-- Published: Friday, 22 December 2017 | Print | Disqus
By Alasdair Macleod
We approach 2018 having seen the seeds planted in recent years for a monetary revolution. They include the massive world-wide expansion of credit and debt since the last credit crisis, and the advent of potentially disruptive cryptocurrencies. Geopolitical shifts of tectonic scale have occurred, hardly noticed by the ordinary person. That was until now. We are now on board a train which is gathering speed towards its buffers: the end of dollar hegemony and its potential collapse.
It might take a few years yet to get there, but the speed of our train is dependant to a large degree to how the engine’s boiler is stoked by America through her isolationist plans. It is very hard to see how the dollar cannot decline significantly with America’s autarkic trade policies, benefiting gold.
Geopolitics are likely to become more prominent in 2018, risking an upset of the precarious balance in what amounts to an ongoing financial war. Upset that balance, and chaos results. President Trump threatens to do just that by formally identifying China and Russia as America’s main adversaries in his National Security Strategy, released only this week.[i] The document repeatedly casts China and Russia as geopolitical villains seeking world domination, and America as the world’s saviour.
The subtext is Trump will compete for dominance on military grounds, while the battle for global power is in fact economic. It is a strategy America is bound to ultimately lose, because empires always thrive on trade, not suppression. Suppression is an end-game. By opting for trade isolationism and military power, the Americans are risking everything on the dollar’s status being maintained, because if the dollar sinks, so does America. However, that is an increasingly likely outcome.
Essentially, Trump’s National Security Strategy document highlights the struggle ahead for a country which has already lost economic control over the world, and like all empires before it, is now in decline. America is being outspent by China nearly everywhere, and, bizarrely, America’s response is to isolate herself through trade protectionism. Instead, by ramping up her military capability, America is becoming more belligerent as her own economy declines, relative to those of China and Russia.
China’s and Russia’s immediate response to Trump’s National Security Strategy was to declare it is a return to the cold war. The question for next year is will this encourage China and Russia to show less restraint, less patience, in their plans to dethrone the dollar?
This has to be our central theme, and how the relationship between unsound fiat and sound money, gold, is affected. Goldmoney readers are rightly interested in the prospects for gold in 2018. They look good, from an investor’s point of view. From an economist’s point of view, it’s not gold that looks good as such, but that the decline towards destruction for the dollar, the world’s reserve currency, is now progressing towards its inevitable conclusion.
This article examines the outlook for gold in monetary and economic contexts, organised under these headings, followed by some concluding remarks:
How US economic policies can be expected to undermine the dollar, and lead to an accelerating decline in its purchasing power;
China’s economic and monetary objectives, and how they are being progressed in partnership with Russia;
The erosion of the dollar’s petrodollar status, and the consequences thereof;
Global interest rates, the advancement of the credit cycle, and the effect on the gold price; and
The disruption to the monetary order created by cryptocurrencies.
US economic policy, and the dollar
The White House under President Trump appears to understand that the Democrat’s policy of transferring wealth from ordinary people to the state, and that the concomitant state control over its electors’ day-to-day business and behaviour is ultimately destructive. From a narrow economic point of view, arguably this was what President Trump was elected to change.
The market response to him winning the Presidency was initially positive, with the dollar rising strongly, before the difficulties his administration faced in overturning the status quo become the primary concern. The dollar then began to decline against other currencies, before a slight year-end recovery in recent months. Since Trump was elected, it has become clear that reversing the socialisation of the US economy is not straightforward. The struggles over Obamacare and a budget that proposed to reduce the tax burden on wealth creators are testament to that, as well as the bruising battle for control of the permanent establishment. Instead of a clear progression to a Reagonomics supply-side revolution, the economic risks appear to be increasing, rather than diminishing.
Trump’s underlying economic problems appear to be two-fold. He and his immediate advisors are trade protectionists, believing that US jobs can be protected, and even increased, through trade tariffs and protectionist policies. All history screams at us that this is a horrible mistake, and classical sound money economics clearly explains why.[ii] His second problem is he has inherited welfare legislation that is increasingly costly, and virtually impossible to reverse. So not only is the White House economically rudderless, but it is unable to reduce the burden of the state on the overall economy, necessary for the state’s destruction of wealth to be reduced.
The hope is that tax cuts will eventually generate increased nominal taxes, through economic recovery. Even if we assume that this happens, the budget deficit will increase significantly before it decreases.
Dollar bulls are expected to take this on trust. But while the intention behind supply-side stimulus may be improvement over previous consumer-driven policies, it is far from clear that the hoped-for economic benefits will materialise. An important plank of supply-side reform is a return to free markets. That is not what is happening. If anything, the drift towards state control is increasing, which is what trade protectionism is really about.
The current mistaken policy over trade was exposed to earlier generations by the Smoot-Hawley Tariff Act of 1930, which made the depression considerably worse than it would otherwise have been. Tariffs are not just a tax on consumption, but they are a tax on producers importing raw materials and those importing goods for further assembly as well. They are therefore regressive with respect to economic progress. They do not fix the trade deficit, nor are they in any way constructive to supply-side reform. Furthermore, the trade deficit is certain to increase despite tariffs, driven by a higher budget deficit and an expansionary monetary policy.
Smoot-Hawley occurred at a time of sound money, because dollars were readily convertible into gold. This was why the economic collapse in the thirties to which it contributed resulted in a devastating collapse in prices. Today, that’s not the case, and the negative impact of America’s trade isolationism is bound to be defrayed by yet more monetary inflation.
There is another good reason why monetary policy is likely to undermine the dollar as well, measured by its purchasing power in commodities, goods and services. It is a mistake made by the Fed and nearly all mainstream commentators to think interest rates control money’s purchasing power by regulating its quantity. They do not: all they control is the allocation of money between cash and loans of different maturities, not the overall quantity. An increase in the overall money quantity is a function of central bank interventions in the bond markets (particularly quantitative easing, asset purchase programmes and their reversal) and variations in the quantity of bank credit. Raise interest rates high enough, and you end up with a monetary-induced crisis by bankrupting borrowers of circulating credit. The one thing you do not get is a controlling brake that fine-tunes the quantity of fiat money, and through it the purchasing power of the currency.
Understanding this point is central to grasping some of the errors behind interest rate policy. The Fed appears to believe the opposite is true, otherwise monetary policy would not be what it is. Dollar bulls, who think otherwise and are confident in the dollar’s objective exchange value, are in error. Furthermore, as the US’s credit cycle progresses and money flows from financial to non-financial businesses, the rate of price inflation increases as well. Banks usually respond to price pressures at this stage of the credit cycle by supressing the true cost of borrowing, because they are competing with each other for market share. This only serves to reduce the currency’s purchasing power even more.
On purely domestic fiscal and monetary considerations, it is therefore hard to visualise the dollar entering a new bull phase. More likely, the current rally is no more than a countertrend bounce in an ongoing decline with important implications for commodity prices. This is obviously positive for the price of gold measured in dollars.
China’s economic policies and objectives
China’s economic policies and objectives are best understood if one regards the Chinese state as a latter-day East India Company, which was known colloquially as John Company. John Company, founded in 1600, obtained a charter from the British Government to trade with the East Indies, which was interpreted as all of the Indian sub-continent and all the territories to the east, included China and Japan. It obtained control over the whole Indian subcontinent, which it ran as if it and its peoples were company property, while trading with all the other lands. Indians of any race and creed, as well as Britons seeking their fortunes, owed their primary allegiance to John Company, but were permitted to trade on their own account. Nabobs returning to Britain had made their fortune under the aegis of John Company, and it prospered under the success of this strategy, particularly in the hundred years until 1858, the year after the Indian Mutiny.[iii]
Not only was John Company almost as powerful at its height as China is today, but China appears to model herself in key respects on John Company. The allegiances of the population are similar, and there is no democratic choice, but citizens are free to make their own fortunes. The glue that makes it stick together is the opportunity for wealth creation, while the state provides the physical and financial infrastructure, and the overall strategic direction. And like John Company, the Chinese are securing trade on an Asia-wide basis, but with a greater reach inland and also towards Europe.
It is inappropriate to compare China with a modern Western democracy, which is the approach of most financial and political commentators. China controls everything, and there is no other choice for its people. If the government decides to create new cities, it has the power to populate them. If it decides to build a bridge to nowhere, it can command nowhere becomes somewhere. While this approach is alien to modern Westerners and runs against concepts of free markets and democracy, it has been and remains a successful strategy.
Foreign relations are carefully managed, in the context of an Asia-wide trade strategy. The most important partnership is with Russia: Russia has energy and the raw materials for industry, as well as superior defence capabilities. Between them, Russia and China control the bulk of Asia’s landmass. Through their joint leadership of the Shanghai Cooperation Organisation and the BRICS alliance, they have secured trading relationships with the Indian subcontinent, Iran, and others. The Chinese diaspora in South East Asia ensures those countries are tied in as well. Like John Company of old, China controls or influences the largest economic unit in the world.
This strategy was anticipated by Halford Mackinder, commonly acknowledged as the father of geopolitics, in two contributions in 1904 and 1919. He identified the geopolitical control of the Eurasian landmass from its Heartland, consisting of a region stretching from Eastern Europe to the Yangtze River. What is not so well known is he updated his theory in the 1940s when he was in his eighties, to include “The Monsoon lands of India and China consisting of a thousand million people of ancient oriental civilisation, that will grow to prosperity”. Mackinder’s prescience is being realised by China’s version of John Company, though the population of his Monsoon Lands is closer to three thousand million today.
One hundred and sixty years after the Indian Mutiny, China’s version of John Company is driven by communications, automation and modernisation. With high-speed rail, goods transverse the whole Eurasian continent at less than half the time taken by sea, and this time will be cut even further. Data processing, online businesses and artificial intelligence are now the norm. With robotics, machines do routine tasks more quickly and accurately than humans in control of lesser machines. The fast pace of this new industrial revolution, and the progress for everyone involved throughout Eurasia is truly remarkable.
The general public in the West is hardly conscious of these developments, only being vaguely aware that more and more products seem to be imported from China. They are certainly not aware that America has already lost its position as the world’s policeman, the guarantor of economic freedom and democracy, or whatever other clichés are peddled by the media. And only this week, President Trump in releasing his National Security Document, and pledging “America would reassert its great advantages on the world stage”, showed the American establishment is similar to a latter-day Don Quixote, unaware of the extent of change in the world and the loss of its power.
Like a monetary embodiment of Cervantes’ tilter at windmills, the world’s reserve currency is rapidly becoming an anachronism. And for China to realise her true destiny, it must dispense with dollars, and if in the process it crushes them, then so be it.
Of course, crushing the dollar has enormous economic implications, not least of which is the potential for it to collapse into a hyperinflationary spiral, further propelled by a central bank trying to buy off the consequences of every systemic crisis. The central planners in China must have been anticipating this risk for some time, which explains why the state has quietly and secretly amassed large quantities of bullion since 1983, and encouraged her citizens to do likewise since 2002.[iv]
The erosion of the dollar’s petrodollar status
In all currency pairs, international traders have to take into account factors driving two currencies in assessing a future exchange rate. The purpose of foreign exchange at its most basic is to settle gross cross-border trade movements, with the balance of these flows paramount in determining the exchange rate. Today, by far the largest trading nation is China, so settling trade between the dollar as the default currency for trade and the yuan is the most important currency issue today.
China manages her currency rate to her perceived national advantage. In recent years, this has meant tracking industrial commodity prices. When they were falling measured in dollars, the yuan was managed lower with them. But with commodity prices rising from last January, the yuan has also risen. We can therefore assume that as China’s imports of commodities accelerate to satisfy the ambitions of her current thirteenth five-year plan, the yuan will continue to be managed to rise in line with the general level of commodity prices.
From this flows the relationship between the yuan and the dollar. That said, China manages to keep commodity prices suppressed through the simple expedient of bypassing markets by purchasing agreements that only use market prices for reference. Doubtless, China hopes that through off-market supply agreements, her infrastructure plans will not raise commodity prices unduly against her.
This hoped-for period of relative calm in international commodity markets should allow China to pursue her plans to increasingly use yuan for trade settlement with her energy and commodity suppliers. She has already set up some of the financial instruments to make the yuan more acceptable to suppliers, and held back on others, notably energy. The oil-yuan futures contract has been the subject of considerable controversy, because it will allow oil suppliers such as Iran to bypass the dollar entirely and to hedge yuan by buying gold through matching yuan-gold futures.
For the avoidance of doubt, these contracts are only available to non-domestic traders, and any gold bullion acquired through the yuan-gold futures contracts will be sourced from international markets, not China nor her citizens.
The problem with these contracts is they amount to a frontal attack on the US-dominated international financial system. Since the collapse of the Bretton Woods Agreement in 1971, the Americans have rejected all monetary roles for gold, and selling commodities or goods for gold is strongly discouraged. More sensitively, pricing and selling oil in anything other than the dollar is a direct threat to the petrodollar and the dollar’s hegemony. For these reasons, the Chinese have held back on plans to introduce an oil-yuan futures contract, though the exchange is set up and ready to go.[v]
It is quite likely the subject of these contracts has been discussed between Beijing and Washington, given their sensitivity. However, if the Chinese don’t introduce oil-for-yuan futures soon, it is likely other exchanges might, given the potential demand and China’s preference for settling energy purchases in yuan. There already exists a yuan-for-gold future in Dubai, and it would make enormous sense to introduce a matching oil-for-yuan future alongside it.
The largest oil exporters by volume to China are Russia, followed by Saudi Arabia. Both Russia and Angola, another major supplier, are selling oil for yuan. Saudi Arabia will need to do the same, to maintain market share, and there are rumours this will happen early in the new year.[vi] Saudi Arabia is tiptoeing cautiously towards China and Russia, recognising that is where her commercial future lies. However, it was the agreement between Nixon and King Faisal in 1973, which created the petrodollar and ensured all other commodities would continue to be priced in dollars after the Nixon shock.[vii] If the Saudis start accepting yuan for oil, it will mark the end of that agreement and therefore the beginning of the end for the petrodollar. At that point, the oil-for-yuan futures contract becomes inevitable, if not already introduced beforehand.
Applying the brakes on the speed of change is never easy, and if the market wants something, someone, somewhere, will provide it. This is the reality behind the oil-for-yuan issue. Elsewhere, China’s plans move on. Financing structures for Asian infrastructure spending are being assembled. For example, a private £750m fund, chaired by ex-Prime Minister David Cameron, was announced this week and it will act as a lead manager for UK and European based infrastructure investments in Silk Road and other Asian Infrastructure Investment Bank projects. This will help ensure the City of London continues to play a major international financial role after Brexit.
These developments will undoubtedly be a major blow for the dollar in 2018, adding to selling pressure on the exchanges. Once these pressures become more apparent, foreign owners of dollar investments are bound to become nervous, being over-weighted, holding $17.139 trillion in mid-2016, the last date of record.[viii]
Global interest rate outlook, and the implications for gold
In 2018, major economies can expect to run into a brief expansionary phase of the credit cycle before the next credit crisis. By the expansionary phase, we mean the reallocation of credit from financial assets to non-financial activities, which will be recorded as a further fall in bond prices, the beginnings of an equity bear market, and a material acceleration in nominal GDP.
This phase happens in every credit cycle, when returns on financial investments decline and risks in non-financial lending appear to have receded, along with memories of the last credit crisis. When extra bank credit is then applied to non-financial demand and supply, prices of goods and services inevitably begin to rise as that credit is spent and the price effect spreads through the economy. In some nations, this process has been evident for some time. Given these things develop a momentum of their own, it is likely that in 2018 prices of raw materials will resume their upwards trajectory, and price inflation in fiat currencies will rise as well.
Fuelling this trend will be China, whose appetite for industrial commodities is planned to escalate significantly. This is why China is likely to offset some price inflation pressures through managing the yuan’s exchange rate upwards against the dollar. While China’s commodity purchases will predominantly bypass markets (as stated earlier in this article), there can be little doubt major shortages will develop as other economies, benefiting indirectly from China’s expansion, increase their demand for raw materials. A combination of rising goods and services prices will be coupled with falling bond and equity prices, as the reallocation of bank credit from financial activities gathers pace. Central banks will desperately try to moderately adjust interest rates upwards, hoping not to trigger a credit crisis. The result is they will always be one step behind the markets, and these are the optimum conditions which favour gold.[ix]
Driving the global economy, is of course, China. Without China, other major economies would stagnate, with ordinary people heavily encumbered by a triple burden of taxes, regulation, and wealth destruction through monetary inflation. It stands to reason that those closest to the Asian story benefit most. Commodity suppliers, led by Russia, the Central Asian states, Australasia, the Middle east, sub-Saharan Africa and Latin America all benefit from China’s thirteenth five-year plan. Canada does as well. Europe benefits from increased trade through the Silk Road, where goods are now in transit for less than two weeks compared with a month by sea, a time that will soon be cut to less than ten days.
The observant reader will notice the United States is missing from this list. America has moved from being the world’s dominant economic power, to only supplying the commonly used currency, a currency that is rapidly becoming irrelevant for trade. By pursuing an isolationist “America first” policy that restricts free trade, America will end up last.
For this reason alone, the bearish headwinds facing the dollar and an isolated US economy in 2018 appear to be badly underestimated.
The cryptocurrency disruption
The rise and rise of cryptocurrencies, notably bitcoin, is a new source of financial and monetary disruption. It has even had some people who are deeply suspicious of state-issued currencies selling their gold to buy them, leading to commentary suggesting bitcoin is the new gold, and that gold as sound money is now redundant. This view appears to be confirmed by the limited supply characteristics of bitcoin, which is more comparable with gold than infinitely issuable state currencies.
Any serious student of money should know this to be a mistake. If there is one statement the reader should take away from this article to cogitate upon, it should be the following:
Cryptocurrencies share exactly the same theoretical monetary qualification with state-issued currencies.
The only reason we use state currencies is they are forced upon us. That is a different issue from genuine validity through freedom of choice. Both fiat and cryptocurrencies are equally monetary imposters, despite their different supply characteristics. As such, they are competing with each other, not gold, which has always been the sound money selected by ordinary people and communities, independently from one another, for millennia. It is simply preposterous to confuse the fakes with the real.
If the cryptocurrency phenomenon continues to run, it will be at the expense of state-issued currencies, because it is between the two that monetary preferences will swing. And because selling government fiat to buy cryptocurrency has an exaggerated value, the benefits of doing so are magnified. This will be of increasing concern to governments in 2018, assuming the cryptocurrency bandwagon continues to roll.[x]
It appears the crypto-bubble may still be in its early stages. Admittedly there is bubble-like speculation currently, but so far, it is mainly technology specialists and a limited number of prescient entrepreneurs who have understood the displacement value of a marriage of new blockchain and financial technologies. Only now is cryptocurrency moving into the mainstream, with service providers realising they must conform to basic financial regulations, and regulated futures and listed investment vehicles are now being established.
For institutional speculators, wary of overpriced investment markets, the temptation of cryptocurrencies must be increasingly hard to resist. It is difficult to see how governments can stop it, because transactions are essentially on a peer-to-peer basis. If they tried to destroy cryptocurrencies, they would merely push them into a parallel monetary system, not destroy them.
Assuming the phenomenon continues to run, the result is likely to be widespread wealth creation through cryptocurrency ownership, compared with the wealth destruction endemic to government fiat. It is hard to see how that can persist without undermining fiat money’s credibility in the public’s collective mind, and therefore its purchasing power. For this reason, cryptocurrencies are likely to be a further stimulant to the gold price, measured in fiat, as cryptocurrencies damage the status quo.
On domestic and international considerations, the outlook for the dollar is deeply negative, and so is correspondingly positive for the dollar price of gold. Price inflation in the US will likely increase, and the Fed, fearful for bond markets and asset prices generally, will be too slow in its response. In any event, raising interest rates does not restrict the money quantity, which according to monetarist thinking is what will be required to bring price inflation under control.
Instead, rising interest rates alters the allocation ratios between cash and term loans. Eventually, central banks raising interest rates will trigger the next credit crisis, but until that happens, the dollar is likely to be weak against commodity prices in particular, and the yuan as well, assuming the Chinese authorities continue to track commodity prices in their currency management strategy.
Internationally, portfolios are loaded to the gunwales with dollars, a remnant of past dollar strength, so they are quite likely to turn sellers. Meanwhile, the largest trading nation by far, China, is doing away with the dollar, and is fully aware that this policy could easily end in a disaster for the world’s reserve currency. Presumably, the Chinese anticipated this eventuality when they began to accumulate gold from 1983 onwards, and encouraged their citizens to do so as well after 2002. Owning physical gold is the ultimate protection against a fiat currency collapse.
Next year is almost certain to see the introduction of hedging facilities for oil exporters to China, forced to take yuan for oil. An oil-for-yuan contract is ready for launch, and could easily be announced in the coming weeks. This event, which is increasingly inevitable, will mark the end of the petrodollar, and can be expected to begin a major financial upheaval, likely to spread to all commodity markets.
Meanwhile, the Americans seem oblivious to these challenges. Only this week President Trump in his National Security Strategy document again promoted his trade isolationist policies, while maintaining that America still has primacy over other nations. This is wholly delusional, because the economic locomotive pulling the world along is China, not America.
The cryptocurrency phenomenon, if it continues, is likely to be an additional destabilising factor for the dollar. In truth, bitcoin and the dollar share the same lack of true monetary status, but their supply characteristics are where they differ. Cryptocurrencies seem likely to expose fiat currencies’ weaknesses, which after all is why they come into existence.
This background of negative events for the dollar is also the primary positive factor for gold. For years, control of the gold price has been suppressed in American markets, through the expansion of unbacked gold derivatives. That control is likely to be first challenged by a weakening dollar, and ultimately wrested from US futures and London’s forward markets, if only because physical gold markets are now firmly under Chinese control.
[iii] It is not widely appreciated how powerful John Company was at its height. Its private army was twice the size of the British army and it possessed a vast fleet of merchant Indiamen and warships, numbered in their thousands.
[x] There are moves to put cryptocurrencies on the agenda for the next G-20 meeting in April.
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