A global currency crisis is brewing. For the first time in forty years, investors have to contend with the effects of high inflation on their portfolios. Most investment strategies in use today were developed without considering how to deal with problems presented by high inflation.
Financial regulations developed in the last forty years were also developed under the assumption that inflation had died. Most market players are not prepared to handle high inflation, and many are trying to figure out how to navigate the financial market safely. Answers to such difficult questions can sometimes be found by understanding the root cause of the problem.
Fiat Money
Government-issued currencies are used to measure the value of goods and services in trade. Inflation is defined as the sustained general increase in the prices of goods and services. It can also be interpreted as the sustained loss of value of government-issued currencies. The root cause of the current high level of inflation is hidden somewhere in the evolution story of the monetary system used in the world today.
The world is on a fiat monetary system that is anchored by the US dollar. It is called fiat money because it was declared as money by a government decree. It was made legal by law. It does not have any intrinsic value. Its only value is the faith and trust that the people have in the government that issued it.
Fiat (paper) money was born out of the practice of issuing receipts for gold, or silver stored with goldsmiths, or in the vaults of early banks. These receipts were freely exchanged for goods and services by the bearer who could also choose to redeem the gold or silver the receipts represented from goldsmiths or banks. This monetary system is what is known as the gold standard.
Tradable receipts were also issued against other valuable commodities like copper and silk. It is these receipts that evolved into the bank notes we know today. This description of the origin of paper money highlights the fundamental difference between the monetary system that was in use in the nineteenth century and the one in use today.
In the nineteenth century, paper money represented some real value in gold or silver or some other commodity. Paper money in use today does not represent any real value. It derives its value from the faith and trust that the people have in the government that issued the currency.
Rome and Athens
In the history of money, many civilizations before us attempted to use items of little value as money of high value, and it always ended with disastrous consequences. Both Rome and Athens were brought down when their respective coin-based (gold and silver) monetary systems collapsed.
Like all great civilizations, they got involved in wars, massive welfare programs, and civil work projects which needed massive funding. After spending all of their resources and money, they came up with clever ways to continue funding the activities of great civilizations.
To make more coins, they began mixing copper with gold and silver in their coinage processes. This effectively debased their money, and inflation spiraled out of control in just a few years. The coins gradually lost value as the public woke up to this debasement.
Eventually, these two great civilizations had to collapse. The debasement of their money caused economic chaos that made it impossible for them to continue funding wars, massive welfare programs, and public civil work projects that made them great.
The Gold Exchange Standard
World War 1 found most of the then-developed world on the gold standard – fiat money was backed 100% by gold. To fund the war, warring countries resorted to deficit spending and money printing. After the war, these countries found that global trade was seriously hampered by runaway inflation because there was more money circulating than commerce.
Desiring the good pre-war days when trade was robust, and economies were stable, the world started to journey back to the gold standard. But the journey became painful when countries realized that the process involved devaluing currency units to match the units of gold that backed their respective currencies. This made countries to settle for a quasi-gold standard they called the gold exchange standard.
This happened in 1922 in Genoa, Italy. The world met to discuss the solution to this problem. It was agreed that under the gold exchange standard, only the USD, and the GBP could be exchanged for gold, and that other world central banks could keep the USD and the GBP alongside gold as reserves. However, only the USD was backed by 40% gold reserves.
Other countries could hold the USD and the GBP as gold proxies. This made sense because international trade at the time was dominated by these two currencies and gold. The price of gold was fixed at US $20.67 an ounce. Departure from the gold standard had commenced.
Currency Wars
In 1944, the world met again in Bretton Woods, New Hampshire, USA. The global economy was very chaotic. World War 2 was just about to end and just like in World War 1, warring countries had resorted to deficit spending and money printing to fund the war. Germany, France, Great Britain, and the U.S. mischievously devalued their currencies to gain competitive advantage in international trade.
The agenda of this meeting was to find a solution to the currency wars that were crippling international trade and to agree on how international trade will be conducted in the post-war years. It was agreed that all countries would peg their currency to the USD and the U.S. would make the USD redeemable in gold to foreign central banks only at US $35 an ounce. When a country fixes its currency to gold, it has to buy or sell as much gold as is offered or demanded to maintain that currency price.
To avoid being cheated out of its gold, France redeemed US $150 million of its USD reserves for gold in 1965, and announced plans to redeem another US $150 million. France had found out that by printing money to fund the Vietnam War, the U.S. had compromised its ability to convert USD reserves of other countries into gold. Spain also converted US $60 million of its USD reserves to gold.
In 1967, Britain caused a run for gold when it devalued the GBP to help correct rising inflation and a negative balance of payments problem. In 1968, claims on gold by overseas USD holders became pandemic.
To stem gold outflows, a two-week bank holiday was declared on March 15th, and congress used this time to repeal the requirement for a gold reserve to back the USD. The U.S. gold supply became available for sale at US $35 an ounce, but gold had already found a higher price in the free market abroad.
The Dollar Standard
Gold was eventually expelled from the global monetary system on August 15, 1971. The U.S. president Richard Nixon announced on prime-time TV that the USD was no longer convertible to gold. The USD, and all the global currencies that were pegged to gold through it became fiat currencies. That decree by president Richard Nixon relegated the world to a fiat monetary system called the dollar standard.
Amazingly, other countries did not protest against the demotion of their currencies to the dollar standard. For many countries, memories of the two devastating world wars reminded them that they were better off as allies of the U.S. It was not prudent to squabble over currency with the U.S. The departure from the gold standard was complete.
In the meantime, the U.S. bled most of its gold reserves, and speculators were angling for even more. The sheer public will, and the free market completely overwhelmed the Bretton Woods system. The USD was freed from any fiscal constraints and the U.S. now prints the USD at will.
Gold was also freed from the USD. It became its own free-floating international money, not bound to any country. Its value has appreciated from US $20.67 an ounce in 1922 to US $1,975 at the time of this writing. A 9,454% rise! On the opposite side of the scale, the USD has lost over 90% of its purchasing power over the same period.
The Petrodollar
After the Bretton woods system collapsed in 1971, the USD lost its global demand because other countries did not have any incentive to hold USD reserves. The U.S. couldn’t keep printing money for wars, massive welfare programs, and massive civil work projects without experiencing the inflationary consequences of such a malpractice.
The U.S. came up with another scheme to force other countries to hold USD reserves, and oil was used to provide the perfect solution. Oil is the most traded commodity in the world, and every country needs it, and buys it in massive quantities. To resolve the declining USD demand problem, the U.S. had to find a way to force oil producing countries to sell their oil only in U.S. dollars.
The plan to identify a major oil-producing country and approach it with a deal that it cannot refuse was hatched. In exchange, that country had to agree to not only price and sell its oil in U.S. dollars, but also to invest the profits from its oil trade in U.S. treasury securities.
The target country was Saudi Arabia. The deal was that the U.S. would offer military protection for Saudi Arabia’s oil fields, provide the Saudis with weapons, and perhaps most importantly, guarantee the Saudis protection from their arch enemy Israel, whom they had just fought along with other Arab countries, in the 1975 Yom Kippur War.
There was nothing material to give the U.S. in return, but the Saudi’s received protection guarantees for their rich oil fields from the most powerful army in the world. The Saudi royal family knew a good deal when they saw one. This one was exceptional, and they grabbed it. Other oil-producing countries in the Middle East got wind of the deal and wanted in. The U.S. obliged, and the Middle East became littered with U.S. military bases.
Once again, all countries in the world started to accumulate USD reserves. These reserves were used to purchase oil from oil-producing countries, hence, the petrodollar. The U.S. government could once again print the USD for warfare, massive welfare, and civil work projects without experiencing uncontrolled inflation.
The excess U.S. dollars from printing are exported to the rest of the world when other countries’ demand for oil increases. The U.S. then went on an offensive against major oil-producing countries that did not get on board with the deal but had the potential of undermining it with their large oil reserves. It led a successful campaign to characterize these countries as undemocratic, state sponsors of terrorism, agents of regional destabilization, and other heinous state crimes.
The U.S. managed to isolate these countries and convinced friendly countries to undermine the economies of these uncooperative countries by choking them with sanctions. You are right if you figured out that these countries are Iran, Russia, and Venezuela.
Other countries that came on board with the deal but became errant down the line by entertaining thoughts of selling their oil in other currencies other than the USD had their leadership decapitated. You are right again if you are thinking about Iraq and Libya.
The U.S. has mischievously maintained trade deficits since 1975. As a net importer, the U.S. exports excess dollars within its economy to its trading partners. It is also correct to say that U.S. trade deficits export inflation to its trading partners. In the U.S. bag of economic tricks, trade deficits stand out as the powerful trick that subdued inflation despite the many rounds of money printing.
Each year, U.S. immigrants repatriate billions of U.S. dollars back to their home countries. Many developing countries now have remittances from the diaspora as important components of their GDPs. These remittances also export dollars from the U.S. economy and play a role in preventing inflation in the U.S. The petrodollar is the genius that revamped the global demand for the USD.
Free Money Is the Solution
The defunct Zimbabwean dollar is a good case study of how fiat money dies. Robert Mugabe completely wiped out the value of his country’s national currency during his long reign as the president of Zimbabwe. He was an eloquent political genius but incompetent on finance and economic matters.
His government was corrupt and brutal, and when cornered, it resorted to printing the Zimbabwean dollar out of its problems. It overlooked fiscal constraints, and printed the national currency to oblivion. Successive regimes that have been in power in the U.S. are not different.
They are also corrupt ,and brutal, and when cornered, they resort to printing the U.S. dollar out of their problems. Corruption in Zimbabwe was a blatant affair. The president, his wife, and government officials looted government coffers in broad daylight. But corruption in the U.S. is convoluted, and hidden from the average citizen.
The 2007/8 subprime mortgage crisis best illustrates U.S. corruption. In the six years preceding the crisis, Wall Street banks went on the rampage, and gave mortgages to almost everyone who cared to apply. Very little attention was paid to the credit standing of applicants. The Wall Street banks were aided by policymakers who made credit cheap by dropping the policy interest rate to 1%.
These mortgages were called subprime because they were of poor quality. They were bundled together and sold as fixed income investments to pension funds, other banks, individuals, corporations, and investment funds around the world.
Inevitably, the policy interest rate rose to 5.25%, and the credit market choked on a high interest rate stranglehold. Cheap credit had caused asset bubbles to form all over the U.S. economy. Mortgage defaults came in fast, and the entire global economy was threatened by a devastating collapse of the global credit market.
The U.S. government responded by printing money, and bailing out the Wall Street banks, and the corporations that were threatened by the subprime mortgage crisis which followed in the wake of this fraudulent banking practice. There was almost no judicial reproach in the aftermath. Some token judicial effort was made was just for the record.
Big names were bailed out. Citigroup, JP Morgan Chase, Morgan Stanley, Goldman Sachs, Wells Fargo, AIG, General Motors and many others. In total, the U.S. government printed 4.5 trillion dollars, and bailed out any troubled too big to fail U.S. corporation.
The management and shareholders of U.S. corporations were not allowed to pay for their mistakes. They were instead rewarded generously when the U.S. government paid for their mistakes with printed dollars. The too big to fail U.S. corporations moved from a state of insolvency to a cash-rich position in an instant.
In the years that followed the 2007/8 mortgage crisis, the U.S. stock market soared, and corporate management pay packages skyrocketed. Fat dividends were paid out to shareholders of bailed-out firms, and the Walls Streets’ favorite presidential candidate’s campaigns kitty raised record amounts. The leftover money was used to buy back shares to ensure even higher dividend payouts.
This type of corruption even passes legal scrutiny. The Zimbabwean dollar died a few years ago, but the USD prospered until recently when high inflation knocked the wind out of its sails. If both The U.S. and the Zimbabwean governments resorted to printing their national currencies, why is the USD still enjoying good fortune, but the Zimbabwean dollar had to die?
The U.S. economy and army are many times bigger than Zimbabwe’s. Over the years, the U.S. has fought many countries to protect the global reserve currency status of the USD. Zimbabwe, on the other hand, has a small economy and army. It does not have trade deficits in its bag of economic tricks, and it cannot police the world to its advantage. Its national currency had to pay the ultimate price.
The European Debt Crisis
In 2010, five Eurozone countries plunged Europe into a sovereign debt crisis. Greece, Spain, Portugal, Cyprus, and Ireland were unable to refinance or repay their sovereign debts or bail out over-indebted banks under their supervision.
Weighed down by these countries, the European Union followed in U.S.’s footsteps and printed EUR 1.1 trillion, and bailed out troubled financial institutions under its supervision. The United Kingdom, which was also reeling from similar economic problems, printed GBP 445 billion, and bailed out financial institutions in its jurisdiction. Japan and Sweden also went down this route.
Covid-19
There was an outbreak of a deadly flu in Wuhan, China, in 2019. The flu was caused by a very infectious type of coronavirus that scientists profiled and named covid-19. The virus spread quickly to other cities in China, and the rest of the world, and it was declared a global pandemic just a few months after the discovery of the first case.
Quarantines, and lockdowns of infected populations and cities were the preferred containment measures for Covid-19. All factories, schools, shopping malls, hotels, restaurants, places of worship, and office workplaces in affected cities were shuttered to enforce quarantines. Lockdowns of exposed populations were enforced by suspending all road, air, rail, and sea transport.
Before covid-19, the success of globalization had created efficient global supply chains. International businesses were relying on just-in-time processes for their business logistics operations. There was no need to maintain excess inventory to support production. Just-in-time processes could be trusted to efficiently move raw materials from primary producers to factory floors and finished goods from factories and processing plants to the market.
The shuttering of factories, shopping malls, office workplaces, and lockdowns of entire cities to contain covid-19 punched massive holes in global supply chains. Trade systems are beginning to melt. Severe shortages of raw materials, manufacturing components, and finished goods are now rife. As a result, prices of commodities and finished goods and services are rising.
While traveling from Malaysia to Rotterdam in the Netherlands, the ship Ever Given ran aground in the Suez Canal on March 23, 2021, and blocked this important global sea route for six days. Approximately 12% of global trade and 30% of global container traffic traverse the Suez Canal, transporting over US $1 trillion worth of goods per annum.
This ship punched a one-week hole in global supply chains and further exacerbated supply chain disruptions the world was experiencing from covid-19. The economic fallout from covid-19 was massive, and governments around the world rolled out equally massive economic stimulus plans to support their respective economies.
The U.S., the proprietor of the global reserve currency, the USD, printed more than US $5 trillion, and dished it out to households, mom-and-pop shops, restaurants, airlines, hospitals, local governments, schools, and other institutions around the country grappling with the blow inflicted by covid-19.
The Russia-Ukraine War
On February 2, 2022, Russia officially recognized the two self-proclaimed separatist states of Ukraine in the Donbas and sent troops to the region. Three days later, Russia invaded Ukraine and escalated a conflict that began in 2014 when it annexed Crimea into a full-scale war.
The U.S. responded to this invasion by weaponizing the USD, and leading other countries in doubling down on the economic sanctions that were first imposed on Russia in 2014. These countries include all the European Union countries, the United Kingdom, Australia, Japan, South Korea, and other countries.
The sanctions include banning the Russian Central Bank, 10 key Russian banks, and Russian oligarchs from the SWIFT payment system. Travel bans, and freezing of foreign assets belonging to the Russian president Vladimir Putin, senior Russian government officials, Russian members of parliament, and Russian oligarchs. Cutting trade with Russia, closing airspace to Russian aircraft, banning Russian state-owned television networks, and halting the certification of the Nord Stream 2 gas pipeline.
Russia is the world’s largest oil and natural gas exporter, the world’s largest exporter of wheat, and also an important exporter of industrial metals and agricultural fertilizers. The European Union relies on Russia to supply 40% of its energy requirement. Sanctions on Russia have so far not touched the oil trade between Russia and the European Union, but plans to wean the European Union off Russian oil and gas by the end of 2022 have been announced.
The sanctions were designed to destroy Russia’s economy, crush the Russian ruble, and limit Russia’s ability to fund it’s war with Ukraine. The combined effect of the Russian invasion of Ukraine, and the sanctions lead to a more than 40% loss of the value of the Russian ruble, and the banning of Russian stocks and bonds from trading on international stock exchanges. The Russian stock market also suffered a decline.
Russia responded to these sanctions by raising interest rates to 20%, forcing exporters to convert 80% of their proceeds in foreign currency (EUR and USD) to rubles at a discount, restricting foreign currency trades, and banning foreigners from selling Russian stocks and assets. An announcement that Russia will sell its oil and gas to hostile countries that had hurled sanctions at it only in Russian rubles was also made.
The Russian Central Bank went further and conspicuously announced that the ruble will be tied to gold at 5,000 rubles per gram as of March 22, 2022. A troy ounce has about 32 grams. Therefore, Russia fixed the price of an ounce of gold at 160,000 rubles. At the time of this announcement, USD/RUB was exchanging at 100, and the price of an ounce of gold converted to US dollars was US $1,600 instead of US $1,928, which was the market price at the time.
This move wiped off about 17% of the USD market value of gold. Russia followed through with its announcement to sell its oil and gas to hostile countries in rubles which it fixed at 5,000 per gram of gold. Anyone wishing to buy oil or gas will have to pay in rubles or gold, and they will not get the USD value for the gold they tender as payment.
Russia waged a currency war against the U.S. when it devalued the USD by 17% in terms of gold. Its response to the U.S. lead sanctions worked beyond the wildest expectations of many. The Russian ruble recouped all war and sanction-induced losses and is now the best performing currency in the world. The USD/RUB exchange rate at the time of this writing is 65.55.
The fixed peg of the ruble to gold at 5,000 per gram causes the price of gold in USD to rise with the strengthening of the ruble and drop with the weakening of the ruble. The ruble strengthened in this case. The USD devalued even further in terms of gold.
COMEX and LBMA
COMEX is an abbreviation for the commodities Exchange based in New York, USA. It is the primary futures and options market for trading metals such as gold, silver, copper, and aluminum.
LBMA is an abbreviation of the London Bullion Market Association. It is the international trade association representing the global over the counter (OTC) bullion market. It considers itself the global authority on precious metals. It has membership of about 150 firms including traders, refiners, producers, miners, fabricators and vault and carrier service service providers.
Russia fixed the price of gold at 5,000 rubles per gram. The current USD/RUB exchange rate is 65.55. At the time of this writing, the price of an ounce of gold in USD, as per the Russian fix, is US $2,440. The current market price of gold, as determined by COMEX and LBMA, is US $1,905 an ounce.
A revelation of how the price of gold is determined will change your perception of gold. Unlike other commodities, where the market forces of supply and demand determine the price, the price of gold is set by several banks, an oversight committee, and a panel of internal and external members.
They establish the spot and the fixed future price by calculating averages in gold futures markets. Gold futures are standardized binding contracts to buy or sell gold at an agreed price on an agreed date in the future. Under this mechanism, the price of gold is determined by the supply and demand of gold futures contracts instead of the supply and demand of the physical metal.
This pricing mechanism gives COMEX and LBMA a lot of room to manipulate the price of gold. These two have been inflating the supply of gold futures contracts and dumping them in gold futures markets to suppress spot and fixed future prices.
COMEX and LBMA have been coordinating with the major central banks to suppress the price of gold and prevent it from appreciating against government-issued currencies, which are being debased by money printing. COMEX in the U.S. and the London Bullion Market Association (LBMA) in the UK operate major gold futures markets.
By pegging rubles to gold, Russia is waging a currency war to challenge the global reserve currency status of the USD. Reminiscent of what the US did in 1975 with Saudi oil, Russia has declared it will only sell its oil and gas to hostile countries in rubles. In essence, Russia pegged its oil and gas to gold, with rubles as the proxy for gold.
The effect of this is that Europe and the other countries which have imposed sanctions on Russia have to buy rubles from Russia or pay for oil and gas with gold. Remember, Russia was locked out of the SWIFT payments system by sanctions.
European countries holding USD reserves will increasingly have less use for them and will want to exchange them for more useful and stable reserves. The ruble is pegged to gold, and it easily fits the bill. No wonder the ruble is already the best-performing currency in the world.
Russia has also set the stage on which the discovery of the price of gold will be yanked from COMEX and LBMA by the market forces of demand and supply of the physical metal operating outside the futures market.
The Looming Global Currency Crisis
The U.S. penchant for weaponizing the USD against countries, entities, and individuals it disagrees with does not auger well with the status of the USD as the global reserve currency. Iran, Russia, and Venezuela were blocked from the dollar payments system.
These three countries cannot access their USD reserves and gold held in western countries. According to Putin, western countries stole these reserves and destroyed the trust that the world had in the USD as the global reserve currency.
To resolve high inflation, central banks usually raise interest rates which increase the cost of borrowing money. The high cost of borrowing money eventually reduces the money supply and resolves high inflation.
For monetary policymakers to be on top of their game, they have to raise interest rates to resolve high inflation, and cut them to resolve recessions. Therefore, periods of high inflation should coincide with low interest rates, and recessions should coincide with high interest rates.
But in an apocalyptic twist of economic events, high inflation and a looming recession have converged on the global economy. The U.S. being the proprietor of the global reserve currency, is supposed to raise interest rates to tame high inflation, and at the same time, cut them to prevent the looming recession. Changes in U.S. interest rates have global ramifications because the USD is the global reserve currency.
Between fighting inflation and preventing a recession, the U.S. has chosen to fight inflation. The Federal Reserve Bank is raising its policy interest rate, and the USD is strengthening against all global currencies. It took an interest rate hike of 6% to plunge the world into the great depression of 1929 and 5.25% to plunge the world into the global credit crisis of 2008.
The share of global trade and foreign debt denominated in US dollars is 70 percent and 60 percent, respectively. A strengthening USD means that most countries will increasingly require more of their local currency to pay for imports, and settle foreign debt obligations. This explains the current volatility in global foreign exchange markets.
The U.S. printed US $4.5 trillion and ostensibly resolved the 2007/8 subprime mortgage crisis. It also printed more than US $5 trillion to cushion the U.S. economy from the negative economic impact of covid-19. Money supply expansion from these two money printing episodes is equal to almost 50% of the U.S. GDP. This explains the first component of the elevated level of global inflation.
Supply chain disruptions from covid-19, and Russia’s invasion of Ukraine caused the prices of commodities that the world relies on China, Russia, and Ukraine to supply in bulk to skyrocket. Prices of finished and semi-finished goods from China, and oil, wheat, agricultural fertilizers, and industrial metals from Russia and Ukraine have also skyrocketed. Consequently, prices of other goods and services are also rising. This explains the second component of the current high levels of global inflation.
At the time of this writing, the relevant U.S. policy interest rate is a paltry 0.75% – 1%. The inflation train has already left the station, and raising interest rates now to resolve rising inflation will have to be at the expense of letting the recession genie out of the bottle. The U.S. has to choose between taming high inflation and preventing a recession.
It is not possible to do both. Raising interest rates at this point can tame rising inflation, but it will raise the cost of capital, collapse the global credit market, and cause a recession. Cutting interest rates now can postpone the looming recession, but rising inflation will spiral out of control. This is the global currency crisis that is brewing.
The value of financial investments is measured in government-issued currencies that are pegged to the USD. A global currency crisis can disrupt foreign exchange markets, and throw the valuation of financial investments into disarray.
Currency crises are unique economic problems and some generations are lucky not to experience them. This one is brewing in our lifetime. You may want to speak to a financial adviser who is well versed in this unique economic problem about your financial investments.
