Debtor's Prison

Greetings Fellow Inmates,

The past few days have seen a continuation of the rhetoric coming from official sources across the world about the declining confidence in the dollar as a reserve currency. On 04.06.09, the first deputy managing director of the IMF, John Lipsky, told a panel at the St. Petersburg International Economic Forum that it was certainly possible to create a new global reserve currency to replace the dollar over time. John Lipsky is the effective spokesperson for the IMF and his statements should be taken seriously. He said that such a “revolutionary” step would have positive effects in the long run. On this we remain cautious for reasons we outline below. The salient point here is that this escalation of rhetoric from the institution that is the central candidate for the administration of such a new global currency begs one to one to take it seriously. Please remember, that a scant two years ago, talk of a single world currency was exclusively relegated to conspiracy theorists. Now even the IMF has jumped on the band-wagon. Take a moment and think about that.

The Chinese also continued their anti-USD rhetoric to add to the concrete actions they have taken in the past few months to move away from a dependency on the USD as a store of value. On 06.05.09, the State Administration of Foreign Exchange said that it is considering buying up to $50bln in IMF bonds; a statement that was confirmed by Lipsky. This after Russia also expressed its desire to purchase $10bln of such bonds. For China and Russia, this would be an obvious diversification away from their dollar holdings as well as a means of obtaining more clout in the IMF. More generally, if such an IMF bond issuance grows, then it would mark the beginning of a move towards the monetary centralization at that institution. It is interesting to note that of course the IMF has no tax base itself, but instead relies on the contributions of its member nations (mostly the US). Therefore, these bonds would be backed by stake claims on membership. This is troubling since it further blurs the lines between debt and fiat since there is no real underlying productive means through which those bonds can be backed.

China has also been backing its rhetoric with action. It has signed bilateral trade agreements with seven nations in which all trade will be executed in Renmibi. This will allow the RMB to become a more internationally-used means of exchange and part of the process of fully liberalizing it and allowing it to float. Guo Shuquing, chairman of the China Construction Bank (the second largest) said his bank was exploring offering RMB-denominated trade finance credit. Again, this will boost the RMBs usage internationally and allow China to bypass USD-denominated transactions. Also within the realm of possibility is that in the foreseeable future all oil transactions between Russia-China and Iran-China will be executed in RMB. All this talk would make it seem as though the RMB will be a force to be reckoned with. This, however, doesn’t mean that it will replace the USD as the reserve currency. China’s financial infrastructure is not apt to absorb the gargantuan pressures this would require and is unlikely to be so before the USD event horizon. What is the alternative to the USD then?

As you know, the IMF’s Special Drawing Rights (SDRs) are frequently mentioned as the leading contender for the new global reserve currency. Currently, SDRs are units of account meant to quantify each of the IMF’s members’ contributions and are composed of a basket of currencies, mostly USD (44%), EUR (34%), JPY (11%) and GBP (11%). Even Lipsky admitted that the SDRs could be used to supplant the dollar. Amongst the several issues that concern us here at DP is the current structure of the SDRs. For starters, they are primarily composed of the current reserve currencies themselves. As such, they have the same underlying vulnerabilities to a break in confidence. Remember that we believe that quantitative easing currently being undertaken by those very currencies will lead to a severe USD crisis of such proportions to potentially lead to a fiat currency crisis in general. This exposes the SDRs to the same problem. Not only for this reason does it seem evident to us that SDRs will have to be restructured. Some of our readers have suggested a basket backed by commodities as well as currencies. This is certainly a plausible scenario, but opens up a different can of worms.

Volumes upon volumes have been written about the gold standard and its subsequent abandonment in favor of fiat currencies. Amongst the most pervasively-mentioned reasons for this event was the “strait-jacket” theory in which the economies around the world were hampered as they grew by a relatively fixed money supply. Therein came the necessity to issue more “money”, in order to grease the wheels so to speak and allow economies to grow at their own “natural” rate. We are able to see some sense in this line of reasoning, as it seems like an economy should have its own inherent growth dynamics independent of the fixed quantity of a precious metal used as means for exchange. The problem, as we see it, is that the move away from gold was not supplanted by an economically directly proportional money supply, as Milton Friedman suggested, but rather an arbitrary one determined by central bankers. But this is another matter. The point is that an SDR backed by commodities will have the same “strait-jacket” problem. Moreover, it seems unclear how such a weighting of the basket would change in time as different commodities wax and wane in relative importance.

Ultimately, what troubles us is that there seems to be no viable proposed alternative that solves the very issues that have brought us to this problem and that will lead to a dollar crisis and the institution of a single world currency. As we see it, the crux of the problem is that we live in a world of fiat backed by debt. As debt levels are arbitrarily increased, this “inflates” the house of cards that has been built. If the GCC can teach us anything is that nothing is too big to fail under a large enough mountain, and that mountain is DEBT. We have often written about Uncle Benny and Uncle Merv’s balance sheet adventures, where they are ballooning the size of them and backing their respective currencies with more and more debt of the toxic variety. More generally however, this trend is worldwide and all reserve currencies are doing it. What this means is that the trillions of dollars worth of savings piled up across the world are nothing more than pieces of paper that stake larger and larger claims into all of our (uncertain) futures. Excessive debt always leads to a correction, and in this case it will bring down fiat currencies with it.

We try to be pragmatic here at DP and so we must admit that a substitution of a fiat system is extremely unlikely. What we like to ask is why this FAITH has to be placed on debt? Why must we enslave our futures for the simple sake of devising a means of exchange through which we can trade with one another? What we would like to see is a single world “currency” system in which an actual metric of economic activity is dynamically measured and subsequently used to calibrate the amount of transaction units (ie, money) available. By metric we mean real science, not the statistical chicanery most governments call their “official” stats. This new “money” doesn’t have to be backed by anything, this is after all the very nature of the fiat system. In a world where the majority of transactions are digital, such a proposition as ours does not seem implausible. What is certain however is that as long as debt backs the fiat system, we will not be free. But you knew that, fellow prisoners.

May your capital be safe and your investments prosperous,

MAAA