Money, Credit, and Devaluation

An economy is made up of a few simple parts and a lot of simple transactions that are repeated a zillion times. Each transaction consists of a buyer exchanging money or credit with a seller for goods, services, or financial assets. The total amount of spending (money + credit) drives the economy. These transactions are above all else driven by human nature, and they create three main forces that drive the economy: 1. Productivity growth 2. Short term debt cycle 3. Long term debt cycle. Laying them on top of each other creates a template for tracking economic movements.

Credit is different and more important than money/currencies because credit creates debt. It is an asset for the seller but a liability for a buyer. But when credit amount increases to an unbearable amount, it hurts the economy and creates a vicious cycle of the debt burden. Taking credit for productive purposes solves the debt burden issue after it has been paid in the form of money to the lender. Else, it creates an additional burden on the borrower to pay back the principal amount and the levied interest. “One person’s spending is another person’s income”. This debt burden lowers the spending of one person thereby hampering the other person’s income which then underdrives the economy. People take a large amount of credit from the institutions to meet short term goals and then hesitant to pay back the loan amount (creation of a bubble). Debt eats equity.

Individuals have lower creditworthiness as they are unable to pay the loan amount, thus less spending > less income > less wealth > less credit > less borrowing > less spending. This appears similar to a recessionary loop but the difference is that interest rates can’t be lowered further to stimulate borrowing as it has already been lowered and soon hits 0%. This is called Deleveraging. The US in the 1930s and 2008 GFC, England in the 1950s, Japan in the 1990s, Spain, and Italy in 2010. To lessen the debt-to-income ratio, policymakers pull four levers to bring down the deleveraging - Austerity, restructure debts, redistribute wealth - in 1930s Hitler came to power, the war in Europe, and depression in the US (deflationary ways) and printing and devaluing money. Latter is the easiest way out of a Debt crisis (inflationary and stimulative; in the 1930s and GFC the Fed printed over $2T). The Central Bank buys Govt Bonds to lend money to govt allowing it to run a deficit and increase spending on goods and services through its stimulus programs and unemployment benefits. The deflationary ways need to balance with the inflationary way to maintain stability.

After all this, people aren’t worried about currency risks. Quoting Ray Dalio, “Right now how worried are you about your currency declining relative to how worried you are about how your stocks or your other assets are doing?” Of 750 currencies during the 1700s, only 20% remain but all devalued. The most important thing for currencies to devalue against is debt because the goal of printing money is to reduce debt burdens. Increase in the supply of money and credit both reduce the value of money and credit. When the central bank is faced with the choice of allowing real interest rates to rise or printing money and buying those cash and debt assets to prevent real interest rates to rise, they choose the latter, which reinforces the bad returns of holding cash and debt assets.

The chart below (graph #1) shows spot currency returns of the three major reserve currencies in relation to gold since 1600.

As shown, "devaluations typically occur as relatively abrupt declines during debt crises that are separated by periods of currency stability during periods of prosperity."~ Ray Dalio in his Principled Perspectives-The Changing Value of Money. Big devaluations have tended to be more episodic than evolutionary. The frequency and the magnitude of currency jumps are also significantly higher esp. during crises periods in case of EM currencies as compared to developed market currencies (Chan et al, 2014).

Period 1850-1913

Economies saw profitable returns in the 60-year debt/currency cycle as currencies were able to remain fixed against gold/silver. This attractive interest rate period came to be known as the 'Second Industrial Revolution'. In the 1860s the large financing needs of the Civil War prompted the US to suspend gold convertibility and print money (known as “greenbacks”) to help monetize war debts. The Panic of 1873, Panic of 1893, Panic of 1907 were turbulent debt crises but not big enough to devalue currencies. China saw a stock market bubble led by rubber production stocks leading to the 1910 crash and an end of Imperial China. The big exceptions were the US devaluation to finance the Civil War debts in the 1860s, the frequent devaluations of Spain’s currency due to its continued weakening as a global power, and the sharp devaluations in Japan’s currency due to its silver-linked standard until the 1890s (and silver prices falling relative to gold prices in this period). Graph #2

Period 1913-1930

In WWI (1914-18), countries borrowed a lot to fund it, which led to the late debt cycle breakdowns and devaluations that came when war debts had to be wiped out. The Spanish flu also occurred during the period, beginning in 1918 and ending in 1920. The Chinese and Japanese currencies devalued to monetize war debts. In 1919-22 the printing of money and devaluations of several European currencies was required as an extension of the debt crises. As shown in graph #3, this led to the total extinction of the German mark in the 1920-23 period and big devaluations in winner countries’ currencies as well. The 1920s boom period (Roaring ‘20s) due to domestic political and international geopolitical restructurings summoned the infamous 1929 bubble burst. Central banks printed money post-1929 and devalued it.

Period 1930-50

The 1930s was a global debt crisis period that led to economic contractions. WWII witnessed debt increase thereby printing more money and more devaluations. The value of money and debt was completely wiped out for the losers of the war (i.e., Germany, Japan, and Italy), as well as for China, and was severely devalued for Great Britain and France even though they were the supposed winners of the war. During wars gold or silver or barter, rather than money and credit, is the coin of the realm. Graph #4

By the mid-1950s, before that devaluation, the dollar and the Swiss franc were the only currencies worth even half of their 1850s value.

Period 1965-77

After the war, the excessive borrowing sowed the seeds of the 1968-73 devaluation. The downward pressure in currencies and upward pressure in gold started in 1968 made President Nixon end the Bretton Woods monetary system, leaving the Type 2 monetary system in which the dollar was backed by gold. Graph #5

Period post-1980s

That delinking gave central banks the unconstrained ability to create money and credit. This led to high inflation and low real interest rates to the big appreciation in the real gold price until 1980-81 when interest rates were raised significantly above the inflation rate, which led currencies to strengthen and gold to fall until 2000. Post that, a more gradual and orderly loss of total return in currencies against gold, consistent with the broad fall in real rates across countries during those decades was seen.

With that being said, after the Bretton Woods system removal, gold has outperformed all major currencies as a means of exchange (See graph #6). A key factor behind this robust performance was that the supply growth of gold has changed little over time – increasing by approximately 1.6% per year over the past 20 years, whereas fiat currencies can be printed in unlimited quantities to support monetary policies, as exemplified by QE measures in the aftermath of the global financial crisis.

Negative speculations of currencies make gold stronger. Euro, being an important alternative to the dollar, should have a positive link to gold prices. But gold, being against the current fiat-based monetary system, becomes a hedge against depreciation in Euro as well as in the US dollar. This relationship marks the gold rush if at all Euro or dollar depreciates or loses faith in people. Table #1

The graph of Total Credit Market Debt to US GDP shows the potential for debt deflation. By the end of 2019, the global debt stood at more than $255T, according to the IIF. Global debt as a percentage of GDP had reached 322%, which is 40% points higher than at the start of GFC '08. The first rise indicates the 1920s credit boom, followed by debt deflation. Now, the wave credit boom is seen with a much higher possibility of another credit debt deflation. Graph #7

Deflation is a contraction in money and credit, following that it would occur only after a major societal build-up in the extension of credit and the simultaneous assumption of debt. Most of the debt in the early 1980s was “Self-liquidating debt” (a loan that is repaid with interest in a moderately short time utilizing the financial returns generated by the production of G&S), but as the bull market matured, “non-self-liquidating debt” (a loan not tied to production when FIs lend money to consumers for purchases) became predominant. Although in 2019, the ratio is 350%, lower than GFC’s 380%, but is still comparable and certainly increasing.

In conclusion, what we are currently seeing is a similar debt crisis as a fourth wave (as mentioned in my earlier article "Next Wave of Global Debt Crisis and Globalization"). With the hit in economies due to worldwide pandemic, this can escalate further.

References: The thoughts and views of different periods are of Ray Dalio's Principled Perspectives and How the Economic Machine Works by Ray Dalio. Post-1980s is written based on my findings and analysis of yellow metal and fiat currencies' performances.

From graph 6, *As of December 2018. Based on the annual average price of a currency relative to the gold price. **The ‘Mark’ was the currency of the late German Empire. It was originally known as the Goldmark and backed by gold until 1914. It was known as the Papermark thereafter.

-By AMIT AGRAWAL

IFMR Graduate School of Business, Krea University