ICangles Investment Post…

It is increasingly clear that the arrangements at the center of the world’s monetary system are fraying. On Monday Standard & Poor’s cut its outlook on the credit rating of the United States to negative indicating there is a very real possibility for a downgrade. By Tuesday gold prices topped $1,500 an ounce. Also last Friday China admitted inflation was picking-up steam, as it announced an official annual uptick of 5.4 percent that almost surely understates the true amount. On the European front Moody’s downgraded Ireland’s credit rating last Friday. That action followed earlier comments from Germany’s finance minister that Greece may default on its debts. All of this came despite the world being in the midst of an economic recovery.

These announcements received a fair amount of media coverage. Each was a sign of the formidable challenges in keeping the current system together. The assumption however is often that not only will the difficulties be overcome, but the important players in the world are working to keep the current system intact. Some other news that came out on Monday doesn’t fit that particular narrative. In a meeting in China representatives of the BRICS (Brazil, Russia, India, China and South Africa) announced an agreement to expand trade using their own currencies in place of the U.S. dollar. It was a sign of the possible return to global trade blocks in place of the current system with the U.S. dollar as the world’s reserve currency.

Going back to the future in the sense of a return to country blocks characterizing world trade in a similar fashion to what transpired after the dollar fell away as the world’s reserve currency during the Great Depression is an alarming possibility. Back then many countries couldn’t afford to pay back loans to the United States and the global trade regime imploded under the bad debt load. Whereas that past saw a move in the U.S. to a full fiat currency, today the reverse is far more likely. Rising gold purchases by not only individual investors but central banks shows declining faith in the Euro, as well as the U.S. dollar. And it is a virtual certainty that the existing system of exporters subsidizing purchases of importing nations through existing currency and debt arrangements is on its last legs.

When it comes to Chimerica (the trade and currency arrangement between China and America) the signs could hardly be clearer that the current currency arrangement is doomed. Moody’s declaration was just the latest confirmation that the United States cannot continue piling up debt at the current pace. In addition under the Federal Reserve’s policy of quantitative easing, the biggest buyer of U.S. debt is no longer China or Japan, but the U.S. government as it basically prints the money to purchase its own debt. Similarly rising consumer and also asset inflation in China is the untenable cost of holding the yaun/renmimbi fixed at a low rate to the U.S. dollar, as America injects significant liquidity.

Yet, China is resistant to letting its currency strengthen lest its exports become less competitive and workers lose their jobs. The fact is that neither country will be able to hold its part of the center together, and the United States is already not purchasing enough Chinese goods to sustain strong job creation in that country. In China job growth is now centered around its own real estate bubble and unsustainable investments in unnecessary infrastructure and production capacity. But even these investments aren’t enough to soak up all the excess liquidity and consumer inflation is also rising here as it is in the rest of the world and China is no longer a deflationary counter to inflationary forces.

Global Inflation Chart courtesy of MarketWatch

The situation around the other major currency in the world, the Euro, is hardly any better or all that different. The PIIGS (Portugal, Italy, Ireland, Greece and Spain) by joining a Euro built around German financial strength were able to borrow money cheaply by leaning on Germany’s ability and perceived willingness to bailout the Euro financial system. Like China, Germany obtained economic advantages out of the arrangement. Financial institutions captured good returns by making loans outside of Germany. Loans to the PIIGS were partly used to buy German exports and create German jobs. That arrangement is fast unraveling. In terms of either the Euro or the U.S. dollar, the world’s currency system has essentially been one of exporters selling goods and importers selling debt in return. At its center is unsustainable debt.

Current inflation calculated by methodology in place in 1980 courtesy of Shadow Government Statistics.

Such a center cannot hold. Rising commodity prices demonstrate that the excess liquidity can no longer be contained in a world so engorged with debt it can’t stuff much more down through asset purchases. The corporate bubble around the Internet and stock purchases popped, and the corporate appetite for leverage was satiated. Then the consumer bubble around residential real estate popped and the consumer’s appetite for debt was quenched. Now with rating warnings and fears over defaults—whether it is an outright default in the case of some European nations or a stealth default in the instance of the United States or the crash of China’s state run banking system—the government debt bubble is poised for bursting.

The corporate bubble ravaged the initial public offering market, the consumer bubble hammered the credit markets and the government bubble will almost certainly wipeout today’s global monetary system. What will take its place is a matter for debate. But the days of a fiat reserve currency system, where exported goods are exchanged for debt are numbered. Odds are good we will see a return in some form or fashion to hard money, whether linked to gold or a commodity basket of some sort. At the very least we will again witness a tight money policy reminiscent of Paul Volker’s time at the Fed. The question is how bad will things need to get and how much time will pass before this point is reached.

It’s likely to be a painful transition however, since the option of expansionary fiscal and monetary policy to alleviate the next downturn will no longer be available having been chiefly responsible for this very predicament. If implemented such policies would be ruinous. On a global basis this next downturn is almost certainly to be the worst of the three, as the existing money paradigm falls apart. For instance residential real estate in the United States could hit new lows as unemployment and rising financing costs unload a double blow on this still struggling sector. Yet, such a bottom will almost surely be the buying opportunity of a lifetime for U.S. stocks. The stage will finally be set for sustainable growth arising from a center of real productivity gains, rather than the illusionary gains from cheap money creation and debt.