The View From Hubbert’s Peak
In 1971, the American President put an end to a 2,500 year trend; the Wall Street Journal called it “Nixon’s Worst Weekend.” Considering the old boy had some really bad ones, this must have been something special. In August of that year (on Friday the 13th) it was decided that the U.S. would no longer pay out gold for its paper dollars. OPEC Ministers took note, and in September they met, deciding it would be necessary to collect more paper dollars, if possible, since gold was no longer on offer and oil was the only asset they had to sell.
It would take another two years for those decisions to matter (during the October 1973 embargo in the wake of another Arab-Israeli war). The Oil Embargo marked the end of ‘free’ energy, and kicked off a massive rise in the price of oil because the U.S., the world’s swing producer since Colonel Drake’s Pennsylvania strike in 1859, had finally reached peak production at around 10 million barrels per day in 1970. This moment is the original Hubbert’s Peak, the beginning of decline for the U.S. oil industry, at least until recently. The surge in U.S. production since 2010 has stalled out around 9.5 mb/d and, due to the Saudi decision to give the American tight oil producers ‘a good sweating,’ that rate has begun to fall in the last few months.
It is certainly possible that U.S. production will surpass the 1970 peak, but with low prices it is hard to say when that will be; it is also hard to say how long that will last as tight oil wells have a devilishly high rate of decline. It is worth noting, as Arthur Berman has recently done in his fine article, that even the best producers are losing money now, and lots more are being lost by those who are not the best. Making it up on volume is a dog that does not hunt for $45.
The Wizard of Oz
The ultimate irony for this generation of investors is that, despite the occasional obligatory chant about ‘free markets’ and the wonders of capitalism, most of the day is spent obsessing about what the world’s most important central planner will do next. By Supreme Central Planner, I mean, the Fed.
“Pay no attention to that man behind the curtain”
The ‘Man’ behind the curtain is now a woman, but the power of the Fed is not in doubt; it still illuminates the Emerald City and all who look to it for guidance and more free money, which can be printed instantaneously and in any amount. At some point, the value of ‘free money’ will fall out of the sky, like Dorothy’s house onto the ruby slippers. Are we anywhere near that point?
On September 17, the mighty Fed decided to do nothing, continuing a 9-year inning without a rate increase. (Did the markets breathe a sigh of relief? On the first full day of trading after the announcement the S&P fell by 1.6 percent and the Dow Industrials fell nearly 300 points; so, no, they didn’t.) This Bloomberg article suggests the Fed kept its powder dry because of China. “China affects the world more than ever before, and its influence over global markets will only increase as it approaches the U.S. economy in size.”
Gold isn’t doing much to suggest that paper money is on the ropes but you may still be forgiven for thinking gold is a crouching tiger and it is only a matter of time. Oz is the abbreviation for an ounce of gold – “Follow the yellow brick road”; that is the path of hard money. Nobody is on that path anymore, so currency wars, i.e. who can devalue the right amount at the right time to gain a competitive advantage for their nation’s trade, are to be expected.
The Fed failed its first test in the 1930s, and the question must be asked, now that China is well on its way to becoming the world’s most important financial player, will they make the same mistake? Will they tighten the money supply to the point that disaster follows? Deutsche Bank thinks the tightening has begun, though they do not predict disaster. At this moment in the great game, turbulence in markets is not particularly reassuring. Liquidity is evaporating, in pockets, and that generally ends badly.
It is important for non-mathematicians to understand a dilemma which is not much discussed, if realized at all. When rates are low, even small increases make a significant difference. Raising rates from 1 to 2 percent, a ‘mere’ one point rise, has the same effect on the cost of the money you borrowed as raising rates from 5 to 10 percent – it is a doubling of the cost. It took a long time to crawl out from under extremely low rates in the 1930s (as it did after the 1893 crash before the Fed came along), which included a world at war. The liquidation process did not end until the rubble bounced in Germany and buildings were vaporized in Japan.
Central Planners have not yet figured out a way to end the problem without a liquidation event; the problems of 2008 were not allowed to run their course. In other words, there is no precedent for a rate recovery from such an enduring trend without first undergoing a massive deflation. What is different this time is that gold is no longer seen as an official backstop, though central banks still own plenty of it (for some reason). As terrifying as deflation is, hyper-inflation is worse. Consider what happened in France after 1790 and Germany after 1923.
The Next Suez Moment
1971 was symbolically pivotal in another way. The Royal Navy, symbol of British power from the time of Trafalgar on, pulled up its anchors and sailed away from Singapore (Churchill’s ‘Gibraltar of the East’), having left Aden (in Yemen) a few years before, where it kept watch over the Indian Ocean and its most prized possession, i.e. India itself, for 128 years. The liquidation of the British Empire did not happen overnight. The 30-year running gun battle with Germany leading up to the Bretton Wood’s coronation of the U.S. dollar as the world’s supreme currency was not quite the bitter end. It took another 12 years before the British ruling class learned that the sun had already set upon their power.
On July 26, 1956, Egyptian President Gamal Abdul Nasser nationalized the Suez Canal. The British and the French, who had financed and built it along with the Egyptians, were outraged. On October 29, Israel invaded the Sinai. On November 5, British and French paratroopers landed and defeated Egyptian troops along the Suez Canal. On the following day, Ike won an overwhelming electoral victory over Adlai Stevenson and, at the height of his (and America’s) powers, he told the British and French leaders to back down. America held their notes. The world held its breath. Prime Minister Anthony Eden resigned during the crisis and events effectively marked the end of heavily indebted Britain’s time as one of the world’s great powers.
The $64 trillion question now facing the current world’s economic superpowers, by which I mean the U.S. and China, is not whether the Fed will raise rates any time soon, but when will the Yuan replace the Greenback as the world’s reserve currency? Whether or not paper money turns to dust generally is a separate question. The U.S. is now the world’s leading debtor nation, owing something on the order of $18 trillion. This is by far the most money that has ever been owed at any time in history. Does anyone really believe that it will ever be paid back?
Inflation (printing money) and default are the usual suspects, but the unwinding of American debt will not necessarily happen in an orderly fashion. China’s Yuan becoming the world’s reserve currency would not be a Black Swan event; it may be a Gray Swan, but we have seen this sort of thing play out many times before, and not just to Britain.
It has been a constant throughout history that both the Operations & Maintenance (O&M) and capital costs of running an empire at some point exceed the benefits or gains obtained from having that empire. Prestige does not pay the bills. Hadrian’s Wall, a high-water mark of Roman expansion, is in a pretty bad state (like a lot of American bridges that are crumbling on the home front).
If it were otherwise, this article would be written in Latin; Facilis descensus Averno. (Loosely translated: The descent to hell is easy. Coming back up is the hard part: Hoc opus hic labor est.) The oft-quoted phrase: “Rome wasn’t built in a day,” misses a more important point, i.e. that it took centuries for the place to fall apart. About 150 years before so-called barbarians put the Eternal City out of its misery, Constantine moved the capital to what is now Istanbul. The Bezant, a gold coin, was the western world’s supreme currency for about 800 years after that, until the Venetians ruined the city during one of the Crusades.
The Venetians (the Ducat), Florence (the Florin), Spain (thanks to American gold and silver), and the Dutch (whose Guilder was garnished with an occasional tulip), all had their turn in the catbird seat – the supreme privilege of minting the reserve currency (and running up debts without anyone calling them in). Britannia ruled the waves and the financial system after finally beating Napoleon in 1815 and their turn did not end until 1944, after decades of war first ignited in 1914 by Victoria’s grandchildren.
The New Face of Money
Nobody plans to give way as keeper of the supreme currency, so there is no schedule to follow and no way to know when the torch will be passed from the dollar to the Yuan. Central planners and economists, who all drink from the same cup, may acknowledge that such a thing could happen decades from now (after all, Rome didn’t fall apart in a day), but will vigorously dispute the conclusions in this article. However, history has shown that the shift comes suddenly, usually in the heat or aftermath of war.
American troops have now been involved in the Middle East for 25 years (nearly as long as the face-off between British and German troops and navies in the 20th century) and the U.S. Navy’s Fifth Fleet is stationed in Bahrain, having filled the void left when the Royal Navy departed. The U.S. Navy is the world’s single largest consumer of oil and aircraft carriers don't come cheap. Clearly, the ‘price’ of oil is greater than we think it is, and someday this will probably be recognized as the principal cause of the dollar’s fall from grace. The temporary rise in the dollar against most other currencies is partly the result of being the best looking leper in the colony. Furthermore, an expected rise in dollar rates makes the currency seem relatively more attractive, though this is a double-edged sword.
It should be clear now that the reserve currency status is neither a birthright nor a privilege that stays forever in one place, which means it isn’t a question of if China will replace the U.S. as title holder but when. Imagine that a Republican president in January 2017 decides to act upon a campaign pledge to tear up any agreement between the U.S. and Iran. Imagine further that an air strike is aimed at Tehran. Regardless of Iran, or who is president, what if something happened in Pakistan that brought about a large scale American military response? What would China do?
That country has an insatiable and rising need for Btus from the Middle East and its development of a port at Gwadar is highly significant. “Beijing says it wants to use Gwadar as the hub of an energy corridor to its western province of Xinjiang. But at the same time, Beijing has secured a string of port facilities in the Indian Ocean that increasingly allow it to project its own naval power westward.”
With a population four times that of the U.S., and a per capita car ownership rate roughly one-tenth that of the U.S., even an elementary school math student can figure that over the next decade or so, there will be a lot more cars drinking a lot more oil filling Chinese streets (even if most vehicles eventually run on electricity – a switch that will take a long time).
A military misadventure in that part of the world would be considered a direct threat to Chinese strategic interests. As Ike said ‘no’ in 1956, Xi Jinping may well say ‘no’ this time around. What would happen if China decided, or even threatened, to sell a substantial fraction of its trillion dollar U.S. Treasury horde? This may seem unthinkable, but even if they did not, after 35 years of falling and now zero rates, the direction is only up for the cost of money, as is the cost to service debt, along with the burden to those who are most indebted (i.e. the U.S.).
What should no longer be unthinkable is that the clock is ticking on America’s status as the holder of the reserve currency. If you still doubt this proposition, consider that China is in the process of setting up a third benchmark for oil, along with Brent and West Texas Intermediate, for trading oil futures contracts. And unlike the existing contracts, these will be traded in Renminbi. Who needs the dollar?
Alexander Hamilton’s face is on the ten dollar bill for a reason; he devised the system that made the U.S. the world’s supreme financial power. (Pretty good work for a penniless orphan from the Caribbean. He was also one of the few founders who did not ever own slaves.) If he goes off the $10 bill it would be a very bad omen. Susan B. Anthony would be a good choice for the $20 bill; she is already on the roster. Andrew Jackson does not deserve to be there anyway, as he was no champion of liberty even before he betrayed the native allies who helped him defeat the British. ( In 1814 we took a little trip, along with Colonel Jackson down the mighty Mississipi . . . )
Speaking of Liberty, she graced U.S. silver dollars and gold coins for a long time. In hoc signo vinces.