Saturday, July 25, 2020

The Big Historical Cycle George Friedman Misses

A big problem with The Storm Before the Calm is that it ignores the most significant historical cycle driving the current crisis: The monetary cycle.

The monetary cycle consists of the transition from sound to unsound money, eventually resulting in a monetary crisis and a reset of the system. The transition is sometimes driven by external events like a war, other times by the seemingly irresistable temptation of governments to fund themselves through the printing press.

The current monetary cycle is unprecedented insofar as every currency in the world has been a pure fiat currency since 1971. Historically, monetary cycles end and begin when the market displaces a debased currency with a sound one. The two World Wars, for example, put a severe strain on the British Pound, which had been the world's reserve currency for more than one hundred years. The debt accumulated, and the fact that Britain had sent all its gold to the United States in payment for food and arms, made the Pound an unsound currency by the end of WW2. At the Bretton Woods Conference held in 1944, based on the fact that the United States at that point owned 70% of the world's gold, it was agreed that the U.S. Dollar would replace the Pound as the world's reserve currency. Furthermore, all other currencies would peg themselves to the dollar rather than be backed by gold. The Dollar remained the sole currency redeemable for gold.

This system persisted into the 1960s, by which time the U.S. could not resist printing more money than it could back with gold to fund the Vietnam War and the Great Society programs. Foreigners were trading in their dollars for gold, at the rate that the 20,000 tons of gold owned by the U.S. at the end of WW2 had been reduced to 8,000 tons. To prevent the rest of U.S. gold reserves from fleeing the country, Nixon "temporarily" suspended the redemption of dollars for gold on August 15, 1971, a suspension that persists to this day. 

This has resulted in the unprecedented fiat monetary system noted above. The dollar continues to be the world's reserve currency, if for no other reason than that there is no suitable alternative. Furthermore, since 1980 we have been in a debt bull market of falling interest rates. See below.

Federal Funds Rate since 1950

The falling interest rate regime is not an accident or a result of the free market, but has been a deliberate policy of the Federal Reserve. This isn't a conspiracy theory; it is part of the Fed's charter to manage interest rates. Falling interest rates support the dollar (and the accumulation of dollar debt) because it makes the purchase of debt more attractive. If I anticipate that the interest rate on the U.S. 10 year treasury bond will drop, then if I buy a 10 year treasury carrying a 5% interest, I will be able to sell it at a profit when the interest rate on new 10 year treasuries drops to 4%, since the higher interest rate on my bond represents greater value.

So the increased printing of dollars did not cause a crisis in the dollar as long as interest rates have had room to drop. The accumulation of debt in response to lowering interest rates happened accordingly.

U.S. Debt to GDP ratio

But notice that since 2008 interest rates have been close to 0. What happens when there is no more room for interest rates to drop? Then the debt cycle would naturally reverse, interest rates rise, and there is a major financial crisis, likely much worse than 2008 and on a global basis (since most other countries are running up debt and printing currency as fast as we are).

But that hasn't happened. Debt is still being bought despite tiny interest rates. Who is buying debt now that interest rates aren't going lower? The answer is the Federal Reserve:

Federal Reserve Balance Sheet in Millions
Federal Reserve Balance Sheet in Millions

This has gone into hyperdrive since the COVID crisis hit. Since we were already running a deficit before the COVID pandemic, all the trillion dollar "stimulus packages" since then are financed purely through Federal Reserve money printing - that is the spike at the far right. Just in the last couple of months the Federal Reserve has bought up $3 trillion in government debt. This signals the end phase of the monetary cycle, which will result in the demise of the dollar and its replacement as the worlds reserve currency.

Friedman misses all this. He interprets the drop in interest rates over the last 30 years as an indication of capital accumulation. It would be in a regime of free market interest rates. But we don't have that: Interest rates are manipulated through Fed policy. As debt increased over the years, interest rates should have risen as well, incentivizing savings as a balance to debt accumulation. By forcing interest rates lower, the Fed has short-circuited these market forces and put us in a situation where a catastrophic financial crisis can only be put off by ever more furious money printing.

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