now reading: It's Time for the Global Monetary Textbook to Be Rewritten
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It's Time for the Global Monetary Textbook to Be Rewritten
By Jeffrey Snider
President John F. Kennedy once said, "For the great enemy of truth is very often not the lie – deliberate, contrived, and dishonest – but the myth – persistent, persuasive, and unrealistic." He said that in June 1962 delivering the commencement address at Yale University. Ironically, the President deployed the phrase as a recent convert to Keynesianism. The myth he wished to dispel was that budget deficits and concerted government fiscal action were always harmful.
The Great Inflation was still several years away and the US economy at that time was closer to recession than many were comfortable with. Not just one, either, but two in rapid fashion – the first had ended in April 1958 and the second begun in April 1960. Though mainstream statistics and economic assessments had shown the US had come out of it in February 1961, there were concerns that a flagging recovery might send them back into a third.
The world was gripped by grave monetary uncertainty. On October 20, 1960, the London price of gold spiked above $40 per ounce; it wasn't ever supposed to move much away from the official price of $35, or rather, more appropriately, one dollar for 0.88671 grams of gold. That elicited the formation of the London Gold Pool which was a technical default upon Bretton Woods.
From 1958 through 1962, the US had spent or lost about 30% of its gold reserves, by far the largest in the world. The year 1958 was the first of those two recessions. Following it, Western European nations, in particular, suddenly began exercising their rights under Bretton Woods to convert their growing surpluses of dollars into specie at the official price.
In January 1961, the Federal Reserve's Federal Open Market Committee understood the ramifications, as one staff economist succinctly described them:
"It would be a very serious matter indeed if both the liberal foundations of our international commercial and financial policies for bringing our international accounts into balance and the degree of flexibility which we have been able to maintain in our domestic monetary policy were to be shaken by so rapid a deterioration in our reserve position, as the result of gold losses due to a loss of international confidence in the future of the dollar, that we should have no alternative to a policy of contraction, on both the international and domestic fronts, which would be the very opposite of what may be called for by the basic economic facts of both the international and the domestic situations."
It was this prospective "policy of contraction" which weighed on Kennedy. He argued in 1962 for an opposite stand. It became his goal to ensure a tax cut even though the federal government's fiscal situation was still in deficit. In essence, he declared there were times when the fiscal condition doesn't matter, even to something as inherently necessary as market determinations.
Appearing before the Economic Club of New York in December 1962, the President explained that budget deficits:
"…are not caused by wild-eyed spenders but by slow economic growth and periodic recessions, and any new recession would break all deficit records."
That was the strong dollar in a nutshell. The focus on fiscal mechanics was but a symptom of greater concern, as always, the economy.
The strong dollar now half a century later has passed into the realm of myth. There cannot possibly be one today, for there is no machinery behind it to render one judgment or another. It all floats, and in more dimensions than anyone seems capable of appreciating.
As such, the fairytale lingers on even in the places where it most should not.
In March 2015, Jeffrey Frankel, a professor at Harvard's Kennedy School, wrote in The New York Times that the surge in the dollar's exchange value that had begun the prior summer was a tremendously positive sign of really good things to come. Laboring under the title A Strong Dollar Is A Sign Of A Strong Economy, Frankel claimed:
"Overall, the strong dollar is good news. This is because of the macroeconomic fundamentals behind it. Indeed textbook theories explain this episode unusually well."
Textbooks grounded in the past and examining conditions like those of the early 1960's would say such things. But to merely assume they applied to a more modern monetary foundation because of prior correlations was a dangerous tactic. The dollar of today is not Kennedy's dollar. Back then, the eurodollar was just coming up for its major contributions, good and bad; now, it is the only thing that matters.
Rather than strong anything, the global economy experienced a massive downturn 2015-16. It hit many places extremely hard, those most vulnerable to the negative pressures placed on them by a nominally strong, but in reality destructive, dollar. Nearly all of those places, with but a few exceptions, have yet to recover from it.
I include in that list the US economy, though not nearly punished to the same magnitude as those unfortunate other overseas connections. Having recited numerous times in particular the grim labor market statistics for income growth (or lack thereof) I won't do so again (other than to repeat that last year was one of the worst non-recession years for American labor, and so far 2018 isn't any different). The "rising dollar" is no strong dollar because it is an absence of monetary strength in a system that isn't actually dollar-based.
As Economists remain wedded to outdated textbooks, we have so very few indications of what is going on out there in the offshore eurodollar world. There are several key sources, however, that can sporadically flash themselves onto our attention.
The Federal Reserve, in addition to being an inept central bank dutifully obedient to the same outdated monetary doctrine, also collects often copious amounts of data typically in pursuit of same. Some of it is occasionally useful despite the intent behind the collection.
Among those, the Fed tabulates and publishes weekly statistics showing the amount of US Treasury securities held in custody on behalf of foreign agents. These latter entities include all manner of central banks, governments, and overseas institutions. The way in which they come to possess US government debt is as misunderstood as the eurodollar, and in many ways because there is a relationship between them that you can't find in the textbook (briefly, the global dollar "short").
We all (outside the Economics profession) know what happened on August 9, 2007. In terms of this custody data (which, incidentally, wasn't begun until the first week of July 2007), the Fed records a small reduction the week of August 9 and then two big ones the subsequent two weeks following. By the end of August 2007, four weeks of activity, some $47 billion had disappeared from custody.
Any large subtraction gives us a good sense of undesirable monetary pressure. The way in which these UST's end up as they are, commingled with eurodollar necessities, would generally be rising if everything was as it should be.
So it would be at other intervals over the intervening almost eleven years since. In early August 2011, for example, another big weekly drawdown occurred amidst dramatic repo market illiquidity.
At the end of that year, starting the first week of December 2011, custody holdings would decline by an enormous $73 billion over five weeks. The week prior, on November 30, 2011, the Federal Reserve had announced more coordinated action with the Bank of Canada, Bank of England, Bank of Japan, European Central Bank, and Swiss National Bank.
"The purpose of these actions is to ease strains in financial markets and thereby mitigate the effects of such strains on the supply of credit to households and businesses and so help foster economic activity."
During that period, additional actions would be taken with the same intent, particularly by the ECB aimed at European banks (the largest group of eurodollar suppliers).
To sum up: in times of serious global "dollar" strain, foreign institutions are forced to use, mobilize, or swap their UST holdings to try and deal with it.
More recently, this Fed data showed a massive reduction in custodied UST holdings the week of April 18, 2018. Of the few who noticed, the enormous $38 billion decline was characterized as foreigners selling their assets because the economy here is going to improve so much the Fed is going to have to raise rates faster and farther than what's expected now. This would make them far less valuable, supposedly.
The week that all happened was the same that registers in currency charts applied to currency exchanges all over the world. The Argentine peso, as mentioned last week, had been merely falling before April 18. It has crashed since. The same is true among the other major EM's; from Brazil's reals to Indonesia's rupiah. Even India, an economy that stands out among its peers for all the right reasons, their rupee has been caught in the global dollar vortex all the same. INR this week nearly traded to a record low.
Going back to the Fed's UST custody figures, we find that it wasn't just the one week. Though that was the largest, the balance has continued to decline substantially as these currencies have been pushed down all over again. Over the last four weeks (the week of May 9 is the latest) a stunning $66 billion has been withdrawn. It's one of the largest monthly drawdowns since 2007. Something is going on out there, but what?
One thing is for sure, it's not strong dollar stuff. The "dollar" is "rising" again, but not because the US economy is picking up making it a stable place to invest, and from which to invest. In the eurodollar world, up is not good.
The flipside to a "rising dollar" is a falling something else. As noted above, there are many from which we might choose to highlight. One I didn't list was the real nemesis to strong dollar Harvard Economists, China's yuan, or CNY. Though they continue to enjoy dog-like deference on these issues from the mainstream media, even by late 2015 most in the media had at least come to figure out CNY DOWN = BAD. I write it that way mockingly because once you step outside the strong dollar myth it really is obvious.
If there was one currency translation the mainstream narrative had going for it last year, it was the dramatic U-turn toward the weak dollar primarily as it related to CNY. China's currency skyrocketed in two distinct episodes. It was a comeback that shocked many if for no other reason than they were still in shock over CNY DOWN.
How and why yuan made its comeback is something I've written about before (not all Hong Kong, but mostly) and won't do so again here. Instead, there was behind it something like a strong yuan idea. Like the textbook version of the strong dollar, everyone thought that in 2017 China's economy more than in anywhere else would either accelerate dramatically, or, if it didn't quite achieve enough lift and fell a little short, Chinese authorities would come to the rescue once more and assure the most favorable outcome.
Largely from this seed the narrative of globally synchronized growth was born, an expectation that each of the world's major economies would be on the same upswing at the same time and therefore reinforce each other in a way that hadn't been achieved since before the Great Financial Crisis a decade ago. The Chinese, as they had been in that pre-crisis world, would be at the forefront.
It didn't happen. Even more concerning, while China's economy never did accelerate in one key indication it kept growing worse. Fixed Asset Investment (FAI), the economic piece that more than anything reinvented a once backward, agrarian economy into a modern industrial powerhouse propelling the country to nearly superpower status, has continued to decelerate. It is a hugely disturbing indication – especially for China's downstream trading partners.
Given the authoritarian, top-down structure of their economy, FAI is broken down into largely two nearly equivalent pieces. The first is the private economy, making up about 60% of FAI. This is the building of ghost cities, the future economic advance that will further the country's immense demographic shift out of the 19th century and into the 21st. In short, ghost cities don't stay ghostly for very long, and rapid economic growth requires lots of them.
The other is the government, or state-owned (SOE) FAI. These are the infrastructure projects that are necessary within any ghost city, or those required before any ghost city can be started. But SOE FAI has also been used as the channel for "stimulus", and not just any but textbook "stimulus." As good Keynesians always claim, a lot of extra fiscal spending even if wasteful is as useful in firming upswings as avoiding downturns.
In early 2016, that's just what the Chinese did, though this time with open reluctance. How do we know? For one, they said so (Liu He's essay published in May 2016 about the "L" recovery is all you really need to know). But more than that, SOE FAI has now dwindled down to practically nothing (very low single digit growth). State sector FAI was growing by more than 20% in early 2016 but is now growing at less than 5%. It has not been this slow since December 2011.
Let's put all this in terms of Brazil's real, or India's rupee (or Europe's euro via Hong Kong's besieged dollar). The majority part of "reflation" sentiment and actual flow was predicated on the idea that China's resurgence would bail out the rest of the global economy (with contributions from the developed world). A reborn Chinese system would mean very good things for those nations situated as resource contributors, as well as commodities, nations whose currencies and asset markets had been absolutely pounded by the 2014-16 "rising" (not strong) "dollar" (not dollar).
Fast forward to later 2017. China's economy not only isn't acting as expected, it may even still be slowing. By word as well as in action, Chinese authorities appear unwilling to do anything about it. Instead, they seem much more focused on dealing with (19th Party Congress) any potential serious consequences that could arise from possible future economic fallout.
What does that do to the risk profile of a real or a rupee? That's the question that most people focus upon but it's still one step short. What does all this renewed global economic risk do to the "dollar?"
One may even further investigate what it is that is holding China back – only to find China's "rising dollar" problem of the past was never actually dealt with successfully. They still have the same external monetary problem which then contributes an internal monetary one, the net result of which is this burgeoning wave of global disappointment for the same strong reason.
President Kennedy was right. Most of the world's financial imbalances can be traced back to economic imbalance, typically deficient growth. He had committed to gold and $35 during his campaign for reasons of the truly strong dollar. What he didn't quite get in his newfound enthusiasm for the orthodox textbook was that so often monetary instability was the cause of deficient growth. Allowed to linger together for long enough it appears as something like a self-reinforcing chicken and egg problem from which there is no escape no matter how much time passes.
In an interview with the Wall Street Journal last year, President Trump recognized just the outlines of this modern monetary truth. "I mean, I've seen strong dollars. And frankly, other than the fact that it sounds good, lots of bad things happen with a strong dollar." It didn't use to be that way, and Trump almost certainly doesn't grasp the real forces behind all this, but he at least saw how the monetary textbook needs to be rewritten, and more so how unhelpful the perpetuation of the myth really has become. It is persistent, somehow still persuasive, and, as the rest of the world can attest, totally unrealistic.
If they didn't get it the first three times, and they didn't, the global offshore money system is beckoning toward Economists with what increasingly appears to be a fourth demonstration.
Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor.
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