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Famed Austrian economist
Ludwig von Mises wrote in
his seminal work, Human Action (originally published by the
Yale University Press in 1949), that “There is no means of avoiding the final collapse of a boom brought
about by credit expansion. The alternative is only whether
the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”
The collapse of a historic credit
bubble occurred in 2008. However, despite years of further credit expansion,
“a final and total catastrophe” of the
U.S. dollar system has yet to occur.
While an inflationary U.S. monetary policy has serious consequences,
hyperinflation is not an immediate
result. There are three general ways in which the U.S. dollar system could
break down: (1) rejection of the U.S. dollar as the world reserve
currency, or (2) as an eventual
consequence of U.S. federal
government insolvency and
(3) a domestic failure of
confidence. Of the three, U.S. federal
government insolvency is the most serious
because it would result in both the loss of the U.S. dollar’s world reserve currency status and also in a failure of domestic confidence. However, a
new threat to the U.S. dollar has emerged which could trigger a hyperinflationary
collapse before the U.S. federal
government’s finances become
unworkable, e.g., when debt
service begins to crowd
out military and Social Security spending. Specifically, the perceived legitimacy of the
U.S. financial system has not merely
been tarnished by recent scandals but is in danger of collapsing. The consequences of
a domestic breakdown of confidence and trust in the
U.S. financial system cannot
be overstated.
World Reserve Currency Status
The most commonly cited challenge to the U.S. dollar system relates to its waning status
as the world reserve currency.
The BRIC countries (Brazil, Russia,
India and China), along with South Africa, no longer
use the U.S. dollar for trade settlement
amongst one another. The Chinese have internationalized
the renminbi (RMB), which is
now used in trade settlement with the other BRIC countries,
as well as with Australia, Japan, the United Arab Emirates (UAE), Iran and various South American and African
countries under bilateral
agreements. Iran, which is the world’s 4th largest oil exporter, has refused to accept U.S. dollars
in exchange for crude oil
since 2009. While European countries utilize the
euro, South American countries have instituted a local currency payment system, the Sistema de Pagamentos em Moeda Local or SML. At the same time, the IMF stands ready
to settle international trade
using Special Drawing Rights (SDRs). However, local settlement at the regional level is largely irrelevant.
At the global level, the implicit crude oil backing of the U.S. dollar
by the Organization of the Petroleum
Exporting Countries (OPEC) remains
in place and the U.S. military remains
dominant. As long as OPEC backs the U.S. dollar,
and as long as there is
no viable challenger, the U.S. dollar is unlikely to be deposed. The euro, for example,
is a troubled currency and its future is questionable. China’s economic ascent is likely
to continue and the RMB can be
redeemed for Chinese-manufactured
goods. However, the Chinese economy is currently in a recession, the RMB is not a fully international currency
and China’s military
is not ready to take on the role of a global superpower.
At present, no national currency stands as a viable challenger for the position held by the U.S. dollar and there
is no consensus regarding
its eventual replacement.
However, discussion of the gold standard has moved from the fringes of the financial world into the mainstream. The price of gold has risen in response to widespread currency debasement, i.e., as a hedge against
inflation.
OPEC and many other countries could, potentially, fall back to gold if the U.S. dollar were
no longer viable, i.e., if the prices
of global commodities, and especially
the price of gold, were
to rise at an accelerating rate measured in
U.S. dollars. China and Russia, for example, are significant buyers of gold and crude oil can be
purchased with gold instead of U.S. dollars pursuant
to bilateral agreements,
if not on world markets generally.
An eventual return to the gold standard is possible but seems unlikely in the near term.
Governments, banks and corporations around the world hold trillions
of U.S. dollars along with
U.S. dollar denominated financial
assets, such as U.S.
stocks and U.S. Treasury bonds. Even
countries hostile to the United States cannot benefit by refusing U.S. dollar
transactions or by dumping U.S. Treasury bond
holdings in the market. Ignoring
the fact that the Federal Reserve and its Primary Dealers, together with other Western central banks, stand ready to intervene as needed to support
the U.S. dollar, retaining the majority
of the value of U.S. dollar holdings is always a superior alternative
in the short run, particularly
if the alternatives are economic sanctions, war, or, in the case of the U.S. dollar’s
collapse, a 100% loss.
In other words, the tolerance of the world financial
system and of the global economy for the U.S. zero percent interest rate policy (ZIRP), ongoing U.S. Treasury bond market interventions,
i.e., Operation Twist, and quantitative easing is far greater than is commonly believed.
The U.S. dollar certainly will
be replaced as the world reserve currency at some point in the future,
but claims that the U.S. dollar is
in danger of imminent collapse as a result of
international rejection are exaggerated.
U.S. Federal Government Debt and Unfunded Liabilities
Setting aside the world reserve currency status of the U.S.
dollar, the largest threat
lies in the risk of U.S. federal
government insolvency. Before the 2008 financial crisis, the U.S. federal government had reached a point where no combination of economic growth, tax increases
or government budget cuts
will allow it to pay back its public debt and also meet its
unfunded liabilities.
As a percentage of GDP, total U.S. federal
government debt is larger than
that of Spain and nearly
as large as that of Portugal and Ireland.
The U.S. federal government’s
budget deficit, which
stands at approximately
8.7% of U.S. GDP, is as high as that
of Greece and higher than those of Spain, Portugal
and Italy.
Total U.S. government spending at all levels is approximately 40% of GDP
and, unless economic
conditions improve, will increase further. Unfunded liabilities of the
U.S. federal government
total $61.6 trillion ($534,000 per household). The liabilities include federal debt ($9.4 trillion)
and obligations for Medicare ($24.8 trillion), Social Security ($21.4
trillion), military retirement and disability benefits ($3.6
trillion), federal employee
retirement benefits ($2 trillion) as well as state and local government
obligations ($5.2 trillion). Based on Generally Accepted Accounting Principles (GAAP), economist John Williams has projected
U.S. federal government insolvency and, as a result,
hyperinflation, as soon as 2014. Mr.
Williams’ projections do not include the fact that numerous
U.S. states, counties and cities
are insolvent or at risk for bankruptcy.
The insolvency of a sovereign
nation becomes inevitable
once new borrowing is required to service existing debt, but the Minsky moment only arrives when (1) further borrowing becomes impossible and also when (2) monetization results in rejection of the currency.
The more unworkable U.S. federal
government finances become,
the more likely a hyperinflationary
collapse of the U.S. dollar will become. Increases in the money supply and in debt levels suggest that the probability of a hyperinflationary collapse of
the U.S. dollar is increasing
at an accelerating rate.
An inevitable outcome is not necessarily an immediate one and U.S. policymakers
are masters of “kicking the can down the road.” Another
financial crisis or a further economic decline in the U.S. could accelerate the financial
breakdown of the U.S. federal government,
but a robust U.S. economic
recovery, technological breakthroughs and other decelerating factors could delay it.
Despite the fact that
Mr. Williams’ Hyperinflation Special Report
2012 is required reading, the timing of the predicted
outcome assumes a low
international tolerance for the monetization
of U.S. federal government
debt. Mr. Williams implicitly
assumes that the market
for U.S. treasuries is a
free market and that, therefore, either U.S. Treasury bond yields will skyrocket or that willingness to lend to the U.S. will collapse,
but that may not be the case. Together with other central banks, the Federal Reserve could continue to manipulate
U.S. Treasury bond yields
and the value of the U.S. dollar for an indefinite period of time. On one hand, according
to Herbert Stein’s Law, “If something cannot go on forever, it will
stop.” On the other hand, the U.S. dollar remains ‘the worst currency in the world, except
for all the rest.’
Since the start of the Federal
Reserve System, the U.S. dollar has passed one
apparent ‘point of no return’ after another and with each one, e.g., the start of QE3, critics have argued that the collapse of the U.S. dollar is
imminent. The roots of the arguments generally date back to 1971 when
Nixon closed the gold window.
Severing the link to gold
was a crucial point of no return, but, more than forty years
later, a hyperinflationary
collapse of the U.S. dollar has yet to occur. If history is any guide, additional points of no return lie ahead
for the U.S. dollar.
Domestic Confidence in the U.S. Dollar
Within the United States, outside of Wall
Street and Washington D.C., the overall economic environment in the broad U.S. economy remains deflationary. Bank lending to consumers and small businesses remains depressed while debt service represents steady deflationary pressure.
In other words, private sector debt levels remain
high and money is relatively
scarce in the ‘real economy’.
Reported increases in consumer credit are significantly the result of increased student loans, which are linked to unemployment and poor job prospects for young
people.
A scarcity of physical notes or a
race to shed currency in favor
of hard assets seems unlikely to originate within the U.S. unless there is first a conspicuous scarcity of goods. Virtually unlimited support for banks by
the U.S. federal government
and by the Federal Reserve has thus
far proven sufficient to prevent a panic. U.S. households
do not generally have cash and often
rely on electronic conveniences, such as automated payroll deposits, electronic bill payment and on credit and debit cards. Additionally, unlike countries that have suffered
hyperinflation in recent history,
U.S. citizens have no practical
alternative currency. In the absence of runaway inflation, the impetus
to flee the banking
system or to rush out of the U.S. dollar is unlikely to originate in a domestic collapse of confidence regardless
of U.S. monetary policy.
An outlying but growing problem is the risk of a breakdown of
confidence and trust in the U.S. financial system related to its perceived legitimacy. Recklessness, criminality,
out-of-control automated trading
systems (ATS) and apparent failures
of regulation and law enforcement pose a serious threat to the U.S.
dollar system.
Before the 2008 financial crisis, confidence in the U.S. financial
system was shaken by fraudulent sub-prime mortgage lending and securitization practices. The collapse of the housing bubble and the 2008 financial crisis revealed profound systemic risks. In 2010, the so-called
“Flash Crash” reopened questions about
the stability of U.S. financial
markets and, in 2011
“robo-signing” and other
foreclosure frauds were reminiscent of sub-prime lending.
In late 2011 and 2012 perception of the U.S. financial system suffered a
staccato of blows, including
the failure of MF Global Holdings Ltd., with the loss of $1.6 billion
in customer funds; JPMorgan Chase & Co.’s
$6.2 billion “London Whale” OTC derivatives trading loss; the failure of Peregrine Financial Group Inc. (PFGBest),
with the loss of over
$200 million in customer funds;
money laundering by HSBC for drug
cartels, including Mexico’s
most violent criminal organization, Los Zetas, and
for states that sponsor terrorist
organizations; Knight Capital Group Inc.’s high-frequency trading (HFT) loss of $440
million; as well as a growing
number of civil and criminal
cases linked to mortgage,
foreclosure and securities
fraud.
Scandals elsewhere in the world, such as the rigging of the
London Interbank Offered Rate (LIBOR) by Barclays,
in cooperation with other banks, including JPMorgan Chase &
Co. and Citigroup, Inc. in the U.S., further undermine confidence in the U.S. financial
system.
A Black Swan?
Recklessness, criminality, out-of-control automated trading systems (ATS) and apparent failures
of regulation and law enforcement could trigger a hyperinflationary collapse. The result
of a domestic breakdown of confidence and trust in
the U.S. financial system would
not be a traditional run on banks or a rush into cash due to mistrust of banks (creating demand for physical notes) or a
rush out of dollars into hard goods
due to runaway inflation but rather
a run on financial markets. If investors, pensioners, private
institutions and fund managers withdraw
from the markets in order to preserve their capital, it could potentially cause not merely a stock market decline but a crash. In the worst
case, a domestic breakdown of confidence and trust could lead to a near total collapse of U.S. financial
markets. The failure of financial firms, the accelerated disintegration of
the U.S. dollar’s world reserve
currency status and the
final bust of the U.S. government’s
finances would follow. Neither the federal government nor the Federal Reserve can fix the U.S. financial system
if its perceived legitimacy were to fail. An inflationary policy response, at that point, would only exacerbate
the problems of the U.S. dollar. History may record yet again that
“there is no means of avoiding the final
collapse of a boom brought about by credit expansion” because
the escalating moral hazard
engendered by limitless bailouts is itself
a cause of collapse.
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