What have we (The Fed) done?
In a previous piece written on the WattWatt Medium blog, ‘What is Backing Bitcoin?’, we explained what Bitcoin is backed by first by explaining how the national fiat currencies we all use are created. The basic premise is that new fiat currency is created when a bank locks up some form of collateral on its balance sheet. If the US Federal Reserve wants to create $100 more US Dollars, it does it this by buying $100 worth of US Treasury bonds (US government debt) or mortgage backed securities (debt generated when a bank lends money to someone so they create something new). Now that we’ve explained that, I wanted to go into specific detail on an ongoing situation with the US Dollar and other major national fiat currencies.
Essentially, I propose that the US Dollar and other major currencies may likely undergo a monetary crisis in the next two years.
The background to this issue is that the Federal Reserve and other central banks diluted the value of their currencies after the debt crisis of 2008. They called it ‘quantitative easing’, which essentially was when they went from creating new units of their money only backed by their governments’ debt to also accepting debt in the form of mortgage backed securities and shares of corporations off the stock market. This was used to help the banks remove a lot of the debt off their balance sheets and inject cash to keep them solvent. If the central banks did not do this, these banks could have run out of money and not be able to lend anymore. However, what this also did was kick the can down the road to solving what to do about the loans that were no longer worth much since the borrowers weren’t able to repay and the assets bought with the borrowed money were overpriced and now are still worth much less than when they were purchased with the debt.
What’s the Value Backing USD Now?
In WattWatt’s writeup on what is backing Bitcoin, we touched on how a dollar is created and therefore what has to be collateralized before that dollar is produced (Debt, in a word, US Treasury bonds or mortgage backed securities for US Federal Reserve created Dollars, debt contracts for previous loans made by the bank for bank created Dollars, in several words).
Basically, the mechanism defending the value of Dollars created by the Federal Reserve is ensuring the US Treasury can repay its bond holders and the home owners repay the mortgage backed securities’ owners. Will the US government continue to be able to collect enough in taxes from the US economy to service its debt?
The mechanism defending bank created Dollars is their underwriting process when they review each application for a loan. Can Robert repay us the $15,000 he owes us, with interest, for his car loan?
This is what actually backs the Dollar but its not exactly what drives its value. Markets exist that price the value of national fiat currencies, they are not, in the end, set by a government. Some governments issue pegged currencies but even these currencies are subject to the reality of a market. To counter a market changing the price away from the peg, these governments hold reserves of the currency to which they are pegging and are ready to use these reserves to push back in the market and keep the price stable relative to the pegged currency. If someone wants to drive the price of Emirati Durhams from 3.6 Durhams per Dollar down to 3.0 Durhams per Dollar, the UAE has billions of Dollars to enter the market and buy these cheaper Durhams and some more, ensuring the market price doesn’t go down. If the market sells off more than the UAE can sell, though, the price of Durhams can rapidly move away from the peg. Therefore, the UAE has a large amount of Dollars in their reserves.
In the case of the Dollar, the market driven value is what the Dollar is used for:
- If you’re a country like the UAE looking to construct a national currency, you need to go on a market and buy USD. You then store these Dollars, essentially dropping the overall supply.
- If you are a country in the 21st century and need to buy oil, you need to have USD to make the purchase on the international market. The overwhelming majority of internationally traded petroleum is priced in USD, despite some efforts by the Saudis, Chinese and Russians to move away from this.
- If you operate in the US and fall under the jurisdiction of the IRS, you need to have USD ready to pay your taxes. You cannot pay the IRS in Pesos or Bitcoin, they will consider your taxes unpaid. If you do not go on the market or hold USD away from the market ready for tax season, the US government will punish you in court and find ways to make you want to acquire USD to pay this obligation.
- If you are Saudi Arabia and want US military protection, you need to go on the market and buy USD and US Treasury bonds.
- If you are China and you want to recycle your newly printed Chinese Yuan so you can trade with your biggest customer, the US, and your most important petroleum retailer, Saudi Arabia, you need to go on a market and buy USD.
Learning From Others
Monetary crises are certainly nothing new. At the moment of writing, there are several ongoing national currencies where the users of the currency are losing faith in its ability to retain its value:
- Turkey- in less than one year, the Lira lost almost half its value versus USD (from 3.5:1 to ~7:1). President Erdogan took away independence of the central bank, after which the balance sheet of the bank tripled in less than a decade.
- Argentina- down 53% of its value a year ago
- Brazil- down 20% vs a year ago
- Venezuela- down to less than 1% of its value a year ago
You Need to Know about the Triffin Dilemma
Robert Triffin announced that Bretton Woods was going to fail in 1959, a while before the Nixon Shock occurred in 1971 and the US pulled out of the agreement to stick to pricing Dollars relative to gold and assure much of the rest of the world that their Dollar reserves could not be diluted. This is the Dilemma in one sentence:
A national government cannot both produce a currency other’s can depend on to remain stable in price, which allows this government to print money and sell it to them to raise money for operations at very low cost, and also avoid a strong valued currency that makes their exports attractive to other economies.
The US Dollar has been diluted very little relative to other fiat currencies and therefore is accepted as a high quality reserve currency. The Chinese Renminbi has been diluted a significant amount, so nobody takes it very seriously as a reserve currency. However, the US Dollar, which one must have to purchase US produced goods, is relatively expensive to buy, making it expensive to buy US goods. The Chinese Yuan is cheap to buy, so when you need some to buy Chinese goods, it’s much easier to acquire.
The main point of issue with US Dollars, according to Triffin, is that the US government must have BOTH a surplus budget to assure the value of its Dollars AND a budget deficit, the only way the Federal Reserve can authorize the printing of new Dollars. Remember, the Federal Reserve collateralizes newly minted USD with US Treasury bonds.
This is completely incompatible with the nature of US Dollars as reserve currencies- more money needs to constantly be created to keep up with growing economies and populations. If this isn’t the case, and the volume of money remains the same, then there will be ever increasing demand for money from a growing economy and population and no change in supply, resulting in deflation. It will become more lucrative to simply collect USD and store them than to use them to invest in new ventures, buy things, and lend it out to people and companies that can create value with them. Inflation hurts thrifty savers, deflation hurts growth in the economy.
The rest of the world, depending on US Dollars, needs more Dollars being created to meet their growing demand for them, and this can only occur if the US government is borrowing more.
The Tinder Created by the US Government
[‘Total amount of debt estimated by end of 2019’]
- Agency debt: debt taken out by federal agencies and government sponsored enterprises [$9.57 trillion]. Includes Fannie Mae, Freddie Mac, FHLB (Federal Home Loan Banks) and GNMA (Government National Mortgage Association)
- US Treasury debt: debt taken out by the federal government [$22.7 trillion]
- State government debt: [$1.22 trillion]
- Local government debt: [$1.94 trillion]
Launching trade wars and sanctions against creditors has hurt the US Dollar’s place as a trusted reserve currency, according to Larry Fink, head of the largest investment fund in the world, Blackrock.
The US Federal Reserve has gone overboard in leveraging the reserve status of US Dollars when bailing out failed banks that could not meet their liquidity requirements. They did this through Quantitative Easing, a program by which the Federal Reserve helped the failed banks have enough USD in their accounts to meet the 10% reserve requirement and, at the same time, removed mortgage backed securities that were at the time losing their value. Of course they were losing their value, since these securities were based on homeowners repaying their loans on overpriced houses at interest rates they could not afford to pay.
Then, instead of reeling in irresponsible lending practices that lead to this asset bubble based on easy credit, they kept interest rates as close to 0% as possible, fueling another bubble- this time corporate debt.
No, the S&P Index tripling in less than a decade is not a sign of a growing and strong economy. There’s no way the US economy could grow by 3x in 9 years. It’s a sign of buying pressure from publicly traded corporations, led by executives compensated in publicly traded shares of the company, borrowing at record levels with low cost debt and using this money to purchase their own shares. This new debt needs to be serviced and this cost is causing a significant amount of these corporations to have negative revenue when accounting for their new debt expenses.
I’ll conclude by laying out the mechanisms I believe will occur leading to hyperinflation of the US Dollar:
- Foreign countries stop buying as many US Dollars and US Treasury bonds, either because they have a better alternative or they have less need for USD. It should be noted that this can be held back because of the attractiveness of the US market for exporters like China and Japan, who need to hold US Treasury bonds and USD to keep their currencies weak relative to USD. If the US Dollar slips in value, US consumers will see higher prices for imported goods.
- Interest rates go up significantly because of US Treasury rates going up due to #1 (less demand from the market for US Dollars and US debt), the increased risk of default by the US government (it cannot keep a balanced budget and shows no sign of lowering its spending) and the corporations in its tax base defaulting.
- In order to continue paying its expenses, the US Treasury has to accelerate borrowing while the US Federal Reserve has to ramp up purchases of US Treasury bonds to keep interest rates low. Trillions of new USD are put into the market.
- While interest rates are going up and Dollars are being diluted, the banks storing trillions of dollars in their Federal Reserve Excess Reserve accounts lose confidence in their dollars and either start lending these reserves or selling them in the market. Even more trillions of dollars are injected into the markets this way but at a very accelerated rate. Hyperinflation occurs and the purchasing value of a Dollar drops significantly. The Dallas Fed chairman has hinted as this possibility recently.
- We all lose because the world economy’s primary means of exchange loses its value and we all have to find a new means of trading with each other. Ideally, an improved store of value and means of exchange is launched around this time, giving people a secure new currency to keep trade moving.
If you’ve made it this far, congratulations. You’ve read an entire post of doom and gloom on monetary policy. I think you should be proud of yourself here. If you’ve just skipped to this part, I can’t blame you. I’ll be writing a TLDR soon to help people get the point without the risk of losing your attention.
I’d like to make a personal plug here for my next post, time unknown, for educating people on Ideal Money and how it could be the solution we need for all this. Instead of money backed by a fixed asset or money backed by constantly increased debt, I propose we create a programmed money that adjusts itself according to the demand for it. This could ensure that the purchasing value of this money, per unit, never changes. One Ideal Money Dollar would buy you a small coffee in an average coffee shop in 2019 and one Ideal Money dollar would buy you the same coffee a decade later in 2029. The Federal Reserve attempts to do this by watching the ratio between USD and the CPI (consumer price index) but it’s very easy to argue that they have failed at this.
Thank you for reading this and I hope it sparks some further interest in this issue. Until next time,
Vincenz B
