But why should investors care about something so foundational? Well, I think it’s a bit like an 18th century merchant understanding trade winds. They might not help much with what to buy and sell on a daily basis, but they determine how far you’ll go and in which direction.
The currency system you choose determines the future of investment returns
Currency Resets happen for a reason. Because each currency system – whether it’s based on commodities, bank credit, military supremacy or political will – has a bias built into it. And a flaw. (Which currency system you favour reveals a lot about your personality and character, but let’s not get into that much detail.)
Credit-based money, like ours today, tends to run up too much debt. This leads to financial crises and the need for a central bank. In a credit-based monetary system, financial markets go through cyclical booms and busts because the amount of money in the economy depends on the amount of lending.
But during bad times, lending crashes. This crashes the money supply with it, making credit-based monetary systems dangerous. 2008 was the textbook example, but it’s an old phenomenon. You need to invest accordingly – be crisis proof and speculate on the booms.
Currencies based on political unions fall apart when the political will evaporates. The Latin Monetary Union broke down thanks to World War I, Yugoslavia’s breakdown featured impressive financial chaos and the euro is looking wobbly right now thanks to coronavirus controversy.
Commodity money like the gold standard is inefficient, expensive to manage, politically awkward and far too honest for politicians to be trusted with. They want the power of seigniorage, to run sustained budget deficits (usually to finance wars) and gold makes all this expensive or impossible.
But, while it lasts, commodity money can provide stability, just as precious metals are inherently stable. The Industrial Revolution and the Bretton Woods system are examples of this stability generating economic prosperity.
As long as politicians are given the power to abandon commodity money, it’s only a matter of time before they do. America’s founding fathers understood this well. It’s why the constitution they wrote specified that “No State shall […] make any Thing but gold and silver Coin a Tender in Payment of Debts”.
The US dollar came to be the global reserve currency thanks to the attempt to dethrone the UK’s pound from the same position, as you read in a recent Fortune & Freedom. It has lasted thanks to US military and economic supremacy. During this time, the US dominated the global economy and financial markets too.
The US stockmarket has left all other major competitors in the dust since 2008. And the US trade deficit hasn’t been a problem. In other words, the US’s role as the centre of the global currency system is a powerful advantage.
But, just as all currency systems do, it has run its course.
Why a Currency Reset now?
The US dollar-based system is crumbling in a long list of ways. It has competitors around the world trying to evade it. The amount of US dollar debt is out of control. And the remedies of interest rate cuts and QE are reaching absurd levels.
Being the global reserve currency comes with costs too. A soaring exchange rate, like the US dollar’s during last March, dishes out economic pain to exporters.
The threat of losing your reserve currency status in a disorderly way is also quite dangerous. If people cease to use the US dollar around the world, that means a vast oversupply of the currency. It could crash as people sell out of dollars they used to need to conduct trade.
The point is, an orderly transition to a new global currency order is preferable to a collapse. Even for the Americans, at this point. That’s why Britain agreed to the Bretton Woods system. It would manage the decline of the empire and Britain’s power around the world in a way that passed power to a close ally. And in a managed way.
Well, all of these things are underway once more.
China has already overtaken the US as the largest economy in the world by some measures. Even in nominal terms, it may take the crown in just a few years. China is flexing its military muscle too.
But I think the most important reason for a Currency Reset is much simpler. It’s debt. The world simply has too much debt – vastly more than in 2008. And the Federal Reserve has lost control of it. That’s what we saw on 23 March. The Fed lost control of the stock market and the bond market.
On 13 March, it was willing to give you a hint of what’s to come. The Financial Times’ Gillian Tett wrote this at the time:
Markets contemplate a future in which stimulus does not work
Wall Street’s plunge underlines Fed’s diminishing ability to limit shockwaves
[…] investors may be starting to contemplate a world in which financial morphine no longer functions. After all, another startling detail about Thursday’s drama was that the yield on 10- year bonds rose to 0.88 per cent, compared with 0.76 per cent two days earlier.
This is alarming — and odd — given the Fed support announcement on Thursday; doubly so, since Wall Street analysts now predict that the US central bank will cut rates to zero next week.
Maybe this can be blamed on more forced selling (there are rumours of hedge funds engaged in relative value strategies being forced to unwind positions in a manner that distorts bond prices).
But it might also reflect something else: some investors no longer think that a shot of cheap money works in the face of medical uncertainty, a global recession, looming corporate defaults and weak political leadership. Either way, the key point is this: Thursday’s crash not only pushed March 12 2020 into the history books; it also undermined the image of central bank omnipotence. If President Trump thinks he can reverse the rout by demanding more Fed action, he is gravely mistaken. Prepare for more market spasms.
Did you notice she repeated it three times, including in the headline? Investors have realised that more QE won’t work. And that was before the Fed announced “QE infinity” ten days later, when stocks went down, as we highlighted yesterday.
The thing is, there is nothing else – nothing more the Fed can do. An entirely new currency system is needed. And that means a Currency Reset.
But which system will the world turn to?
John Butler, who introduced us to Currency Resets last week, believes a return to gold is eventually on the cards.
On Monday, I reveal my answer. But you won’t like it…
Editor, Fortune & Freedom