by Alasdair Macleod, GoldMoney:
In the distant future, we might look back on 2022 and 2023 as pivotal years. So far, we have seen the conflict between America and the two Asian hegemons emerge into the open, leading to a self-inflicted energy crisis on the western alliance. The forty-year trend of declining interest rates has ended, replaced by a new rising trend the full consequences and duration of which are as yet unknown.
The western alliance enters the New Year with increasing fears of recession. Monetary policy makers face an acute dilemma: do they prioritise inflation of prices by raising interest rates, or do they lean towards yet more monetary stimulation to ensure that financial markets stabilise, their economies do not suffer recession, and government finances are not driven into crisis?
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This is the conundrum that will play out in 2023 for the US, UK, EU, Japan, and others in the alliance camp. But economic conditions are starkly different in continental Asia. China is showing the early stages of making an economic comeback. Russia’s economy has not been badly damaged by sanctions, as the western media would have us believe. All members of Asian trade organisations are enjoying the benefits of cheap oil and gas while the western alliance turns its back on fossil fuels.
The message sent to Saudi Arabia, the Gulf Cooperation Council, and even to OPEC+ is that their future markets are with the Asian hegemons. Predictably, they are all gravitating into this camp. They are abandoning the American-led sphere of influence.
2023 will see the consequences of Saudi Arabia ending the petrodollar. Energy exporters are feeling their way towards new commercial arrangements in a bid to replace yesterday’s dollar. There’s talk of a new Asian trade settlement currency. But we can expect oil exports to be offset by inward investment, particularly between Saudi Arabia, the GCC, and China. The most obvious surplus emerging in 2023 is of internationally held dollars, whose use-value is set to drop away leaving it as an empty shell. It amounts to a perfect storm for the dollar, and all those who sail with it.
Those of us who live long enough to look back on these years are likely to find them to have been pivotal for both currencies and global alliances. They will likely mark the end of western supremacy and the emergence of a new, Asian economic domination.
The interest rate threat to the west’s currencies
It is a mark of how bad the condition of Western economies has become, when interest rate rises of only a few cent are enough to threaten to precipitate an economic crisis. The blame can be laid entirely at the door of post-classical macroeconomics. And like a dog with a bone, their high priests refuse to let go. Despite all the evidence to the contrary, they would now have you believe that inflation is transient after all, though they have conceded the possibility of inflation targets being raised slightly. But the wider concern is that even though interest rates have yet to properly reflect the extent of currency debasement, they have risen enough to tip the world into recession.
In their way of thinking, it is either inflation or recession, not both. A recession is falling demand and falling demand leads to falling prices, according to macroeconomic opinions. When both inflation and a recession are present, they cannot explain it and it does not accord with their computer models. Therefore, government economists insist that consumer price rises will return to the 2% target or thereabouts, because rising interest rates will trigger a recession and demand will fall. It will just take a little longer than they originally thought.
They now saying that the danger is no longer just inflation. Instead, a balance must be struck. Interest rate policy must take the growing evidence of recession into account, which means that bond yields should stop rising and after their earlier falls equity markets should stabilise. For them, this is the path to salvation. In pursuing this line, the authorities and a group thinking establishment have had success in tamping down inflation expectations, aided by weakening energy prices.
Since March, West Texas intermediate crude has retraced 50% of its rise from March 2020 to March 2022. Natural gas has fallen forty per cent from its August high. If the western media is to be believed, Russia is continually on the brink of failure, the suggestion being that price normality will return soon. And the inflationary pressures from rising energy and food prices will disappear.
What is really happening is that bank credit is now beginning to contract. Bank credit represents over 90% of currency and credit in circulation and its contraction is a serious matter. It is a change in bankers’ mass psychology, where greed for profits from lending satisfied by balance sheet expansion is replaced by caution and fear of losses, leading to balance sheet contraction. This was the point behind Jamie Dimon’s speech at a banking conference in New York last June, when he modified his description of the economic outlook from stormy to hurricane force. Coming from the most influential commercial banker in the world, it was the clearest indication we can possibly have of where we were in the cycle of bank credit: the world is on the edge of a major credit downturn.
Even though their analysis is flawed, macroeconomists are right to be very worried. Over nine-tenths of US currency and bank deposits now face a meaningful contraction. This is a particular problem earlier exacerbated by covid lockdowns and for businesses affected by supply chain issues. It gives commercial banks a huge problem: if they begin to whip the credit rug out from under non-financial businesses, they will simply create an economic collapse which would threaten their entire loan book.
It is far easier for a banker to call in loans financing positions in financial assets. And it is also a simple matter to call in and liquidate financial asset collateral when any loan begins to sour. This is why the financial sector and relevant assets have been in the firing line so far.
Central banks see these evolving conditions as their worst nightmare. They are what led to the collapse of thousands of American banks following the Wall Street crash of 1929-1932. In blaming the private sector for the 1930s slump which followed and was directly identified with the collapse in bank credit, central bankers and Keynesian economists have vowed that it must never happen again.
But because this tin-can has been kicked down the road for far too long, we are not just staring at the end of a ten-year cycle of bank credit, but potentially at a multi-decade super-cyclical event, rivalling the 1930s. And given the greater elemental forces today, potentially even worse than that.
We can easily appreciate that unless the Fed and other central banks lighten up on their restrictive monetary policies, a stock market crash is bound to ensue. And this is what we saw when the interest rate trend began a new rising trajectory last January. For the Fed, preventing a stock market crash is almost certainly a more immediate priority than protecting the currency. It is not that the Fed doesn’t care, it’s because they cannot do both. Their mandate incorporates unemployment, and their ingrained neo-Keynesian philosophies are also at stake.
Consequently, while we can see the dangers from contracting bank credit, we can also see that the Fed and other major central banks have prioritised financial market stability over increasing interest rates to properly reflect their currencies’ loss of purchasing power. The pause in energy price rises together with media claims that Russia will be defeated have helped to give markets a welcome but temporary period of stability.
The policy of threatening continually higher interest rates must be temporary as well. In effect, monetary policy makers have no practical alternative to prioritising the prevention of bank credit deflation over supporting their currencies. Realistically, they have no option but to fight recession with yet more inflation of central bank currency funding increased government budget deficits, and through further expansion of commercial bank reserves on its own balance sheet, the counterpart of quantitative easing.
Besides central bank initiatives to keep bond yields as low as practicably possible, runaway government budget deficits due to falling tax income and extra spending to counteract the decline in economic activity will need to be funded. And given that the world is on a dollar standard, in the early stages of a recession the Fed will probably assume that the consequences for foreign exchange rates of a new round of currency debasement can be ignored. While currency debasement can then be expected to accelerate for the dollar, all the other major central banks can be expected to cooperate. The point about global economic cooperation is that no central bank is permitted to follow an independent line.
