1973 and 1979, which led the Organization of Oil Producing Exporters (OPEC) to embargo crude oil and drive its price higher. It is thought the embargo created higher prices coincident with an economic slowdown because consumption dropped without a commensurate and offsetting downward adjustment in oil prices.
Such macroeconomic analysis begins with the vagaries of geopolitics – the wars. Less blame is placed on what was then the new threat of a dramatically increasing stock of global currency – currency the OPEC cartel would have to accept in exchange for their relatively finite oil.
Since 1971, the cost of creating money dropped to near zero and there was suddenly no limit to potential currency dilution. The Man in the Moon might wonder whether the new anchor-less, post-Bretton Woods monetary system that began in 1971/1973 contributed to OPEC’s decision to reduce oil exports? Perhaps the cartel simply wanted more hard-to-value currency in exchange for its precious resource?
Paul Volcker, who, as Under-Secretary of the Treasury for internal monetary affairs under President Nixon in 1971, and as one of three primary decision makers that advised Nixon to abandon the fixed gold-exchange system, was appointed Fed Chairman in 1979 by President Carter. He was given the mandate of reversing debilitating inflation.
Over the course of eighteen months, Volcker raised overnight rates from 11% to 20%. This created greater demand for U.S. Dollars, reduced the propensity to spend them, and stabilized the currency as a global store of value. As a result, foreign USD reserve holders, like OPEC, were given reasonable assurance that for the first time in a decade that they would receive fair terms of trade. Volcker may have successfully whipped inflation, but his actions effectively saved the USD as a reserve currency (which he helped jeopardize a decade before).
The Great Leveraging
As the purveyor of the world’s reserve currency and its monetary hegemon, The Man in the Moon would likely notice that it has become easy to disparage the United States, the country that first came to visit him.
Since the demise of hyperinflation in 1981, central banks, led by the Fed, have generally maintained an easy credit posture, either through stimulative overnight funding rates or other policies meant to encourage credit growth. As a result, mountains of debt were piled onto bank, household, government and corporate balance sheets in the U.S. and around the world. The naturally-occurring production model for economic growth and stability was effectively replaced with a more managed financial model.
There was an upside to this. It could be reasonably argued that this new financialism doomed communism in Russia and altered it in China, greased the wheels of great technological innovations, and improved coordination and unity among economies willing to play along with the leverage game.
Nevertheless, it seems that years of financial return-seeking mal-investment arising from unnaturally easy credit conditions also forced economic imbalances, market distortions, and, as is becoming more obvious today, the potential for unsanctioned currency-based trade wars. (TMITM might even suspect The Great Leveraging re-defined global cultural relations to the point where it made it easier for less secular, un-levered members of the global community to revolt.)
As a matter of course, central banks forever defend their political impartiality; which is to say, they deny being influenced by the whims of the political dimension to whom they ostensibly answer.
While this may be true, the record seems to show clearly that monetary authorities have become loathe to making long-term economic sustainability their top priority. Whether they cave to political influences or the best interests of private banks, for whom central banks are directly responsible to provide constant liquidity and solvency, is a subject for gossipers. The net result is the same.
Over the last generation, global monetary authorities have been able to help accommodate (or generate) global nominal output growth and inflation through policies that engendered credit growth and debt assumption. This can be seen clearly in the U.S., home to the world’s largest debt markets, where the total credit market debt-to-GDP ratio peaked in 2008 at 3.7. (It is about 3.2 today after holding constant from 1950 to 1980 at 1.5.)
A broader measure of economic leverage would be the total credit-to-GDP ratio, implied in the following graph. Similar leverage implications can also be seen in Europe and China, where Fitch recently reported: “the interest-cost burden of servicing the debt has risen to an equivalent of around 15% of GDP, exceeding nominal GDP growth.”
As a result of this leverage-based economic model, the global supply of credit (and now base money) has grown based not only on real economic incentives driven by production and capital formation, but also based purely on shorter-term financial incentives. As time passed and balance sheets became more leveraged, financial return ultimately overwhelmed production and capital formation as the primary investment driver.
The more economies with established financial asset markets leveraged themselves, the less incentive the factors of production have had to produce. Production competes with financial returns for capital, and it has become unable to keep up. Corporate capital allocators are rationally choosing to operate their businesses in search of financial return rather than investing in new plant and equipment. (Tax incentives for debt assumption and “central bank puts” against rising funding rates also help.)
Capital formation could still occur (and has, judging by the great innovations discussed in TMITM Part 1), but such innovations produce deflationary efficiencies and are accompanied by ever more debt and the need for inflation to service it. Indeed, the widening gap in the accompanying graph also implies how a dollar of debt has produced a decreasing amount of output.
“Economic dis-equilibrium”, formally acknowledged via the onset of QE in Japan in 2001, China in 2008, the U.S. in 2009, and Europe in 2015, has been little more than necessary (and predictable) bank system de-leveraging.
Put in context, QE’s impact today is as extreme as the events from 1971 to 1981. By raising rates in 1979 and 1980, the Fed saved the purchasing power of the US dollar and, by extension, all global currencies. By creating bank reserves today (excess reserves as they are commonly referred to, which implies any reserves are unnecessary), global central banks are planting the seeds for a new bank multiplier effect – a financial re-leveraging. This promises to further devalue currencies vis-à-vis the global production they will be exchanged for tomorrow.
The impact of this would be felt most in the non-bank public and private sector. Under the right circumstances, re-liquefying the bank credit channel could benefit domestic commerce, international trade, and asset market valuations. Another impact of QE is that it temporarily offsets the burden of government debt repayment. QE, however, does not literally reduce federal debt or de-leverage household, corporate, or provincial government balance sheets. Today, total aggregate debt is higher than ever.
During “normal times” – an economic growth phase accompanied or generated by rising systemic leverage – central banks have incentive to promote nominal growth and inflation, which make banking systems profitable and their free-spending political overseers happy. In such times, commercial banks have fiduciary responsibilities to shareholders to constantly increase their market values, which they do by expanding their balance sheets.
Now that economies are highly leveraged, extinguishing debt would require banks to reduce the sizes of their loan books, which would shrink their market values. Thus, it seems economic policy makers never have incentive to promote debt extinguishment in the banking system, regardless of economic conditions or prospects.
So, by all indicators it seems monetary policy makers intend to inflate away the purchasing power value of their currencies, and with it the PPV of savings.
In Part 3, The Man in the Moon takes an analytical dive into monetary identities and the current states of the global economy and capital markets, and concludes there will be “A Great Reconciliation”.
Macro Allocation Inc.