Currency matters: Always and everywhere a monetary phenomenon

The buck stops here

Bunny had a talk with Mr Irving, who told him that it was the Federal Reserve system at work … really just a committee of bankers, who had the power to create unlimited new paper money in times of crisis.

Upton Sinclair (1926) Oil!

Economists seldom agree. But when it comes to the waves of consumer price inflation washing over the world, head scratching and economic double speak have been replaced by consensus finger pointing. The agreed view is that surging price inflation is caused by Russian President Vladimir Putin and his war in Ukraine.

The consensus runs something like this: Around the world, consumer price inflation is at (or close to) multi-decade highs. This is especially true of advanced markets. The latest prints show year-on-year inflation running at 8.3% in the United States, 9.1% in the euro zone, and 10.1% in the United Kingdom. Even Japan is experiencing inflation, with wholesale prices in August some 9% higher than the previous year. This is an eye-watering figure for a country that has experienced falling prices since the mid-1990s.

In explaining inflation, the agreed view identifies various inciters. Choked supply chains, port blockages, second-hand car prices, and microprocessor shortages are all given walk-on parts in the inflation act. But, according to the established view, the main culprit in the global inflation shock is Putin’s war, which has driven food and fuel prices sharply higher.

The price of a barrel of Brent crude oil moved from US$78 at the start of the year to more than US$130 in March; wheat prices rose by two-thirds and European gas prices are more than 14 times the average of the past decade. If we accept this view on the cause of inflation, the consensus goes on to suggest that if energy prices were to reverse – or if war had never happened – we would be free of inflation.

In four short words: this argument is wrong. Amid furious finger pointing, the argument ignores the actual star of the show – the wild printing of money by many of the world’s central banks, and especially the US Federal Reserve (the Fed).

Dazed, confused, and captivated

Inflation has rattled people to such an extent that the release of US inflation data in the second week of September saw stock markets falling by the most since the early months of the pandemic. The price of sub-investment grade bonds dropped. Short-dated US Treasury yields spiked. Yet, strip out food and energy prices, and inflation is still roaring. Core inflation in the US rose at an annualized rate of 7.4% in August, exceeding economists’ forecasts and well above the Fed’s target for overall inflation of 2%.

Over the course of 2022, the US dollar has surged, gaining 25% against the Japanese yen, and achieving parity with the euro. During the last part of September moves against sterling became even more pronounced as a statement by Kwasi Kwarteng, which was meant to usher in an era of economic growth, instead triggered a crisis.

Counterintuitively, just as the Bank of England had started to get serious about taming inflation, Britain’s central bank has been forced to announce that it was ready to buy unlimited quantities of long-dated bonds to restore order to financial markets – simply a variant on quantitative easing. Earlier, the pound had crashed to its lowest level ever against the dollar. In all of this, the irony is that investors seeking protection from inflation are embracing the very thing that caused it: the US dollar. Something akin to a global Stockholm syndrome appears to be playing out.

Human beings have short memories, which may be partly to blame for this psychological bond to the greenback. Plus, it may be easier and more politically expedient for some to trot out the “Putin’s war” soundbite rather than reflecting on the sheer volume of money that has been put into the system by central banks. Europe’s money supply has grown by about 20%, or €2.5 trillion over the past two years – a robust expansion by any measure. But this is a far cry from the Fed’s actions, which have grown the country’s money supply by 38% since early 2020. To give the US figure some colour, the US$5.9?trillion created by the Fed since the start of the pandemic is equivalent to printing the economies of Mexico, Switzerland, and Spain out of thin air – twice.

The root of the problem

This lens provides a different perspective to the consensus view on the origins of inflation and leads fund manager Tim Price to wonder if “… everything we are told about inflation is a lie.” Perhaps Putin triggered inflation. But if money causes inflation, it is hard – maybe impossible – to escape the argument that the root cause of our current global conundrum is the wild printing of money, and specifically printing of the US dollar by the Fed.

If Putin catalyzed inflation, rather than caused it, then a second-order consequence is that that the world’s most loved currency might not be coated with as much Teflon as euro parity suggests. The criteria for sound money are that a currency is trusted, regarded as a store of value, widely accepted as a medium of exchange, and considered to be a stable unit of account. In addition, the monetary authority behind the currency must be seen to manage it prudently.

To clarify, in this case ‘prudent’ speaks to growing money supply in line with – or perhaps modestly ahead of – the growth structure of the economy. This means growing money supply at a rate that is a composite of growth in productivity and growth in population. With the US population growing by 0.5% per annum, and US productivity growth running at about 1% annum, the pace at which money supply should be growing is about 1.5% per year. Actual growth in money supply is about 10 times this rate. In which case, perhaps it is galloping money supply growth – and not gallons of fuel – that is causing runaway inflation.

More than this, even if the Fed was overly zealous during the pandemic, their job is ultimately to set interest rates so that inflation reaches its target. This is the very definition of prudent policy that underpins sound money. With the US economy still strident, and inflation running far ahead of the targeted 2%, The Economist has come to the conclusion that the Fed is producing “almost the opposite of what good monetary policy is supposed to achieve”.

Stop the presses! Or not?

All of this said, while abundant printing of money is now a well-established pattern in the US, it needs to be acknowledged that this happened at a time of severe economic stress – in the US and globally – where money was created to fund government deficits as part of important social spending programmes. But this begs further questions.?Could those funding programmes actually justify the printing of money? Could printing money be an acceptable, ‘necessary evil’ and an alternative to borrowing if a government is running a large budget deficit and building up debt? If the action doesn’t provoke inflation, then, yes, you could call this defensible and level-headed funding. Unfortunately, there are two problems with this approach, specifically when it comes to the greenback.

The first problem is that to support strong structural growth, you need a high investment rate. Yet, gross fixed capital formation in the US measures five percentage points below the world average of 25% over the past decade. This suggests that the printing of money has facilitated consumption, not investment. The second point is that printing money has happened alongside a steady ramp up in debt-to-GDP ratios. The US debt-to-GDP ratio stands at 124%, which is way beyond the safety lines. As the seminal work of American economists Carmen Reinhart and Kenneth Rogoff attests, the orange warning light turns on at a 60% debt-to-GDP ratio, and the red light goes on at 100%.

This puts the US situation into stark perspective. When you bring this together, it exposes the greenback, which for so long has been favoured for its believed ability to protect against inflation. Rather than being the protector, the US dollar might be the prime suspect in the cause of inflation. What sits behind this problem is the debasement of money due to prolific printing which, to a large extent, has been used to fund deficit spending and consumption. It is a toxic cocktail.

Source: Obstfeld, Maurice and Haonan Zhou. 2022. “The Global Dollar Cycle.” BPEA Conference Draft, Fall.

The extent to which the dollar is coveted – and high reliance on the greenback – adds a further dimension of risk to capital markets and the world economy. Maurice Obstfeld, former chief economist of the International Monetary Fund, notes, dollar strength tends to impose contractionary pressure on the world economy. This is because the roles of US capital markets and the dollar are far bigger than the relative size of the US economy. While the US accounts for one-fifth of world GDP and just over one-tenth of world trade, the US dollar stands behind almost 90% of world forex transactions, two-thirds of official foreign exchange reserves, and half of all cross-border loans.?US capital markets are those of the world and the dollar is the world’s safe haven. Yet, if you consider the criteria for sound money in the cold light of day, the US dollar fails on most of the metrics. This suggests – at the very least – a case for looking beyond the greenback as a default currency; and perhaps considering other options, even if only as part of currency exposure to get all investment eggs out of the dollar basket.

Diversification in currencies

It would be bold to suggest that the US dollar will fall from its established place as the world’s reserve currency. There is some talk of co-ordinated currency intervention, as happened in the 1980s, with the Plaza and then Louvre accords, first to weaken the dollar and then to stabilise it. The difference is that the Plaza accord, in particular, suited what the US wanted at the time. This made intervention credibly consistent with its domestic goals.

As Martin Wolf, a Financial Times columnist, notes, until the Fed is content with where inflation is going, that cannot be the case this time. Currency intervention aimed at weakening the dollar by just one or even several countries is unlikely to achieve that much. If in doubt, just ask the European Central Bank or Bank of Japan. To boot, even in the face of co-ordinated policy amongst major central banks, forecasting currencies is folly. If in doubt on this score, it is worth revisiting forecasts on the British pound made at the start of the year.

With these circumstances and challenges, arguably, a more considered approach for responding to the current conundrum might be to recognise the faults in the US dollar and look for the merit in other currencies. These could include the less widely held – but structurally stronger – South Korean won, and Singaporean dollar. And alongside these holdings, physical gold.

Sentiment should play no part in this determination, after all the greenback would not be the first dominant global currency whose number was eventually up. Just ask Britain which, for 100 years (1815-1920), held the world’s reserve currency – or, before that, France (1720-1815) or the Netherlands (1640-1720). We also need to consider that if diversification is the only free lunch in investing, then the principle should apply as much to currencies as it does to other denominations of investing, including asset classes and industries.

It is a rare circumstance when economists agree. When it comes to the waves of inflation that are washing over the world, it would be a coincidence inside a coincidence if, in agreeing, economists were also right. Since the 1980s Professor Steven Wilkinson has been suggesting that the world is playing a double-or-quits game. He may be right. Perhaps we are close to peak US dollar. Perhaps the buck stops here.?

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Written by Adrian Saville and Raymond Goss (2022). A version of this article first appeared in Business Day https://www.businesslive.co.za/bd/opinion/columnists/2022-09-18-adrian-saville-are-the-almighty-dollars-days-numbered/.