NEW YORK – The American banking system has collapsed. It doesn’t feature more high-profile failures like Credit Suisse. Central banks will put dying institutions on life support.
But the era of dollar-based reserves and floating exchange rates, which began on August 15, 1971, when the US broke the link between the dollar and gold, is coming to an end. The pain would be transferred from the banks to the real economy, which would be starved for credit.
And the geopolitical consequences would be huge. The seizure of dollar credits would trigger a transition to a multipolar reserve system, giving China’s RMB an advantage as a competitor to the dollar.
Gold, the “barbaric relic” loathed by John Maynard Keynes, will play a bigger role as the dollar makes the banking system useless, and no other currency—certainly not the tightly controlled RMB—can replace it. Now at the all-time record price of US$ 2,000 an ounce, gold is likely to rise further.
The biggest threat to the hegemony of the dollar and the strategic power it provides to Washington is not China’s ambition to expand the international role of the RMB. The danger comes from the exhaustion of the financial system that made it possible for the US to run a negative $18 trillion net foreign asset position during the last 30 years.
Germany’s flagship institution, Deutsche Bank, hit an all-time low of 8 euros on the morning of 24 March, before recovering to 8.69 euros at the end of trading that day, and its credit default swap premiums – insurance on its subordinates. Cost of debt – increased to about 380 basis points above LIBOR, or 3.8%.
This is the same as during the banking crisis of 2008 and the European financial crisis of 2015, although not as much as during the Covid lockdown in March 2020, when the premium was over 5%. Deutsche Bank will not fail, but it may need official backing. He may have already got such support.
This crisis is in stark contrast to 2008, when banks took advantage of trillions of dollars in fraudulent assets based on “fake loans” to homeowners. Fifteen years ago, the credit quality of the banking system was rotten and leverage was out of control. Bank credit quality today is the best in a generation. The crisis stemmed from the now-impossible task of financing America’s ever-increasing foreign debt.
It is also the most anticipated financial crisis in history. In 2018, the Bank for International Settlements (a kind of central bank for central banks) warned that European and Japanese banks’ $14 trillion of short-term dollar lending used to hedge foreign exchange risk could explode. There were a time bomb waiting (“Has the Derivatives Volcano Already Begun to Erupt?”, October 9, 2018).
In March 2020, when the Covid lockdown began, dollar credit was frozen in the rush for liquidity, leading to a sudden reduction in bank funding. The Federal Reserve fanned the flames by opening multibillion-dollar swap lines to foreign central banks. It expanded those swap lines on March 19.
Source: US Bureau of Economic Analysis, Bank for International Settlements
In contrast, the dollar balance sheet of the world banking system exploded, as did the amount of foreign claims on the global banking system. This opened a new vulnerability, namely counterparty risk, or the risk of banks taking on huge amounts of short-term loans to other banks.
Source: Bank for International Settlements
America’s chronic current account deficit of the last 30 years amounts to a barter of goods for paper: America buys more goods than it sells, and foreigners sell assets (stocks, bonds, real estate, and so on) to make up the difference. Kind) sells.
The US now owes foreigners a net $18 trillion, roughly equal to the cumulative sum of these deficits over 30 years. The trouble is that foreigners who own US assets get cash in dollars, but need to spend the money in their own currency.
With floating exchange rates, the value of dollar cash flows in euros, Japanese yen or Chinese RMB is uncertain. Foreign investors need to hedge their dollar income, that is, by selling the US dollar short against their respective currencies.
That is why the size of the foreign exchange derivatives market grew along with the liabilities of the US to foreigners. The mechanism is simple: If you are receiving dollars but paying in euros, you sell dollars against euros to hedge your foreign exchange risk.
But before you can sell them, your bank has to borrow the dollars and lend them to you. Foreign banks probably borrowed $18 trillion from American banks to fund these hedges. That creates a huge vulnerability: If one bank looks as dodgy as Credit Suisse did earlier this month, banks globally will pull credit lines.
Prior to 1971, when central banks kept exchange rates at a fixed level and the United States covered its relatively small current account deficit by transferring gold to foreign central banks at a fixed price of $35 per ounce, some of Wasn’t even necessary.
The end of gold’s link with the dollar and the new regime of floating exchange rates allowed the United States to run a massive current account deficit by selling off its assets to the world. The populations of Europe and Japan were aging faster than the US, and had a correspondingly greater need for retirement assets. That arrangement is now coming to a messy end.
A fail safe gauge of global systemic risk is the price of gold, and in particular the price of gold relative to alternative hedges against unexpected inflation. Between 2007 and 2021, the price of gold tracked inflation-indexed US Treasury securities (“TIPS”) with a correlation of approximately 90%.
However, in early 2022, gold rose while TIPS fell in price. Something similar happened after the 2008 global financial crisis, but last year’s move has been far more extreme. Shown below are the residuals of the gold price regression against the 5- and 10-year maturity instruments.
Graphic: Asia Times
If we look at the same data in a scatter plot, it is clear that the linear relationship between gold and TIPS remains, but has shifted both its baseline and its slope has accelerated.
In fact, the market worries that buying inflation protection from the US government is like passengers on the Titanic buying shipwreck insurance from the captain. The gold market is too large and diverse to manipulate. No one has much faith in the US Consumer Price Index, the gauge against which TIPS payouts are determined.
The dollar reserve system will go out with a whimper, not a bang. Central banks will step in to prevent any dramatic failure. But bank balance sheets will shrink, credit to the real economy will shrink and international borrowing in particular will evaporate.
On margin, local currency funding will replace dollar credit. We have already seen this happen in Turkey, whose currency exploded during 2019-2021 as the country lost access to dollar and euro funding.
To a significant extent, Chinese trade financing replaced the dollar, and supported Turkey’s remarkable economic turnaround in the past year. Southeast Asia will rely more heavily on its own currencies and the RMB. Dollar Frog will boil over from slowing growth.
It is fortunate that over the past year, Western sanctions on Russia have prompted China, Russia, India and the Persian Gulf countries to seek alternative financing arrangements. It is not a monetary phenomenon, but a costly, inefficient and cumbersome way of working around the US dollar banking system.
As the dollar’s credit crunch continues, however, these alternative arrangements will turn into permanent features of the monetary landscape, and other currencies will continue to strengthen against the dollar.
Follow David P Goldman on Twitter @davidpgoldman
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