1. The Background
Yesterday I listened to a financial podcast that I thought was so important I have listened to it again and spent some time today summarizing it for you. It delves into the true nature of global financial markets and how they are going to evolve over the next decade and even longer. Here is the link if you want to listen to it for yourself when you have finished reading.
2. Bretton Woods
For thousands of years gold was the only currency used for significant international transactions inside Europe, across the Middle East, on the Silk Road, and in Asia. So, in 1944 when an agreement was forged between the emerging victors of World War Two that would see the American dollar become the world’s reserve currency, there was no question that it was to be backed by gold. After all, the Americans had amassed 20,000 tonnes of it during the war as their allies sold gold to buy arms. Under this new Bretton Woods agreement all nation states could deal with each other with the convenience of a single currency, or simply swap their US dollars for gold at US$32 an ounce if preferred.
However, the USA soon began running deficits to fund the Vietnam war and welfare (rather than tax its citizens) and to supply the world with the dollars everyone else needed to trade with each other. This deficit spending led to a run on the dollar as other nations like France literally swapped their paper dollars for plane loads of gold. 12,000 tons in all left the United States in the late 1960’s.
So, in 1971 Richard Nixon took the US dollar off the gold standard, temporarily of course. The whole world quickly followed, otherwise their currencies would have endlessly appreciated against the US dollar. To give the US dollar continued legitimacy as the worlds reserve currency now that it was off the gold peg, it was eventually decided to peg it to oil in a famous deal worked out between Henry Kissinger and the leaders of Saudi Arabia, the world’s largest oil exporter. The Saudi’s would from then on only sell oil to the whole world in US dollars in exchange for US military protection. Hey presto, the world still needed the US dollar. The new system worked but was wide open to abuse by the Americans, hence the rampant inflation of the 1970’s. In 1980 the American central bank, under Paul Volker, inflicted great pain on its own economy to save the international dollar reserve asset system and destroy that terrible episode of inflation.
However imperfect the system, it seemed to work because for the next 25 years oil traded between 15 and 30 dollars a barrel. Foreign central bank reserves of US dollars and bonds could buy a fairly consistent amount of oil or be sold to balance a nations books. America kept itself disciplined after the debacle of 1970’s. Trust was restored.
3. America Changes Course
Then in around 2005 everything changed. Oil jumped above $30 and kept going. The inevitable issue of peak oil had arrived and Asia’s consumption of oil was skyrocketing Compounding the problem was the small issue of the Americans piling on astronomical amounts of a financial drug called subprime debt. The USA now faced a choice. They could have once again killed their economy to save the international financial system like they did in the early 1980’s under Volker, or they could pander to their domestic voters and powerful banks and let oil rise, thereby sacrificing the long-term value of other nations reserves of American dollars.
They did the latter and let oil run to around US$147 a barrel in 2008. The oil-dollar peg was breaking down, just as the gold-dollar peg did 34 years earlier.
In essence the Americans had decided to shaft all countries that had trusted them and horded massive amounts of US currency and bonds as part of their core financial reserves. The Americans printed $3 trillion out of thin air to get themselves through the 2008 crisis, and $6 trillion to get through covid. The discipline of raising interest rates to save the global system and at the same time crashing the American system is no longer politically acceptable.
That powerful and fundamental change was the slow and almost imperceptible beginning of the end of the petro-dollar financial system. As proof of the sea-change it caused among central banks around the world you only have to note that:
1: they have now almost completely stopped buying new US government debt.
2: They are in some cases getting rid of their US bonds completely, and they have invested three times more gold bullion than US bonds since 2014.
3: Gold is also being repatriating from America to individual central banks by the thousands of tonnes.
4: The Chinese now buy oil in yuan and the seller can swap that yuan for gold if they wish
5: Finally, the Bank of International Settlements (the central banker’s central bank) has recently made the trading of paper gold contracts more expensive than trading physical gold. This suggests that they want physical gold to play a much larger part of a any future financial system than the existing paper derivative gold market.
After America’s decision to run the printing presses in 2008, across the Pacific, China immediately began the process of creating payment systems so they could switch their oil purchases from US dollars to other currencies. They knew their trillions of US bonds would start to depreciate rapidly and buy less and less oil and other goods as time went on. They need a lot of oil, so this was a matter of national security. The Belt and Road program is also part of this ongoing process. Many other countries are following in their wake.
Russia also saw the writing on the wall and gradually sold all their US bonds, bought thousands of tonnes of gold and started selling oil in Euros and Chinese Yuan as much as possible. The Europeans would also like to do the same, that is, buy oil with their own currency. In fact, every country would like to be able to have the privilege enjoyed by the Americans of being able to print money out of nothing and buying oil!
However, at this stage the world does not trust the Chinese, European or Russian currencies, so most countries are stuck with the US dollar for the time being, until the world can find a trusted neutral reserve currency.
The whole world now knows that the Americans will simply print their way out of all economic tight spots forever, slowly destroying their currency in the process. Covid gave us another $6 trillion in new US dollars, the retirement of the American baby boomers will give us many trillions more. The next financial crises in America may see $9 trillion printed. The American dollar is therefore doomed.
But this is only half the story. Something happened in early 2022 that changed everything, and the world is now going to be moving much more rapidly out of the US dollar and into a new financial system than previously thought. This is because of the war in the Ukraine. Lets call it Bretton Woods Mark Three.
4. Where to From Here?
Early on in Russia’s war of aggression against the Ukraine, the Americans did something never before seen in the Bretton Woods era. They unilaterally decided to confiscate the foreign reserves of the Russian Central bank. This had never been done before and will forever change the future of the world. This was an event so significant that we will look back on it as the equivalent of Bretton Woods Mark Two, ie, the Americans coming off the gold standard in 1971.
This one single action sent a chilling message to all the world’s nations that all the US bonds they hold are potentially worthless and therefore no longer to be trusted. Any nation that has ever been in America’s bad books, and that’s a long list if you go back far enough, is now super-incentivized to get completely away from using US bonds as part of their foreign reserves. That could put some $12 trillion up for sale for something better. This single act of financial aggression will send the whole world headlong out of the US dollar reserve currency system, which means out of the petro-dollar system. Nations will be parking their wealth elsewhere. But where?
This exit from the US dollar will result in US interest rate rising as US bonds are dumped on international markets. This will sharp rise in interest rates will crash the US economy and then the global economy. The US government’s mountain of debt will implode as the interest on that debt jumps from the current 20% of the federal budget and begins to consume 30, 40, 50% of all tax receipts. The current pattern of ludicrous 10% budget deficits in the USA will also be unsustainable. The discipline that was avoided in 2008 is on its way!
Foreigners have already stopped funding America’s debt and America’s own banks will also soon refuse to fund their own government’s deficits. This will result in their central bank funding the government directly. This is what happens to all fiat currencies in their death throws. Print. Print. Print. Think Zimbabwe or Weimar Germany.
In addition, and right on cue, we are seeing the peaking of the US shale revolution. The USA will soon become dependent on foreign oil once again, hence the race to become best mates with Iran and Venezuela is on. Russia gives us 10% of the world’s oil exports and most of Europe would seize up if it didn’t take Russian oil. Russia will now only take all payment in rubles or gold. Ten percent of the petro-dollar system just imploded.
Oil is going way up over the next five years. Either the world economy shrinks to match the current price of oil, or we all get used to paying much higher prices with its knock-on inflation. This is another deathblow to the petro-dollar system and the US dollar that rides on its back.
5. Now For The Good News
The new era we are entering will have some upside. The holders of gold, both governments and citizens, will become fabulously wealthy as the world moves back to gold as a trusted neutral asset for the payment of international transactions. However, the price of gold will have to rise dramatically in dollar terms to create the necessary liquidity to run the new system. To give you an idea as to where gold is going, it has to rise twenty-fold to provide the value and foundation needed to equal the current global oil market and therefore be used to trade it globally. Nations will once again trade their goods for gold or some derivative of gold that is interchangeable with the physical metal. Gold will be the primary global reserve asset, probably before 2030. Savvy central banks already know this and have been accumulating gold for the last decade.
The industries that left America for cheaper production sites overseas will come home as the US dollar devalues and they no longer have to run deficits to provide the world with dollars. The re-industrialisation of America has already begun but will be a sight to behold by the end of this decade. It’s their government that is at fault here, not their world beating industries. Hillary Clinton’s “deplorable” employees from the flyover rustbelt states will have the last laugh as the bankers on the coast’s suffer.
China will also suffer badly. It must sell $1 trillion of US bonds to be free of its petro-dollar reserves. This raises the value of its currency and kills its competitiveness. It will be the same for any other untrustworthy middle-income dictatorship that has benefited from the booming global supply chains of the last 20 years. They will also have to pay a lot more for the raw commodities they purchase. Commodities are king this decade.
Banks will shrink as the old game of issuing ever-increasing debt on ever-decreasing interest rates will go into reverse. Banking will no longer be the big game in town, or be able to bribe the political elite. Wages and salaries will rise in all developed countries as the boomers retire, industries re-shore. and there are not a lot of workers around.
Capital will become more expensive, removing the thousands of zombie companies that have been allowed to survive on the cheapest interest rates in all of history. The efficient allocation of capital will reassert itself and lead to great innovation.
The American military will welcome the reshoring of strategic industries. The Arabs will start to sell oil in yuan and other major currencies and may have already done so. The rising oil price will accelerate the move toward an electric world and provide a boon to green commodity exporters. All commodities and making stuff will rise back to its historic average levels.
Housing will eventually become cheaper relative to wages as interest rates go up, allowing ordinary people to once again afford a home. But the pain for over indebted homeowners must come first.
The everything bubble in stocks, real estate, derivatives and all types of debt instruments will burst. They have benefited the most from the relentless fall in interest rates that led to the debt riddled era. Main St will overtake Wall St.