It’s now increasingly assumed that the US economy is not performing as well as the statistics suggest, and that the Fed must cut interest rates and keep on cutting. The assumption is based on a mixture of Keynesian hope and market experience of the last three or four decades, which cover the work-experience of today’s investment managers. Last week I quoted from an article by Ambrose Evans-Pritchard in The Daily Telegraph of 5 June, who wrote that “Citigroup says that the Fed will have to cut interest rates in July and at every meeting until mid-2025”. Therefore, a research report from one of the largest banks in the US is evidence of this view.
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It must be admitted that in the short term, such a strong consensus over interest rates can become self-fulfilling. Perhaps the ECB led the way last week with the first cut in its deposit rate, which suggests that the back chat between leading central banks confirms that the ECB will not be alone and that we can expect the Fed to follow as soon as it decently can, though officially it is still fence-sitting. And perhaps the Bank of England will cut after the UK’s general election.
Unfortunately, the problem for central banks is that inflation is proving to be sticky, and the prospect of it returning to their 2% target and remaining there is remote. To understand why this is the case requires an understanding of what inflation represents: it is a decline in the currency’s purchasing power. It’s just that evidence of the decline is reflected in a higher level for prices generally.
The origin is in the expansion of unproductive credit, which with a fiat currency comes in two basic forms: a government’s budget deficit not financed by an increase in consumer savings, and the expansion of bank credit financing consumption. Both lead to a dilution of the purchasing power of pre-existing currency units. The reason that an expansion of bank credit for productive purposes does not lead to a higher general level of prices is that it leads to an expansion of output whose supply has the opposite effect, counteracting the dilutive price effect of extra currency units in circulation.
Why has this not been apparent since the 1980s? Well, it has been if you look at the relationship between currencies and gold, which is real, legal, internationally accepted money with no counterparty risk, as the chart below illustrates:
Admittedly, gold only represents an indirect indication of changes in a currency’s purchasing power. But despite official and unofficial price intervention in bullion markets, and in view of continuing systemic suppression of CPI inflation statistics a currency’s price in gold is the best indication of changes to its purchasing power.
The chart shows that since the end of Bretton Woods the dollar has lost 98.5% of its purchasing power, the euro (and its prior constituents) 98.9%, the yen 96.5%, and sterling has fallen below the bottom of our chart at 99.2%. This decline has occurred in three phases: the 1970s, between 2000—2012, and more recently from 2016.
The current phase of currency depreciation measured in real money is at odds with the macroeconomic consensus, that inflation will continue to decline. Importantly, it’s also at odds with the role of interest rates, which are used by central banks to manage inflation.
This is not the economic role of interest rates, as Gibson’s paradox demonstrated. The correlation was and remains between interest rates and the general level of prices, not its rate of change (i.e. inflation). Despite Gibson’s paradox being statistically proven and known to Keynes (he actually named it after AH Gibson) he and his followers were unable to explain it so simply dismissed it as a relic of the gold standard. This is a convenient error.
To illustrate Gibson’s point, assume that you are asked to invest in a foreign government’s debt. You would only consider buying the debt if the yield was sufficient with a margin to compensate for your expectation of its loss of purchasing power over the duration of the loan. In other words, interest rates are compensation for loss of purchasing power reflected in an increase in the general level of prices.
The currency’s future purchasing power is discounted in order to determine an acceptable yield on a government bond, which today not only involves an assessment of monetary debasement but of the overall debt position of the government, the volume of its funding requirements, and other risk factors. Obviously, there is a high degree of subjectivity, or faith involved in this calculation. A foreign investor is almost certainly not interested in a domestic market’s estimates of last month’s CPI.
The risk to a currency’s purchasing power is not solely due to the rate of credit expansion as monetarists posit. Monetarists don’t make any distinction between productive and non-productive use. Nor have they modified their theories which were put forward by David Ricardo in the early nineteenth century when a gold or silver standard were the norm, and a permanent fiat currency outside wartime was inconceivable. The fact of the matter is that the value of a fiat currency depends upon the faith its creditors have in it. Erode that faith and the value declines, irrespective of changes in its circulating quantity.
In examining the entrails of the US economy, economists miss the importance of faith entirely. But the proof is that you can have a decent economy backed by good government finances and a weak currency.
Who would buy Russia’s rouble? Yet, war finance has only led to a government debt to GDP of about 22%, and a primary budget surplus remains. Income taxes of 13%—15% is the stuff of which free market economists can only dream. Yet, the Central Bank of Russia is forced to maintain a 16% deposit rate to sustain faith in the currency.
Contrast that with King Dollar, which has a government debt to GDP of about 130%, an unsustainable budget deficit, and ever higher taxes hampering production.
The first to lose faith in a currency are never its domestic users, who in their day-to-day transactions firmly believe a dollar is a dollar, or a euro is a euro, and that price negotiation is entirely centred on the value of goods and services being exchanged. Almost the entire population, which sadly includes politicians, bankers, and economists, fall into the same trap. They don’t understand that rising prices reflect the currency’s decline.
It’s foreign creditors who are the first to make the correct assessment. If they are not compensated sufficiently for the credit risk in a foreign currency, they will not buy it until the interest rate is raised to the correct level to reimburse them for that risk. But within the fiat framework a reserve currency which acts as the international pricing medium has a special role in setting the relative values of all other currencies.
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This is why despite the deterioration in US Government finances, foreigners have retained large dollar balances. Alternative currencies are less secure, which is why a positive case can be argued for the dollar. But it is a relative valuation, not an ultimate one. For that, the dollar’s value must be compared with that of gold.
While domestic Americans are blind to the threat faced by the dollar, foreigners are not. They are selling dollars for gold, which is why gold appears to be rising. Gold is no more rising than consumer prices are rising: it is the dollar, along with the other western alliance currencies falling in value, reflected in goods’ and services’ prices. It explains why Americans and Europeans are ignoring the rise in the gold price measured in their own currencies, but it is being looked at differently in Asia, particularly in China. Admittedly, there are geopolitical factors involved, but it all amounts to the same thing: there are foreigners who own dollar- and euro-denominated credit who want out.
Another source of confusion for western capital markets is over the rise in the gold price at a time of higher interest rates. The origin of this error was in the establishment of the carry trade in the 1980s, when gold had peaked and was in a declining trend against the dollar as a general belief took hold that the dollar had sidelined gold. This allowed bullion banks to lease gold typically at 2% or less and invest the proceeds in US T-bills yielding 6% or more. The relationship between gold and the dollar became sensitive to this interest rate differential. But before the carry trade, this correlation didn’t exist, as the chart below of the 1970s shows.
The chart confirms that higher interest rates lead to higher gold prices which is a decline in the dollar, and for good reason. It is entirely consistent with Gibson’s paradox. Dollar credit declining in its purchasing power is also declining against gold. And it requires recompense for holders of dollars to offset the loss of their purchasing power. That compensation is in the form of an increase in the interest rate. It boils down to what a foreign holder of a fiat currency requires not to turn seller.
This simple but fundamental truth is why almost every fiat currency collapse is initiated by foreign selling. We see this today with increasing numbers of central banks reducing their dollar reserves for gold, which with no counterparty risk is true international money. Yet it is not admitted by the core of them: the Fed, ECB, BOJ, and the Bank of England. Being wedded to their own domestic illusions, they appear to be genuinely clueless of the danger to their currencies.
It doesn’t auger well for interest rate policies, which as demonstrated in this article fly in the face of the established relationships captured by Gibson’s paradox. It also explains why the populations of these nations ignore the signals from gold, which measured in their declining currencies is hitting record levels. But belatedly, these 1,200 million or so individuals will eventually realise that it’s their currencies going down and not prices rising, and that far from being a speculation gold and silver are safe havens at any price.
Reprinted with permission from MacleodFinance Substack.
