by John Butler
“So what might a ‘dollar crisis’ look like, how would the US government likely respond, and what impact should we expect this to have on financial markets? While we do not purport to have the specific answers to these questions, there are some general considerations we can discuss with some reasonable confidence.
First, let’s define ‘dollar crisis’. While dollar weakness certainly plays a role, what really matters is the impact that this has on US government financing costs. When these rise to levels that cannot be serviced without resort to direct debt monetization by the Fed, you have a crisis. Now imagine if you will that as the dollar slides, major global buyers of US Treasuries and other dollar securities gradually withdraw from the market in favor of alternative currencies or, perhaps, gold reserves. They needn’t sell their existing holdings, mind you, rather merely reduce or cease ongoing purchases. As US borrowing costs rise, all the current assumptions about US debt serviceability must necessarily be re-evaluated for a higher rate environment.
While there is no magic number, in the event that Treasury yields rise back above 5% or so, chances are that financial markets begin to price in a materially higher risk premium for holding US debt. In a self-reinforcing spiral, unless the US government takes swift and credible action to restore confidence in debt sustainability–that is, a convincing program to reduce the deficit–what might have been a gentle and orderly if concerning rise abruptly becomes sharp and disorderly. At this point, desperate measures will be on the table.
First of all, most likely the Fed implements some sort of ‘emergency’ program of Treasury bond buying, perhaps a cap on yields at 5% or so, in order to buy some time. The problem with capping yields, however, is that if the market clearing yield is higher than the cap, then the Fed becomes the ‘buyer of last resort’ and, in short order, finds itself holding the bulk of US Treasury market debt outstanding. While this would no doubt lead to (increasingly appropriate) comparisons with banana republics, the US Fed and government would nevertheless continue to try to exude an aura of being in control of the situation as investors dump Treasuries and the Fed’s balance sheet explodes.
Second, as foreign investors flee US Treasuries and most probably other US assets, domestic investors are highly likely to attempt to do the same. This is when the US government probably imposes some form of capital controls, making it essentially impossible and perhaps outright illegal for US investors to purchase foreign assets. Not only the US but also most countries facing such dire economic circumstances have resorted to comparably desperate measures in response to past economic crises, so extreme actions of this sort should not be ruled out but rather anticipated.
Third, the government may try to make life more difficult for so-called ‘speculators’, that is, people trying to protect themselves by reducing their exposure to devaluing dollars and risky Treasury securities. For example, they might restrict investors’ access to precious metals in various ways. In doing so, US government officials will most probably draw some sort of arbitrary line between those institutions still allowed to transact in precious metals–the big banks–and those not so allowed, such as private investors and households. While such double-standards are no doubt arbitrary, unconstitutional and simply unfair, such actions have ‘legal’ precedent and, as such, may well come into force at this stage.
While capital controls and curbs on ‘speculators’ might also buy some time for the US government to try and restore some degree of stability in financial markets, in fact they will just bring the day of reckoning closer. Indeed, the very idea of the world’s pre-eminent reserve currency being subject to capital controls is downright farcical. Unless rescinded in short order, capital controls will lead to the US not only losing reserve currency status but probably becoming something of a global economic pariah. As such, expect any discussion of capital controls to be couched in ‘temporary’, ‘emergency’ language, although we doubt that such rhetoric will prevent the Chinese, Russians, Indians, Brazilians, Europeans and probably also OPEC nations from forming new associations and alliances to offset the loss of investment and trade with a United States rushing headlong into masochistic, counterproductive economic nationalism.
As for the broader impact of curbs on ‘speculation’ in precious metals and possibly also other commodities, such policies will quickly drive global commodity trading offshore, most probably to locations historically keen to acquire such business from the US, including London, Switzerland, Singapore, Shanghai, Hong Kong, Moscow and Dubai. Yes, the US government will no doubt be able to mandate, by executive fiat, who, what, and at what price various commodities will be traded on US exchanges, but to the extent that the rest of the world thinks the price of something should be higher (or the dollar lower), the associated transactions will take place elsewhere until, inevitably, the bulk of exchange activity emigrates to friendlier jurisdictions abroad.
As one desperate time-buying measure after another approaches its effective expiry date, the next step could be for the US to open negotiations with foreign creditors to restructure its debt, something which might well prove politically impossible, even with the best of intentions. Alternatively, and more in keeping with US and global economic history, the US might simply impose a settlement forcing foreign and possibly also domestic creditors take a huge ‘haircut’ on their holdings of Treasury debt. Although obviously a default by any other name, no doubt the US will call it something else. (We suggest TOUGH, or ‘Treasury Obligations Under General Haircut’, given the historical proclivity of US authorities to employ euphemistic acronyms when implementing unprecedented and counterproductive economic policies.)
At any stage of the above process, and highly likely to occur in our opinion, the US may simply do away with such shenanigans and devalue the dollar unilaterally in some fashion and to a level which, in theory at least, would be sustainable and allow for the US to service, with reasonable confidence, its accumulated debts in sharply devalued dollars. Indeed, the US has done exactly this before. In 1934, FDR unilaterally devalued the dollar by some 60%. In the early 1970s, President Nixon removed the anchor to gold entirely, claiming that this would not be inflationary. More recently, any objective analysis would conclude that the US has had an unstated policy of dollar devaluation since at least 2004 if not earlier, as that was around the time that the US started to attack China’s exchange rate policy and, by implication, that of any other country which chose to maintain stable rather than appreciating exchange rates vis-a-vis the weakening dollar.
As far as investors are concerned, merely reducing exposure to dollars and dollar financial assets may not be enough. To what extent the dollar devalues versus other currencies is, ultimately, a speculative guessing game. Perhaps all currencies devalue in real terms as one country after another resists currency strength. Certainly the euro-area, Japan and the UK have debt problems of their own. And many emerging markets are currently experiencing booms, the magnitude of which have, historically, ended in busts.
While we do have our opinions as to which currencies are rather more or less undervalued vis-a-vis each other, it is a far, far simpler conclusion to reach that, the further along the above process we move, the more likely it is that commodities rise relative to currencies in general as the former begin to function, in varying degrees, as alternative stores of value. Yes, gold and silver have the most prominent historical claims to this role. Yet other metals are not so far behind. And the farther one descends down the rungs of the global economic ladder, one can find historical precedents for all manner of commodities serving as money in some shape or form.
Seeds, nuts, grains, various livestock, peppercorns, cigarettes, liquor; such stores of value may seem uncivilized to some, but please tell us: What is civilized about a systemic transfer of wealth from the many to the few via currency debasement? If this is what qualifies today as ‘civilization’, well then we’ll take our chances with the Barbarians, as indeed the frontier Romans did from around the 4th century onward, when they finally lost patience with the rapacious regime in Rome and invited the Barbarians in, province by province, as the implied tax- and inflation-relief outweighed the uncertainty of governance under their new, northern masters.
In time, even those Romans living closer to home came to regard the Barbaric side of this Hobson’s choice as rather more preferable, resulting in the complete dissolution of the Western Roman Empire. Perhaps it should be no surprise that, for the next millennium or so, the bulk of Western European economic progress occurred not in Italy but rather in the more dynamic trading societies of the north, including the Normans, who would manage to conquer a large part of the more prosperous lands around the European periphery, north and south, including of course the bulk of what is known today as Great Britain.
Meanwhile, the Eastern Roman Empire at Byzantium would last another thousand years. Why? Historians have their various reasons, many of which seem reasonable. In our view, perhaps the most compelling is that, notwithstanding the travails of economic fortune through the ages, the Byzantines stuck with a tried and tested ‘hard money’ policy, rather than succumb, as did their western counterparts centuries earlier, to the temptation of currency debasement and inflation.
Historically, empires both large and small have a curious yet consistent inability to long outlive the purchasing power of their currencies. As the saying goes: What men learn from history is that men do not learn from history. And with that, Exeunt.”