One month ago, Deutsche Bank's unorthodox credit analyst, Jim Reid published a phenomenal report, one which just a few years ago would have been anathema in the hushed corridors of high finance as it dealt with two formerly taboo topics: is a financial crisis coming (yes), and what are the catalysts that have led the world to its current pre-catastrophic state, to which Reid had three answers: central banks, financial bubbles and record amounts of debt.
Just as striking was Reid's nuanced observation that it was the fiat monetary system itself that has encouraged and perpetuated the current boom-bust cycle, and was itself in jeopardy of becoming extinct when the next megacrash hits:
We think the final break with precious metal currency systems from the early 1970s (after centuries of adhering to such regimes) and to a fiat currency world has encouraged budget deficits, rising debts, huge credit creation, ultra loose monetary policy, global build-up of imbalances, financial deregulation and more unstable markets.
The various breaks with gold based currencies over the last century or so has correlated well with our financial shocks/crises indicator. It shows that you are more likely to see crises/shocks when we break from hard currency systems. Some of the devaluation to Gold has been mindboggling over the last 100 years.
The implications of this allegation were tremendous, especially coming from a reputable professional who works in a company which only exists thanks to the current fiat regime: after all, much has been said about Deutsche Bank's tens of trillions in gross liabilities, mostly in the form of various rate derivatives, backed by hundreds of billions in deposits and, implicitly, the backstop of the German government as Deutsche Bank discovered the hard way one year ago.
However, what shocked most readers was that at its core, Reid's report was dead accurate, and as Reid writes in a follow up report published this morning, it is the topic of the fiat system itself as potentially the weakest link in any future crisis that generated the most debate.
In the report titled, "The Start of the End of Fiat Money?" Reid writes that "as we road-showed the document a theme that had minor billing in the report started to gain more and more prominence in the discussions and as such we wanted to expand upon it in this short follow-up thematic note. The basic premise is that a fiat currency system - the likes of which we’ve had since 1971 - is inherently unstable and prone to high inflation all other things being equal. However, for the current system to have survived this long perhaps we’ve needed a huge offsetting disinflationary shock. We think that since around 1980 we’ve had such a force and there is evidence that this influence is now slowly reversing."
And here comes the shocking punchline: not only does Reid concede that the fiat system "may be seriously tested over the coming decade and ultimately we may need to find an alternative" but that one such alternative is none other than cryptocurrencues, i.e. bitcoin, ethereum and so on. Which, while it may be a surprise to institutional investors appears to have been all too obvious to buyers of cryptocurrencies.
If we’re correct, the fiat currency system may be seriously tested over the coming decade and ultimately we may need to find an alternative. This is not necessarily a story for the next few months or quarters but we think the trend reversal is already slowly in place. Maybe we can explore future alternatives to the current monetary system in a second part sometime in the future. Cryptocurriencies are all the rage at the moment and are as much about blockchain as anything else but there could be an increasing desire for alternative medians of exchange in the years to come if we are correct.
Below we excerpt some of the key observations from Reid's note:
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The Future of Money Part 1 - The Start of the End of Fiat Money?
In “The Next Financial Crisis” we suggested how China's fairly sudden integration into the global economy at the end of the 1970s and a very favourable once-in-alifetime shift in demographics from around 1980 onwards could have contributed to the modern boom/bust culture that has made financial crises more regular in recent decades. The argument is based around a view that a positive labour supply shock from China and developed countries' demographics between 1980-2015 has allowed inflation to be controlled externally as the surge in the global labour supply at a time of rapid globalisation has suppressed wages. With inflation controlled externally it has allowed governments and central banks the luxury of responding to every crisis and shock with more leverage, loose policy and latterly more and more money printing. Its not usually this easy as inflation would have normally increased with such stimulus and credit creation.
It could be argued that this external disinflation shock has perhaps ‘saved’ fiat currencies after the runaway inflation of the 1970s in the immediate aftermath of the collapse of the Bretton Woods quasi Gold Standard from 1971 onwards. If this theory is correct then any reversals in this demographic super cycle could spell problems for the fiat currency system. Under this scenario inflation would pick up externally due to working age populations no longer rising and labour pricing power returning. Central banks and governments which have ‘dined out’ on the 35 year secular, structural decline in inflation are not able to prevent it rising as raising interest rates to suitable levels would risk serious economic contraction given the huge debt burden economies face. As such they are forced to prioritise low interest rates and nominal growth over inflation control which could herald in the beginning of the end of the global fiat currency system that begun with the abandonment of Bretton Woods back in 1971.
Fiat currencies and inflation
For virtually all of financial history up to the collapse of the Bretton Woods system in 1971, most currencies were backed by precious metals for the vast majority of times. Over the preceding century or so these systems periodically broke down for many countries due to wars and notably during the Depression years of the 1930s. However, countries generally reverted to some kind of precious metal fix after experiencing high inflation in the years where they suspended membership. Figure 1 shows our global median inflation index back over 800 years and then isolates the period post 1900 where inflation exploded relative to long-term history
Figure 2 then shows this in year-on-year terms and as can be seen, in the 700 years before the twentieth century inflation and deflation were near equal bedfellows with only a gradual upward creep in inflation as new precious metals were mined or governments periodically punched holes in existing coins and thus slightly debasing the currency.
As someone that has studied economic history it always amuses me to hear that we live in times of extremely low inflation when history would suggest these are relatively high inflation times. Indeed a look at the right hand chart of Figure 2 shows we haven’t had a single year of negative (median) global inflation since 1933. What has happened though is that we saw a 35 year disinflationary period start in 1980 that took inflation down from the extremes at the start of that decade to what we think will be the secular lows around the middle of this decade.
Inflation since 1971 – a loss of control and then a positive disinflationary shock
In the first decade of global fiat currencies post 1971, global inflation saw one of its biggest climbs in history. Although the oil shocks were partly to blame, the fact that the shackles of the Bretton Woods system were removed and countries were freer to borrow and find ways of liberalising finance and credit surely contributed to the inflation surge. Gold saw an annualised nominal return of 32.2% p.a. in the 1970s way above the long term return of 1.97% p.a. from 1800.
However a miracle occurred post 1980 which many have attributed to the Volker Fed taming the inflationary dragon. Clearly their tighter policies helped but was the global structural story providing phenomenal disinflation tailwinds from this point and is it now slowly reversing?
China and Developed Country demographics to the rescue
We think that the effective global labour force exploded from around 1980 due to natural global demographics and China opening up its economy to the outside world at the end of the 1970s. Figure 3 shows the 15-64 year olds (working age population proxy) in the More Developed Regions + China where the second bars repeat the exercise with China zeroed before 1980 to reflect its virtually closed economy before this point and the effective surge in the global labour supply thereafter. So we first see the impact in 1990 on this graph.
Obviously, this is highly simplified and in a globalised world we should probably include more countries than China as various lower labour cost nations have transformed from relatively closed low income countries to more developed globalised ones. However, China dwarfs all these by its size. It’s also simplistic to include all of the working age population increase from China in one decade as we do in the chart. It should probably be spread out over time but it’s hard to assess the increments that they should be added over the last 35 years. The disinflationary journey would be the same though. At a developed world level there's little doubt that labour's share of GDP has declined over the last few decades. Figure 4 shows this decline for a selection of G20 countries from 1980.
In addition Figure 5 shows real wage growth (YoY change) over the last few decades for a selection of the largest countries around the world. As can be seen in the two decades we have data for prior to 1980, real wage growth was much higher than the post 1980-period. It's interesting that China's wage growth over the period was much higher which fits with our thesis that the EM workers that integrated into the global economy benefitted most from this globalisation period.
So will a falling working age population increase inflation?
As can be seen in Figure 3 above, the peak of the ‘working age population’ in the MDW plus China occurred around the middle of this decade. Going forward the supply of labour will in aggregate start to decline after rising for the last three and a half decades.
While the pace of decline will be slow, the fact that it’s not increasing at the rapid pace of the last 35 years surely must have an impact on labour costs. If economic growth simply increases at trend over the next few years and decades then all other things being equal a flat to declining labour force should bring upward pressure on wage costs.
Would fiat currencies survive if labour’s share of GDP reversed?
In terms of addressing inequality and the increasing gap between capital and labour, higher wages would undoubtedly be good news. However the problem for the current global monetary system is that over the last 45 years it has relied on governments and central banks being able to turn on the stimulus spigots at the drop of a hat when a crisis has come. This has enabled each crisis to be dealt with via increasing leverage rather than creative destruction type policies. For this to be possible you’ve needed an offset to such stimulus to prevent such policies being inflationary. Fortunately (or unfortunately if you believe it’s an inherently unstable equilibrium) the external global downward pressure on labour costs ensured that this has happened.
So what would happen to the global monetary system if labour costs started to reverse their 35 year trend? If central banks had their current mandates of keeping inflation around 2% then they would be duty bound to tighten policy more often regardless of the external environment. However, such an outcome is probably unrealistic given how much debt there is at a global level. Governments would surely first change their mandates to allow higher inflation or look to reduce their independence rather than allow interest rates to rise to economically uncomfortable levels given high debt levels. Ultimately, if and when labour costs rise at the margin rather than fall at the margin, we will likely have a much more difficult environment for policy makers and in a democracy where politicians have to be elected it is likely that inflation will be the casualty.
If we get higher trending inflation then bond yields would be very vulnerable, especially relative to current near record (multi-century) lows. Given the near record level debt burdens around the world, it is likely that central banks would be forced to buy more securities again to ensure that yields stayed comfortably below nominal GDP. This would likely lock in higher inflation as you would have negative real yields, very loose financial conditions and higher wages.
Eventually, it’s possible that inflation becomes more and more uncontrollable and the era of fiat currencies looks vulnerable as people lose faith in paper money. Once the value of debt has been eroded the debate would likely be live as to what replaces fiat currencies as surely the backlash would be severe against the system that allowed us to get to such a situation. Although the current speculative interest in cryptocurrencies is more to do with blockchain technology than a loss of faith in paper money, at some point there will likely be some median of exchange that becomes more universal and a competitor of paper money.
It’s far too early to fully speculate on the future of money but if there is demand we will look to add a part 2 to this series where we look at the alternatives and perhaps a more in-depth look at cryptocurriences going forward.
What if people retire later?
If populations extended their retirement well beyond 65 years old then the working age population will get a boost. However, while this is undoubtedly happening, in democracies this is proving incredibly hard to legislate on a big enough scale to seriously impact the overall natural demographic story. Maybe one day retirement ages will go up significantly and change the argument but this probably requires a major global shock and subsequent rewriting of contractual agreements between governments and their populations.
We would argue that fiat currencies are the rarity in financial history and are always associated with higher inflation. Perhaps the now 46 year experience with fiat currencies can be broken down into two periods; 1) The 1970s where inflation rose around the word at the fastest pace on record; and 2) the last 35 years where inflation has always been positive at a global level but has progressively fallen largely due to demographics, China and the associated globalisation trend.
Given we know that demographics are now slowly turning, it’s possible that a new era is slowly emerging towards higher wages, which will perhaps be encouraged by the rise in populism. As such, will fiat currencies survive the policy dilemma that the authorities will experience as they try to balance higher yields with record levels of debt?
That’s the multi-trillion dollar question for the years ahead.