Investors should not be misled. Despite the world economic expansion entering a new, more sustainable growth phase, the risk of a major calamity has risen sharply. This isn’t immediately apparent looking at a broad spread of indicators. Financial stability has improved markedly since the GFC. Volatility, to the strange dissatisfaction of policy makers, is low.
Yet, in striving to achieve this outcome, policy makers have inadvertently rendered the world’s monetary system much more fragile. More so than at any other time since Bretton Woods.
It’s not that the world is at risk from a deflationary break-out or that ‘secular stagnation’ looms, these are merely distractions from the real issues which plague the world. In saying that, however, the broader discussion around these two events does demonstrate one thing -- just how quickly policy makers in the US would revert to printing money in the event of any adverse scenario. For the US Federal Reserve, it may simply be a matter of growth or inflation outcomes disappointing. Quantitative easing may end this week, but that won’t spell the end of quantitative easing.
US finances still look stretched, notwithstanding strong economic growth outcomes of late. The IMF projects ongoing budget deficits for the US of around 4 per cent to 2020, up from 5.5 per cent this year. That averages out to an annual public funding requirement of about $900bn. Now to date, funding the US budget hasn’t proved to be a problem. The tool of choice: quantitative easing. Specifically, the US Treasury has issued roughly $7 trillion worth of notes and bills since the GFC. $4.4 trillion of that cash was provided by the Fed, while another $3 trillion or so was provided by foreign governments - some of whom, like Japan, also print money.
Yet that reliance on QE opens up a sizeable funding gap for the US should it end. The US will need another $9 trillion or so over the next decade -- but where will the money come from? The private sector for its part doesn’t look too willing to provide this cash (in the absence of free money provided by the Fed) given the abysmal returns on offer.
Emboldened by the apparent success of QE’s I-III, the most likely outcome is that policy makers revert back to the printing presses. The current round of QE is the third incarnation -- something that makes a mockery of the initial purpose of the program: to fend off depression and deflation. Instead, quantitative easing has already become a mainstay of macro management -- of deficit financing.
Yet how long will the major creditor and reserve economies continue to tolerate this. To some extent, exchange rate management ensures that they will. Even so, being subject to US monetary policy has clear disadvantages and brings with it its own instability.
As an added inducement for change, the US has repeatedly shown its willingness to use its dominance of financial markets as a tool of diplomacy -- to coerce. Russia is only the latest example, with the Russian rouble slumping nearly 30 per cent against the US dollar, to an all-time low.
Inflation has consequently spiked, interest rates are up, this for an already weakened economy. Elsewhere, Russian firms cannot roll-over dollar denominated debt -- dollar denominated repayments are becoming more difficult.
The strategic imperatives for change are obvious, both on economic and foreign policy grounds. As it is, the signs of resistance are already apparent. Developing economies hold around $US8 trillion, of the world’s $US12 trillion, in foreign exchange reserves and as best we can tell, the proportion of US dollars held by these economies has fallen substantially.
Direct (allocated) USD holdings are down to 21 per cent of the total from 27 per cent in 2008 and over 40 per cent in 2000. Indeed, the proportion of reserves that are ‘unallocated’ or not reported has surged in recent years -- to $US5.6trillion or 65 per cent of the total. There is a problem when the world’s largest reserve holders do not want to disclose their holdings -- when they no longer regard US dollars as a safe store of value, as a strategic weakness even.
The status of holding the world’s reserve currency comes with responsibilities. That the US has abused the system with ongoing lazy economic management and foreign policy blunders -- failed in its responsibilities -- is clear. Less clear is how the changes currently underway will play out. The financial system is already unravelling -- currency wars are fought, uncertainty is high and the developing economies are starting to build their own institutions -- the China-backed Asian Infrastructure Investment Bank for instance (We should welcome China’s infrastructure bank, October 27).
Without a clear change in policy from the US, this process is only going to accelerate, and the risk is it could be extremely destabilising. This is one reason why central bank demand for gold has been so strong over recent years -- up 30 per cent over the last year alone.
So what should happen if creditor nations decide the case for change has become a little more urgent? One QE too many -- a trade or territorial dispute with the US. Take your pick. China for its part only holds 1 per cent of its $4 trillion in reserves as gold, whereas many nations in Europe hold 50-60 per cent -- the US holds over 70 per cent of its reserves in gold.
No, it wouldn’t take much for what residual trust there is in the US dollar to evaporate -- for the current monetary system to collapse. Competitive devaluations, trade restrictions, a spike in the gold price, perhaps even a US debt default would follow. The world economy would be thrown into chaos and we are closer to this now than we have been in decades. The case is urgent, western nations must restore the economic order, a failure to do so will be catastrophic.