The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: David, we have talked so often about the privilege that we have as a reserve currency nation. The dollar has been the reserve currency at least since Bretton Woods. But we are seeing news, a lot, even this week, that is making us think, “Are we going to be a reserve currency much longer?”
David: Kevin, I think it is always worth looking at risks and re-analyzing and re-looking at them and re-appraising them as we go on. There is a lot happening this week that I think is worth looking at, in addition to the stresses and strains in the U.S. market.
Let’s just take that as an example. Early this week, we had a downgrade by S&P of U.S. debt, put on negative watch, we are triple A status still, but when you get a negative watch, essentially, what that means is that over the next two years you have a one-third chance of downgrade, assuming that nothing deteriorates beyond what they think it is going to. So they are projecting decline, they are anticipating it. They are saying, “We do have real issues here.”
What is interesting is that when that occurred, we would have expected a sell-off in the treasury market, and we did not see it. What we did see was an increase in the dollar and a decline in the euro, because, actually, trumping the news of our instability here, was instability in Europe.
Kevin: That is the thing that we have talked about in the scope of our programs the last few years. The dollar is a reserve currency. It is in big trouble. But actually, where is the competition? With the euro, they have monetary unification, but they do not have any political unification, so all the southern states can continue to abuse the system, and the northern states can resent them.
David: I think this brings a lot of things back into focus. For the last 48 hours I have watched CNBC and Bloomberg, and for the first time in a long time, they are giving attention to balance sheet issues here in the United States, and they are asking, “Okay, well, if the S&P company says that there is something wrong with U.S. debt, what is it?” As if this comes as a surprise to them. This, to me, shows how far in the sand these ostriches have their heads planted.
This is the issue. It would appear that this has not been an issue up to this point, and the market should be surprised.
Kevin: It is a little bit like being surprised that Greece is in trouble, or Portugal is in trouble.
David: That is exactly what we had with Schaeuble’s statements also this week. He said, “Okay, guess what? We are going to have a debt problem in Greece.” And then everyone in Europe is all over him, saying, “You shouldn’t be saying this. This is not true.” He is just stating the obvious. S&P is just stating the obvious. For the first time you have a company acknowledgement that the king has no clothes, in the United States. Schaeuble, across the pond, is being castigated for just speaking his mind and speaking to the obvious.
Essentially what you have is states, whether it is the United States, or individual states within Europe, who have spent too much money, and they do not have enough income to make payments on the debts that they have. This is issue number one. Issue number two is, what is the value of these IOUs that they have issued into the market?
Kevin: What is their ability to pay?
David: And here is the real complicating factor, because the ECB, the European Central Bank, cares about keeping stability in the financial markets, and specifically, in the banking arena. This is the problem. You have banks in France, you have banks in Germany, and banks in Italy, that are chock full of debt. These are IOUs from Ireland, IOUs from Portugal, IOUs from Greece, and if that debt is diminished in its value, now you are talking about solvency issues within individual banks in these countries.
Kevin: David, you have pointed out before, and we are talking about Europe right now, but talking about Greece, we think, “Well, it’s just a basket case.” But actually, from a debt-to-GDP standpoint, the United States is in worse shape.
David: Right. We are in no better condition. What we have is a privilege accorded to us by one thing, and you mentioned it earlier, Kevin.
Kevin: Reserve currency status.
David: We have reserve currency status. What does it mean to have reserve currency status? What it means is that transactions that happen on an international basis are settled in dollars. It means that oil, when it is sold, even if it is between Iran and Italy, or between Nigeria and Great Britain – guess what? It is not done in euros and it is not done in sterling. Those transactions are settled in U.S. dollars.
Kevin: And it hasn’t always been that way, David. Let’s face it. Just 50 or 60 years ago it was the sterling, it was the British pound. But let’s take a little bit of a look as to how the dollar has risen. You have talked about 1977 being a very good year for not only the United States, but another basket case country, Portugal. 1977 was a good year for both countries.
David: It was the peak year for us in the United States, wherein, as a percentage of international reserves, the dollar made up the largest percentage, at that point, 80%, of international currency reserves.
Kevin: Central banks that held reserves, 80% of those reserves, even if they were a country in Europe, were in dollars.
David: In dollars. 1977 was also the best year in a hundred years for port in Portugal.
Kevin: (laughter) Well, now, that’s a different kind of a reserve.
David: It was a very good year.
Kevin: It is a different kind of reserve and I know you try to keep those reserves. (laughter) Okay, let’s go ahead and talk about dollar supremacy, because we have had dollar supremacy up to this point, but things are starting to look like we are hearing more about the renminbi, we are hearing more about the euro, a basket of currencies, SDRs. Where are we on that?
David: I think the idea of being dollar-centric, and having a unipolar world focused on the U.S. dollar, that is what is on the table. That is what is in question. But it is not newly on the table, it has been on the table for a long time. If you look at the obligations that Europe had to the United States following World War II, there was not only a debt of gratitude, but an actual debt, and they were friends and allies of necessity. We were rebuilding Europe. There was a tremendous benefit to them, that we had resources and they had none.
Kevin: We not only had resources. We not only had a dollar that was backed by gold, but we actually had GDP. We had growth in this country. This is one more thing that happened this week – Goldman Sachs started at about 3½ percent on their estimates this year for our GDP. They have downgraded it twice, Dave. What is it down to now?
David: 3¼ to 2½, and the most recent was 1¾. When you look at Europe and the history of what has happened in Europe, what happened in World War I and World War II was vitally important to the U.S. dollar becoming what it is, because it wasn’t just that we had great innovative minds in America. Certainly we did. And certainly we have seen an improvement in industrial productivity, all through the 1920s, 1930s, 1940s, and 1950s, but what we had was steady growth in the context of Europe taking a major step back and, relatively speaking, we were propelled forward into the number 1 position. It truly was not simply on the basis of dollar strength, but on the basis of fiscal weakness and monetary weakness elsewhere. So the sterling took a back seat. The French franc took a back seat. Even the German mark took a back seat, to the U.S. dollar. Why? Again, replay World War I and World War II and you see how vitally important it was to these countries which were bombed out and had to be rebuilt from nothing, and did not have the resources to do that, that they were forced to borrow. And what did they borrow in? They borrowed in dollars.
Kevin: Yes, but David, that was when we were a creditor country. Now we are a debtor country.
David: And the progression has been more than just us moving from creditor to debtor. It has also been a shift in these countries being essentially in abject poverty, taking handouts from the United States, and being willing to hock their future, because they had none otherwise, and do it in dollar terms. And as they have gotten back on their feet, as the engine of growth has been restored within Germany, and within Europe – guess what? They have had aspirations to go back to what they had. The French want their franc, the Germans want their deutschmark. Or, collectively, they wanted and compiled all of their resources together to make the euro.
Kevin: David, it was fascinating, after World War II, just the utter destruction in all the countries that were involved, except for our country, actually. You have Germany, which, if you have been to Germany, they are still rebuilding after World War II. There are still cranes up where they are rebuilding these old historic buildings. Japan – the same thing. Now, look at the two currencies that became so strong all through the 1970s, 1980s, 1990s, and then ultimately, allowed a merger for the European Union for the German mark, but the German mark and the Japanese yen actually became the bastions of strength as far as currency goes.
David: They were. And there is an interesting parallel, Kevin, when you look at the Japanese yen and the story that it had through the 1970s and early 1980s. It is the same story that is being told of China today, of growth. The engine of growth in Asia – was it China then? No, it was Japan then, and they were invoicing up to 40% of all of their exports in yen terms. This is something that the Chinese are beginning to initiate. They are outpacing our growth here in the United States by three times.
There has been a replacement in Asia. The yen is impaired, the Japanese economy is impaired. China, relatively speaking, has much more significant year-on-year growth. But they have significant things which they still have to put in place if they want to become a regional currency player, or even an international currency player. They question is, can they do those things? Will they accomplish them?
Kevin: And you wonder about how much time it is going to take. In past conversation with Stephen Roach and other experts on China, they talk about time being the difficulty, because there are a lot of things we see with China, but you and your dad, last week, sort of disagreed, I have to admit, about how quickly China is going to take over.
David: And it is a combination of time and favorable circumstances. If you look at developments of the U.S. financial markets, it was the 1920s when we saw a greater issuance of U.S. denominated debt instruments. Prior to the 1920s, we had the U.S dollar, and yes, we had seen a radical change in terms of industrial growth, and we were exporting even more by 1916 than Great Britain. But guess what? Our currency was a domestic local currency. It wasn’t until the 1920s, again, sandwiched between World War I and World War II when we didn’t have competition and we were able to begin marketing U.S. debt, when we began to denominate foreign debt, foreign IOUs, in U.S. dollar terms, to a U.S. audience that was investing feverishly.
Kevin: And there are two key operative words, that, actually, we have recommended for portfolios, as well, and one is stability. You cannot have a reserve currency without stability. The other, is liquidity – the ability to clear international types of transactions very quickly. The dollar has offered that, but we are seeing at this point, countries opting not to do that with the dollar – namely, the BRIC countries. We are talking about Brazil, Russia, India, and China. They are starting to talk about trading outside of the dollar, amongst themselves, just with their own currencies.
David: Right, so in other words, you are settling transactions, and you do not have to convert to dollars first in order to settle those transactions. But if it is a transaction that occurs between South Africa and China, it is going to be settled either in the rand or the renminbi. It is not going to have to go through dollars to be settled, as has been the case for so long.
Kevin, you just hit on a very important point. Currency stability is a vital part of this reserve currency status and it is one of the things that Great Britain began to lose in the 1930s. In the 1930s, Britain provided emergency support to the financial and banking system, and it was at the expense of the pound sterling.
Kevin: That’s when they really lost it, isn’t it?
David: It reinforced the trend of marginalization of the sterling. And the exchange rate slipped relative to the dollar, from 4.86 to 3.25, in about a year, a one-third depreciation in about a year, as the monetary authorities favored the banking system and the financial markets over currency stability. It was, again, one of those things that added to the hand-off of the baton from the pound sterling to the U.S. dollar, as world reserve currency.
Kevin: That was the 1930s with Britain, but that sounds very familiar right now. Oh my gosh, I mean, how much has the dollar declined over the last few years?
David: We have had about a one-third decline just in the 2000-2004 period, and we have been flirting with another support level. If we break 70, I am not sure that we won’t give up another 20% or 30% in short order. It is reminiscent of what the French did. It is reminiscent of what countries throughout time do when they have control of their currencies.
This is the great disadvantage of the European countries who have put their stock in the euro. They don’t control their currency, and when things get out of balance in terms of their debt, in other words, they have too many liabilities and not enough assets or income to pay those liabilities, then they de-value.
The French were serial de-valuers through the 1950s, 1960s, and 1970s. The British were, likewise, serial de-valuers all through this last century. We went from almost a 5-to-1 to the dollar, to now about 1.6-to-1 to the dollar, if you are looking at pound sterling. That has been the legacy over a 100-year period.
We are doing the same thing today, favoring the banking system, favoring the financial system, over our currency, and the one thing that has kept investors coming back to the dollar, year-in, year-out, in spite of us having a poor balance sheet, even 20 or 30 years ago, was that there were no alternatives, and that changed in 1999 with the launch of the euro.
Kevin: David, let’s hit the rewind button just a little bit then. Let’s go back to the end of World War II, to Bretton-Woods, and how it came about. There were no other options, as you said, but there was something that the United States promised the rest of the countries, and that was a solid gold standard.
David: It was the assumption that the dollar was a good as gold. And why was it as good as gold?
Kevin: It was redeemable in gold.
David: So it was gold! By proxy, the U.S. dollar was gold, because if you wanted gold instead of paper scrip, you could have it. That has not been the case since 1971.
Kevin: What happened in 1971? We know Nixon closed the gold window, but talk about what led up to that.
David: We had a whole series of things that happened in Europe, when they began to grow suspicious of our ability to pay. We were offering to settle these transactions in gold versus paper scrip, and we still presented ourselves as completely together, from a financial standpoint – completely solvent. And yet, the French were looking at our balance sheet, saying, “Hmm. We are not sure that what is being presented is the truth.” In other words, this is not the first time, Kevin, that the government here in the United States has fudged the numbers.
Kevin: We had people who had actually seen it happen to Britain ahead of time. Jacques Rouffe is a perfect example. He was advising Charles de Gaulle at the time in the 1960s.
David: Exactly. We have talked about this before, Kevin. He was a young man watching the pound sterling being devalued in the 1920s and 1930s, and remembered it, and he knew what to look for. So there he is in his older years, seeing something similar, something that has a resonance with the past, and saying, “Wow. I think there is a problem with the dollar.”
Kevin: He was a French attaché for France in England at the time that the sterling was losing that power, and coming off of the gold standard. He saw the same thing had to happen. In fact, there was a guy named Triffin, when he saw that the Bretton-Woods agreement was going to create an unlimited amount of dollars, and there was a limited amount of gold in Fort Knox…
David: There was a dilemma!
Kevin: It was called the Triffin dilemma. I can’t believe it even has a name, because it is so obvious, but the Triffin dilemma is, you can’t print unlimited money, make it redeemable in gold, if you have a limited amount of gold.
David: Right. I guess the importance here is that we are watching the things which structurally have to take place for there to be a euro which has legs into the future, for there to be a renminbi which has legs into the future, for there to be a dollar which has or has not legs into the future. These things are swirling all around us, so that in the daily news we hear that there is another meeting in the south of China where five countries get together and determine that they are no longer trading in dollars, they are going to work out a trade relationship where they settle transactions directly.
Kevin: Right. Well, David, we have seen a deterioration in reserves, and we have talked about the countries in Asia wanting to have other reserves and demanding other types of currencies. We were 80% in 1977, where are we now?
David: The dollar as a percentage of reserve assets with central banks, those which are reported, has gone from 80% to 66% at the beginning of this decade, now it is between 60% and 61%. So we are beginning to see a marginal shift. There was a pretty radical shift from the 1970s, but just in this last decade, a marginal shift away from the dollar and toward other currencies. We do not have that true alternative to the dollar, we have the possibility of alternatives to the dollar. That is what we think will be exacerbated by what we see in the news today, this week.
This morning, the central bank governor, Zhou Xiaochuan, said, “We need to be reducing our exposure to the dollar, and we are going to set up vehicles in order to do that. We are not going to tell you now, we are not going to tell you what we are investing in, but we have determined that we are not at a safe level in terms of our dollar exposure.” What that implies is that the central bank of China is not happy with what they own, and are not intending to continue to buy treasuries and finance our deficits.
Kevin: Speaking of deficit, this is what Standard and Poor’s was bringing out on Monday, when they talked about downgrading, or at least creating a negative impression on the dollar’s future. Paying back our deficits is probably the biggest problem the United States has, and there is a concept that you have talked about with inflation that we can actually pay back our deficits by just inflating the dollar. That does not work when almost all of Americans’ money is in dollars, but when it takes 51% of foreigners’ money to support the dollar, which is what is happening right now, 51% foreign buying of treasuries, isn’t it tempting to start to devalue the dollar in the form of inflation, and would this be why the reserves in these various other countries are starting to be reduced?
David: Kevin, I think that is on the money. What we have is a subtle form of default, because we have world reserve currency status. We are not forced to a formal default, but through inflation, we are defaulting on our debt obligations. What is very different, if you are looking at monetary history, is that, classically, what you have with these devaluations, is a stated devaluation. They will come out and say, “We have just devalued the currency by 14%.”
Kevin: You said the French did it over and over.
David: Right, so whether it was 5%, or 7%, or 6.9%, or 14%, or 12%, but it was very specific in terms of a stated monetary de-valuation. We have had de-valuation here, but it has been on a non-stated basis. I think what is happening is that by understating CPI, by understating the official inflation rate, but running a higher inflation rate, 6-6%, or if you are going back to the old models, as much as 10% inflation here in the United States, we are solving our debt issue on the backs of our foreign creditors. Tell me if that doesn’t have geopolitical implications.
Kevin, just to reiterate, we have Moody’s, which left Ireland, this last week, on negative watch, and dropped the country’s debt rating two notches, just above junk status. We have Portugal, stresses and strains there. We have Greek debt which is now yielding over 20%, which is a harbinger of collapse. You are there, in terms of “renegotiation,” or default, if you prefer just plain language.
Kevin: That’s like reading a sign that says, “We are just about to default,” instead of running down the street, saying, “Guess what I just got on my Greek bonds!”
David: Renegotiation! Yeah, language is funny that way, isn’t it? We have Europe, which has great potential, and major constraints. We have China, which has great potential, and major constraints. We have America, which has great potential, and major constraints. I would love to explore some of these issues. Every once in a while we dip our toe into an academic question-and-answer. Barry Eichengreen is a tried and true monetary guru. He has been at the University of California-Berkeley for decades, and is worth, I think, having a conversation with to entertain some of these issues.
Kevin: I think we probably have to ask the question from someone more from an establishment perspective, because let’s face it, David, the central banks are establishment, and as they move these directions, the question as to whether the dollar stays the reserve currency, whether we move to a tripolar currency – the euro, the renminbi, the dollar, or SDRs – you have to ask the guys who have actually come up with that stuff. Of course, Barry Eichengreen just wrote a book this year called Exorbitant Privilege, about this very subject.
David: Kevin, if you were following the yellow brick road, and were going to Oz, once you got there, you would want to look behind the screen and ask a few of the guys who were wizards, “What exactly is happening here? What do you think? What is your perception of reality?” Not that it is the reality that we look at and accept, but one that we certainly appreciate from an establishment perspective. It is helpful to see the direction of the decision-makers the world over.
Kevin: For those who would like to actually hear that conversation and read the book ahead of time, Exorbitant Privilege, we are going to be interviewing Barry Eichengreen next week, discussing this very subject.