Thursday, January 29, 2015

Could the U.S. Become the Unrivaled Superpower Again?

That Grand Narratives based on short-term trends are often wrong should not surprise us.

Two of the most durable and least-questioned narratives of the past 15 years are:
1. The world is becoming multipolar, meaning that rising power centers such as the BRIC nations (Brazil, Russia, India and China) are expanding their share of the global economy, at the expense of the U.S. and to a lesser degree, Europe and Japan. In sum: the U.S. is no longer the dominant superpower, but merely one power among many.

2.  The U.S. dollar is in a long-term decline due to money-printing by the Federal Reserve and the world's desire for an alternative to the dollar as the world's default reserve currency.

Having written extensively on the complex dynamics of currencies (in particular, the strength of the U.S. dollar) since 2011, I am skeptical that these two narratives are correct for the simple reason that the dynamics do not align with these results.

Why the Rising U.S. Dollar Could Destabilize the Global Financial System (November 13, 2014)

Could the U.S. Dollar Rise 50%? (January 12, 2011)

I suspect the exact opposite is about to unfold: the dollar (USD) will rise another 40% to 50% (if not more) in the coming years, and as a result the U.S. will be left as the unrivaled superpower, financially, economically, militarily and geopolitically as its rivals suffer the consequences of the destabilizing dynamics that are just starting to unfold.

Preparing to pen this essay on currencies was a painful exercise because I had to read numerous commentaries to get all the threads aligned.

Here is the basic dynamic that is currently playing out globally:

Rather than address the structural problems revealed by the Global Financial Meltdown of 2008-9, central states/banks responded by increasing the supply of credit and money, and lowering interest rates to near-zero.

Since writing down all the bad debt in the system would have taken down the big banks that were central to the world's financial systems, the central banks enabled debt to be rolled over at lower rates and new credit to expand.

But these policies created an enormous global carry trade, in which financiers and institutions borrowed trillions of dollars and yen on the cheap and invested the borrowed money in emerging-market periphery economies with much higher yields.

As long as the Fed was issuing money to invest in peripheral nations and the dollar was declining, this trade was low-risk and profitable.

But once the Fed tapered its $1 trillion-a-year QE money issuance, the emerging market/periphery nations' economies suddenly took a nose-dive, as the flood of money into their financial systems started drying up.

As the USD started rising, the carry trade became less profitable and threatened to become a losing trade.

Japan's 40% devaluation of the yen introduced another risk, as the yen's decline cut profits when converted to dollars. This matters because 2/3 of the emerging-market debt is denominated in USD.

Here's what's happened beneath the surface: the central bank policies that have fueled "risk-on" global carry trades since 2009 have not addressed any of the structural problems that led to the 2008 global meltdown; all they've done is transfer the risk to the foreign-exchange (FX) market, which dwarfs the global stock and bond markets.

In effect, the central banks have inflated a new risk bubble in currencies, and these risks are only now becoming visible as the dollar's rise starts destabilizing commodities and periphery currencies.

There is a powerful positive feedback to this risk-off dynamic: as emerging market currencies decline and the USD strengthens, the incentives to convert periphery assets and cash into USD only increases. As the periphery currencies weaken, the urgency to preserve capital by selling periphery assets and buying dollars greatly increases.

In response, the periphery's central banks are forced to drastically raise interest rates to offset the drop in their currencies. This constriction of lending will push their economies into recession, further depressing their currencies and increasing the flow of capital into dollars.

This dynamic will increasingly lead to currency crises, which quickly blossom into political crises that then led to geopolitical crises as governments are delegitimized by the sharp decline of their currencies.

There are no winners in this domino-like destabilization of the global economy except the U.S.  Japan is obsessed with importing inflation by devaluing the yen, which is in turn destabilizing Asian exports and currencies. China's currency is pegged to the dollar, so it rises along with the dollar, crushing Chinese competitiveness. China has little room to maneuver within the peg to the USD, and ending the peg introduces a new set of uncertainty and risk.

Europe cannot be the winner as Germany's exports crumble, and the carry trade turns against everyone borrowing in dollars and investing the money in other currencies.

That Grand Narratives based on short-term trends are often wrong should not surprise us.

This essay was drawn from Musings Report 45. The Musings Reports are sent exclusively weekly to subscribers $5/month) and major contributors $50+/year).

Admin. note: I will be off-line for the remainder of the month, other than a few moments here and there to post new content. Thank you for your readership and understanding. 

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