When the game is up, you play a new one

I’ve been pondering the reckoning. Where will all of this money printing and bailout-ing lead us?

As I’ve written previously, it looks like we’re on course to see stagflation.

But there’s another obvious answer I never mentioned. Before the system reaches its reckoning, it could be reset. And we could begin again, with a new system.

This might sound obscure or vague. But it’s so common historically speaking that it has a name – currency reset.

With the topic breaking out in the news, it’s time to revisit some of what all our readers should know.

A currency reset is what happens when the global financial system maxes out. That can happen in many different ways, depending on what the current currency system looks like.

In a debt-based currency system, as we have now, the amount of debt gradually rises until it is simply not palatable. We’re at that point in much of the world. Hence the 0% interest rates and 100-year bonds to forestall the problems this much debt creates.

Once we hit too much debt, the world’s leaders turn to a currency reset to rejig the system. More on what this means below.

Gold-based currency systems max out on trade deficits. The fixed exchange rates that gold standards imply tend to lead to trade imbalances over time. This in turn leads to gold moving across borders in one direction, until a currency reset changes the rules of the game again.

A common currency system, like the euro, features a similar currency reset for the same reason – fixed exchange rates between those on the common currency. The reset comes in the form of a devaluation for those who are struggling – against gold or by leaving the currency union. More on that below too.

Fiat reserve currency systems, as we also have now, tend to provide the reserve currency-issuing nation with an exorbitant advantage. But that leads nations astray over time as they abuse the advantage – it turns out to be a double-edged sword.

The prospect of losing the reserve status unceremoniously is a dangerous one. Which is what creates the need for a more ceremonious change in how the financial system works – a currency reset. Bretton Woods and the Nixon shock were examples of this.

All in, we had five or six currency resets in the last century, depending on how you count them. I think another one is drawing near. And it isn’t just me.

University of Texas professor James Galbraith: “So the whole financial system will have to be reset. This is not an ideological point but a practical necessity for reestablishing a functioning economic system.” He was focusing on the level of debt for his reasoning.

Over in Italy, there are concerns over a repeat of the 1992 currency reset. Which Britain played a rather important part in…

Bloomberg recalls the story from back then:

On the September night in 1992 when George Soros famously broke the Bank of England, it wasn’t just the British pound that crashed. The Italian lira cratered too, the last of its numerous 20th century devaluations.

One veteran who is still at the Finance Ministry in Rome recalls a colleague researching “bankruptcy” and “failed state” amid the chaos as resentment swelled at the indifference of European allies, notably Germany.

The fascinating thing is that the article doesn’t mention what Britain and Italy actually did. They broke free from the ERM – the precursor to the euro. It featured tight exchange rate bands, creating the same problems as a gold standard and proper common currency.

Italy only escaped this system temporarily and became a founding member of the euro. The UK recognised the ERM as an Eternal Recession Machine and departed permanently. Italy’s economy stagnated in the euro, the UK’s grew outside it.

Do you see that a currency reset is a good thing? In the end, at least. It’s a tumultuous moment, but only because the existing system has run its course. The chaos would be worse if the existing system were allowed to continue to break down. That bodes hyperinflation, usually.

Instead, you get a currency reset.

It’s a bit like board games. When you play Monopoly with your family, you don’t kick off where the last game ended. It is reset to 0 each time. Otherwise the losers would refuse to play.

But what sort of currency reset is on the horizon?

The economist Galbraith is expecting a debt jubilee – huge debt forgiveness. Wiping the slates clean, as they call it. That’s what happened for thousands of years when economies hit their current imbalances.

Another option coming out of the International Monetary Fund is for its SDRs to become the global reserve currency instead of the US dollar. An SDR is like a bag full of different currencies, tied up and labelled “1 SDR”. They derive their value from what’s in them, but can be used as a type of international money.

That’s plan A, as I see it. It allows an orderly transition away from the US dollar into a version of the world favoured by… is there a term for it which doesn’t sound kooky? Globalists, elites, internationalists…

Interestingly, when the idea of a global reserve currency was raised by John Maynard Keynes at Bretton Woods, he wanted it to be backed by gold. But that’s likely just a sign of the times – most currencies were gold backed then.

Cryptocurrency enthusiasts argue that a crypto like bitcoin should replace the US dollar as the global reserve currency in the next currency reset. It’s a form of currency that’s outside the control of nations and their governments. Its supply is limited by definition and it is easy to transfer. It ticks the boxes, in other words.

What fascinates me is how quickly debates about currency resets turn into ideological ones. Gold bugs favour gold as a reserve currency. Patriotic Americans favour keeping the US dollar. Anti-Americans want a multi-polar world. Creative thinkers think it should be energy backed, somehow. And crypto enthusiasts favour cryptocurrencies.

Perhaps it’s just a case of everyone talking their own book. But my message for you today is simple.

All international currency systems have an inbuilt bias in them. Which leads to a tendency towards something – too much debt, persistent trade imbalances, reliance on institutions that can be co-opted and much more. This tendency leads them to be maxed out eventually as well. They’ll stop working eventually. And then we’re back to a currency reset again. That’s why they’ve always happened historically.

And we’re due one soon.

The key to investing in such times is to currency reset proof your portfolio. In 1992, that meant holding non-UK assets as devaluation hit. Today it involves holding gold or other non-financial assets, in my opinion. Until we know more about what’ll take shape, at least.

Best wishes,

Nick Hubble
Editor, Fortune & Freedom