America in decline

An American friend, who shares my views on global politics, diplomacy and foreign policy but not on economics or fiscal and monetary policy, recently wrote:

“I agree that the US is in decline. In theory I believe it can come back, but it is getting harder all the time (and the recovery process more painful). If Trump or Biden are elected this year I will give up on the US as it will not recover to a meaningful degree (if at all) in my lifetime.”

Here is the substance of my response…

Whoever wins the election, the country will remain divided. To an outsider, at any rate, the national symbols and myths no longer seem to be working to create the sense of cohesion which they once provided. America is not the nation it once was. I wonder if it is still a nation at all. (It remains a very powerful state, of course.)

In terms of comparative economic and military might and the diplomatic leverage associated with this, the decline is (I think) irreversible. This may not be such a bad thing, given the increasingly destructive nature of US foreign interventions.

The projection of US power has, at least since World War 2, been closely associated with, and facilitated by, the global role of the US dollar in trade and its status as a reserve currency. But the current US-based system is breaking down. This has implications for all countries, but especially for the US.

The Federal Reserve responded to the 2008 financial crisis by lowering interest rates and pumping hundreds of billions of dollars into the system. This was supposed to be a short-term emergency operation. But the expansionary policies continued. A precarious economy increasingly dependent on government spending and a financial system increasingly dependent on cheap credit led the Federal Reserve (and other central banks) to suppress interest rates by any means possible, including by injecting money directly into the financial system through the purchase of securities from commercial banks and other financial institutions (i.e. quantitative easing). Such policies have facilitated and encouraged further borrowing and malinvestment on an unprecedented scale. The problems are now systemic.

Price signals, which are key drivers of any functioning market, have become so distorted that they can no longer be trusted. Fixed-interest securities, shares and many other financial instruments appear to be massively overvalued. Government and central bank interventions are largely to blame for this but other factors – such as the rise of index funds and other forms of passive investing – have contributed to the problem.

I see it as extremely significant that attempts made in recent years by the Federal Reserve gradually to raise interest rates towards more normal levels and to wind back quantitative easing have failed. In both cases, the Fed has reversed course.

In the event of another financial crisis occurring, what would happen? Interest rates are extremely low and central bank options are limited. Defaults and/or falling equity prices would destroy large amounts of paper wealth. In the short term, this could lead to a period of dollar strength but – if the actions of the Federal Reserve in recent times are any guide – the money-printing would be stepped up. This could easily lead to serious inflation and an undermining of international confidence in the dollar. Of course, no one can predict exactly how (or when) the endgame will play out but there is little doubt that the US dollar’s days as world reserve currency are numbered.

Before confidence – and properly-functioning markets – can be restored, bad debts need to be recognized as such and written off. Zombie banks and zombie companies must be exposed and either allowed to fail or taken over. But, because of the extent of the problems, the system itself – the entire post-Bretton Woods, USD-based system – is now irredeemably compromised. There is no easy way out.

Though it may appear otherwise, my basic sentiments are not – and never have been – anti-American. I am not a US citizen but I love and value many features of 20th-century American culture. Many of these features are exemplified and live on in individual Americans even if they are no longer reflected in contemporary social structures and institutions.

The old ways are dying, the old institutions are gone or changed beyond recognition. Even so, I hold to a hope similar to one I have expressed regarding older European and British traditions: namely, that what is good in what has been lost will eventually be rediscovered and find new (and perhaps more enduring) forms of expression.

Investment decisions; geopolitics

In a letter to a friend I briefly outlined my current investment situation and strategy. It's important, I think, to maintain a steady and realistic perspective on the general situation in financial markets both for practical, investment-related reasons and also for understanding current affairs. Politics, economics and finance are inextricably intertwined.

It helps me to state my general position explicitly from time to time. Obvious facts can be vitally important yet they are often overlooked...

I am in a position where I am forced to bet on how the future pans out in terms of economies, interest rates and currencies. I find myself (for reasons I won’t go into) almost entirely in AUD cash. This is my starting point, for better or for worse. AUD is weak against the US dollar. So I am waiting for something to happen (stock market crash or bond yields spiking or AUD rising against USD or other assets becoming cheaper in AUD terms) so that I can make a move with some confidence that I am not being suckered by a fake market.

Nobody knows when things will blow up. But blow up they must given the absurdly high debt levels and low or negative interest rates which are causing massive malinvestment, destroying savings and pensions and destroying the faith that people once had that price signals and so on could be trusted to reflect actual economic realities.

Many companies are on credit-fueled life support: no prospect of ever turning a profit. That’s in large part why the powers that be have to keep interest rates low. If they rise the non-viable companies go bust. Many corporate bonds become worthless, etc.. And zombie companies are not a small percentage of the total these days. Banks are especially vulnerable.

The same logic applies to individuals and families with big mortgages or other debts. Rising rates will cripple them financially as residential real estate prices fall.

And, of course, governments are heavily indebted too. If rates go up, more of the budget must go to service that debt.

US authorities apparently want to weaken the dollar to stimulate exports etc.. The danger is that at some point the dollar will just suddenly start to lose purchasing power as other means of international payment come on stream.

Confidence in the system is rapidly eroding. There is a growing general realization that the current monetary and financial system is failing but it is impossible to know what exactly is going to replace it. Or when.

US policy on the Middle East (and the Far East) is driven mainly by economic and financial factors – and always has been. (Oil. The dollar.) As the petrodollar system breaks down, there are clearly increased risks of conflict between major powers.

China's rise and the US dollar

In a recent podcast interview Louis-Vincent Gave talked about the impending showdown between China and the United States, suggesting that China has a better than even chance of success in their attempts to combat the hegemony of the US dollar.

At the heart of China’s strategy is the Belt and Road Initiative (see map below) which Gave presents as a straightforwardly imperial project. The Roman Empire was at its core a road-building exercise, the roads being designed to facilitate trade and tie the regions into a mutual dependency relationship with the imperial hub. In the Eurasia region, increasingly at any rate, all roads lead to Beijing.

Gave also mentions the new Shanghai oil futures contract (which is priced in renmimbi but is also tied to gold). After six months of operation it now accounts for 14% of the global market. It is just one of many instances of international trading structures being set up which bypass the US dollar.

The United States has only been able to sustain its increasingly debt-dependent government spending programs because the current US dollar-centric global financial system created an artificial demand for US Treasury securities. Rising yields, even at a time of turmoil in emerging markets, would appear to indicate that demand is waning. Gave admits that he expected yields to fall as safe-haven assets like US Treasurys were sought. He believes that rising US government deficits have spooked investors to the extent that US government debt is no longer seen as the safe-haven asset it once was.

If these trends continue over the medium term, US standards of living will inevitably fall. They have fallen a lot already, putting stresses on the social fabric and on political institutions.

Many senior politicians and bureaucrats are aware that America’s prosperity has been dependent for decades on the privileged status of the US dollar. There is a real risk that they will seek to defend the monetary and financial status quo by military means.

The concerns of the Chinese leaders are slightly different. They know that time is on their side and so would be less likely to initiate military conflict. They are aware, however, that if their domestic economy falters social cohesion is at risk. They know they are in an economic slowdown at the moment but apparently believe that it will be manageable.

Dollar bears

The U.S. dollar seems to be losing its status as a store of secure value and it's difficult not to see this both as a contributing factor to, and as symbolic of, a world-wide loss of confidence in the United States itself.

A Bloomberg report published today makes it clear that most of the top-performing global fund managers are sticking to their "long-term bets against the U.S. dollar even as the currency has rallied more than 4 percent since the end of last month." Despite the recent rally, the dollar is still down 12 percent in the past year against a trade-weighted basket of six currencies.

Alessio de Longis, a New York-based currency strategist, was quoted as saying that "the long-term fundamentals still look terrible for the dollar... The U.S. has worse monetary policy and worse fiscal policy than other countries, and that is a bad combination..."

Bill Gross of Pimco said that investors should "revolt" against Federal Reserve-engineered low interest rates and seek alternatives to U.S. bonds. Michael Gomez, also with Pimco, said that Asian currencies were only part way through a multiyear appreciation against the dollar. "We think this is a powerful trend," he said.

The rising Chinese currency (the yuan) is not yet convertible but many believe that Asian countries such as South Korea and Malaysia will let their currencies climb along with the yuan. Other currencies to get a favorable mention in the Bloomberg report were the Australian and New Zealand dollars, the Norwegian krone and the Swedish krona.

Anthony Norris of Wells Fargo thinks the U.S. dollar will rally later in the year but still believes the dollar has to decline in the longer term.

There are, of course, dissenting views, but the fate of the dollar rests with interest rates and government finances, and U.S. monetary and fiscal policies do not inspire confidence.