No wonder the West is going mad. It will get worse soon!
Authored by Alasdair Macleod via GoldMoney.com,
We
will look back at current events and realise that they marked the
change from a dollar-based global economy underwritten by financial
assets to commodity-backed currencies. We face a change from
collateral being purely financial in nature to becoming commodity based.
It is collateral that underwrites the whole financial system.
The ending of the financially based system is being hastened by geopolitical developments.
The West is desperately trying to sanction Russia into economic
submission, but is only succeeding in driving up energy, commodity, and
food prices against itself. Central banks will have no option but to
inflate their currencies to pay for it all. Russia is linking the rouble
to commodity prices through a moving gold peg instead, and China has
already demonstrated an understanding of the West’s inflationary game by
having stockpiled commodities and essential grains for the last two
years and allowed her currency to rise against the dollar.
China
and Russia are not going down the path of the West’s inflating
currencies. Instead, they are moving towards a sounder money strategy with the prospect of stable interest rates and prices while the West accelerates in the opposite direction.
The
Credit Suisse analyst, Zoltan Pozsar, calls it Bretton Woods III. This
article looks at how it is likely to play out, concluding that the
dollar and Western currencies, not the rouble, will have the greatest
difficulty dealing with the end of fifty years of economic
financialisation.
Pure finance is being replaced with commodity finance
It
hasn’t hit the main-stream media yet, which is still reporting
yesterday’s battle. But in March, the US Administration passed a death
sentence on its own hegemony in a last desperate throw of the dollar
dice. Not only did it misread the Russian situation with respect to its
economy, but America mistakenly believed in its own power by sanctioning
Russia and Putin’s oligarchs.
It may have achieved a partial
blockade on Russia’s export volumes, but compensation has come from
higher unit prices, benefiting Russia, and costing the Western alliance.
The
consequence is a final battle in the financial war which has been
brewing for decades. You do not sanction the world’s most important
source of energy exports and the marginal supplier of a wide range of
commodities and raw materials, including grains and fertilisers, without
damaging everyone but the intended target. Worse still, the intended
target has in China an extremely powerful friend, with which Russia is a
partner in the world’s largest economic bloc — the Shanghai Cooperation
Organisation — commanding a developing market of over 40% of the
world’s population. That is the future, not the past: the past is
Western wokery, punitive taxation, economies dominated by the state and
its bureaucracy, anti-capitalistic socialism, and magic money trees to
help pay for it all.
Despite this enormous hole in the sanctions
net, the West has given itself no political option but to attempt to
tighten sanctions even more. But Russia’s response is devastating for
the western financial system. In two simple announcements, tying the
rouble to gold for domestic credit institutions and insisting that
payments for energy will only be accepted in roubles, it is calling an
end to the fiat dollar era that has ruled the world from the suspension
of Bretton Woods in 1971 to today.
Just over five decades ago, the
dollar took over the role for itself as the global reserve asset from
gold. After the seventies, which was a decade of currency, interest
rate, and financial asset volatility, we all settled down into a world
of increasing financialisation. London’s big bang in the early 1980s
paved the way for regulated derivatives and the 1990s saw the rise of
hedge funds and dotcoms. That was followed by an explosion in
over-the-counter unregulated derivatives into the hundreds of trillions
and securitisations which hit the speed-bump of the Lehman failure.
Since then, the expansion of global credit for purely financial
activities has been remarkable creating a financial asset bubble to
rival anything seen in the history of financial excesses. And together
with statistical suppression of the effect on consumer prices the switch
of economic resources from Main Street to Wall Street has hidden the
inflationary evidence of credit expansion from the public’s gaze.
All
that is coming to an end with a new commoditisation — what respected
flows analyst Zoltan Pozsar at Credit Suisse calls Bretton Woods III. In
his enumeration the first was suspended by President Nixon in 1971, and
the second ran from then until now when the dollar has ruled
indisputably. That brings us to Bretton Woods III.
Russia’s
insistence that importers of its energy pay in roubles and not in
dollars or euros is a significant development, a direct challenge to the
dollar’s role. There are no options for Russia’s “unfriendlies”,
Russia’s description for the alliance united against it. The EU, which
is the largest importer of Russian natural gas, either bites the bullet
or scrambles for insufficient alternatives. The option is to buy natural
gas and oil at reasonable rouble prices or drive prices up in euros and
still not get enough to keep their economies going and the citizens
warm and mobile. Either way, it seems Russia wins, and one way the EU
loses.
As to Pozsar’s belief that we are on the verge of Bretton
Woods III, one can see the logic of his argument. The highly inflated
financial bubble marks the end of an era, fifty years in the making.
Negative interest rates in the EU and Japan are not just an anomaly, but
the last throw of the dice for the yen and the euro. The ECB and the
Bank of Japan have bond portfolios which have wiped out their equity,
and then some. All Western central banks which have indulged in QE have
the same problem. Contrastingly, the Russian central bank and the
Peoples Bank of China have not conducted any QE and have clean balance
sheets. Rising interest rates in Western currencies are made more
certain and their height even greater by Russia’s aggressive response to
Western sanctions. It hastens the bankruptcy of the entire Western
banking system and by bursting the highly inflated financial bubble will
leave little more than hollowed-out economies.
Putin has taken as
his model the 1973 Nixon/Kissinger agreement with the Saudis to only
accept US dollars in payment for oil, and to use its dominant role in
OPEC to force other members to follow suit. As the World’s largest
energy exporter Russia now says she will only accept roubles, repeating
for the rouble the petrodollar strategy. And even Saudi Arabia is now
bending with the wind and accepting China’s renminbi for its oil,
calling symbolic time on the Nixon/Kissinger petrodollar agreement.
The
West, by which we mean America, the EU, Britain, Japan, South Korea,
and a few others have set themselves up to be the fall guys. That
statement barely describes the strategic stupidity — an Ignoble Award is
closer to the truth. By phasing out fossil fuels before they could be
replaced entirely with green energy sources, an enormous shortfall in
energy supplies has arisen. With an almost religious zeal, Germany has
been cutting out nuclear generation. And even as recently as last month
it still ruled out extending the lifespan of its nuclear facilities. The
entire G7 membership were not only unprepared for Russia turning the
tables on its members, but so far, they have yet to come up with an
adequate response.
Russia has effectively commoditised its
currency, particularly for energy, gold, and food. It is following China
down a similar path. In doing so it has undermined the dollar’s
hegemony, perhaps fatally. As the driving force behind currency values,
commodities will be the collateral replacing financial assets. It is
interesting to observe the strength in the Mexican peso against the
dollar (up 9.7% since November 2021) and the Brazilian real (up 21% over
a year) And even the South African rand has risen by 11% in the last
five months. That these flaky currencies are rising tells us that
resource backing for currencies has its attractions beyond the rouble
and renminbi.
But having turned their backs on gold, the Americans
and their Western epigones lack an adequate response. If anything, they
are likely to continue the fight for dollar hegemony rather than accept
reality. And the more America struggles to assert its authority, the
greater the likelihood of a split in the Western partnership. Europe
needs Russian energy desperately, and America does not. Europe cannot
afford to support American policy unconditionally.
That, of course, is Russia’s bet.
Russia’s point of view
For
the second time in eight years, Russia has seen its currency undermined
by Western action over Ukraine. Having experienced it in 2014, this
time the Russian central bank was better prepared. It had diversified
out of dollars adding official gold reserves. The commercial banking
system was overhauled, and the Governor of the RCB, Elvira Nabiullina,
by following classical monetary policies instead of the Keynesianism of
her Western contempories, has contained the fall-out from the war in
Ukraine. As Figure 1 shows, the rouble halved against the dollar in a
knee-jerk reaction before recovering to pre-war levels.
The
link to commodities is gold, and the RCB announced that until end-June
it stands ready to buy gold from Russian banks at 5,000 roubles per
gramme. The stated purpose was to allow banks to lend against mine
production, given that Russian-sourced gold is included in the
sanctions. But the move has encouraged speculation that the rouble is
going on a quasi- gold standard; never mind that a gold standard works
the other way round with users of the currency able to exchange it for
gold.
Besides being with silver the international legal definition
of money (the rest being currency and credit), gold is a good proxy for
commodities, as shown in Figure 2 below. Priced in goldgrams, crude oil
today is 30% below where it was in the 1950, long before Nixon
suspended the Bretton Woods Agreement. Meanwhile, measured in
depreciating fiat currencies the price has soared and been extremely
volatile along the way.
It
is a similar story for other commodity prices, whereby maximum
stability is to be found in prices measured in goldgrams. Taking up
Pozsar’s point about currencies being increasingly linked to commodities
in Bretton Woods III, it appears that Russia intends to use gold as
proxy for commodities to stabilise the rouble. Instead of a fixed gold
exchange rate, the RCB has wisely left itself the option to periodically
revise the price it will pay for gold after 1 July.
Table 1 shows how the RCB’s current fixed rouble gold exchange rate translates into US dollars.
While
non-Russian credit institutions do not have access to the facility, it
appears that there is nothing to stop a Russian bank buying gold in
another centre, such as Dubai, to sell to the Russian central bank for
roubles. All that is needed is for the dollar/rouble rate to be
favourable for the arbitrage and the ability to settle in a
non-sanctioned currency, such as renminbi, or to have access to
Eurodollars which it can exchange for Euroroubles (see below) from a
bank outside the “unfriendlies” jurisdictions.
The dollar/rouble
rate can now easily be controlled by the RCB, because how demand for
roubles in short supply is handled becomes a matter of policy. Gazprom’s
payment arm (Gazprombank) is currently excused the West’s sanctions and
EU gas and oil payments will be channelled through it.
Broadly, there are four ways in which a Western consumer can acquire roubles:
By buying roubles on the foreign exchanges.
By depositing euros, dollars, or sterling with Gazprombank and have them do the conversion as agents.
By Gazprombank increasing its balance sheet to provide credit, but collateral which is not sanctioned would be required.
By foreign banks creating rouble credits which can be paid to Gazprombank against delivery of energy supplies.
The
last of these four is certainly possible, because that is the basis of
Eurodollars, which circulate outside New York’s monetary system and have
become central to international liquidity. To understand the creation
of Eurodollars, and therefore the possibility of a developing Eurorouble
market we must delve into the world of credit creation.
There are
two ways in which foreigners can hold dollar balances. The way commonly
understood is through the correspondent banking system. Your bank, say
in Europe, will run deposit accounts with their correspondent banks in
New York (JPMorgan, Citi etc.). So, if you make a deposit in dollars,
the credit to your account will reconcile with the change in your bank’s
correspondent account in New York.
Now let us assume that you
approach your European bank for a dollar loan. If the loan is agreed, it
appears as a dollar asset on your bank’s balance sheet, which through
double-entry bookkeeping is matched by a dollar liability in favour of
you, the borrower. It cannot be otherwise and is the basis of all bank
credit creation. But note that in the creation of these balances the
American banking system is not involved in any way, which is how and why
Eurodollars circulate, being fungible with but separate in origin from
dollars in the US.
By the same method, we could see the birth and
rapid expansion of a Eurorouble market. All that’s required is for a
bank to create a loan in roubles, matched under double-entry bookkeeping
with a deposit which can be used for payments. It doesn’t matter which
currency the bank runs its balance sheet in, only that it has balance
sheet space, access to rouble liquidity and is a credible counterparty.
This
suggests that Eurozone and Japanese banks can only have limited
participation because they are already very highly leveraged. The banks
best able to run Eurorouble balances are the Americans and Chinese
because they have more conservative asset to equity ratios. Furthermore,
the large Chinese banks are majority state-owned, and already have
business and currency interests with Russia giving them a head start
with respect to rouble liquidity.
We have noticed that the large
American banks are not shy of dealing with the Chinese despite the
politics, so presumably would like the opportunity to participate in
Euroroubles. But only this week, the US Government prohibited them from
paying holders of Russia’s sovereign debt more than $600 million. So, we
should assume the US banks cannot participate which leaves the field
open to the Chinese mega-banks. And any attempt to increase sanctions on
Russia, perhaps by adding Gazprombank to the sanctioned list, achieves
nothing, definitely cuts out American banks from the action, and
enhances the financial integration between Russia and China. The gulf
between commodity-backed currencies and yesteryear’s financial fiat
simply widens.
For now, further sanctions are a matter for
speculation. But Gazprombank with the assistance of the Russian central
bank will have a key role in providing the international market for
roubles with wholesale liquidity, at least until the market acquires
depth in liquidity. In return, Gazprombank can act as a recycler of
dollars and euros gained through trade surpluses without them entering
the official reserves. Dollars, euros yen and sterling are the
unfriendlies’ currencies, so the only retentions are likely to be
renminbi and gold.
In this manner we might expect roubles, gold
and commodities to tend to rise in tandem. We can see the process by
which, as Zoltan Pozsar put it, Bretton Woods III, a global currency
regime based on commodities, can take over from Bretton Woods II, which
has been characterised by the financialisation of currencies. And it’s
not just Russia and her roubles. It’s a direction of travel shared by
China.
The economic effects of a strong currency backed by
commodities defy monetary and economic beliefs prevalent in the West.
But the consequences that flow from a stronger currency are desirable:
falling interest rates, wealth remaining in the private sector and an
escape route from the inevitable failure of Western currencies and their
capital markets. The arguments in favour of decoupling from the
dollar-dominated monetary system have suddenly become compelling.
The consequences for the West
Most
Western commentary is gung-ho for further sanctions against Russia.
Relatively few independent commentators have pointed out that by
sanctioning Russia and freezing her foreign exchange reserves, America
is destroying her own hegemony. The benefits of gold reserves have also
been pointedly made to those that have them. Furthermore, central banks
leaving their gold reserves vaulted at Western central banks exposes
them to sanctions, should a nation fall foul of America. Doubtless, the
issue is being discussed around the world and some requests for
repatriation of bullion are bound to follow.
There is also the
problem of gold leases and swaps, vital for providing liquidity in
bullion markets, but leads to false counting of reserves. This is
because under the IMF’s accounting procedures, leased and swapped gold
balances are recorded as if they were still under a central bank’s
ownership and control, despite bullion being transferred to another
party in unallocated accounts.
No one knows the extent of swaps
and leases, but it is likely to be significant, given the evidence of
gold price interventions over the last fifty years. Countries which have
been happy to earn fees and interest to cover storage costs and turn
gold bullion storage into a profitable activity (measured in fiat) are
at the margin now likely to not renew swap and lease agreements and
demand reallocation of bullion into earmarked accounts, which would
drain liquidity from bullion markets. A rising gold price will then be
bound to ensue.
Ever since the suspension of Bretton Woods in
1971, the US Government has tried to suppress gold relative to the
dollar, encouraging the growth of gold derivatives to absorb demand.
That gold has moved from $35 to $1920 today demonstrates the futility of
these policies. But emotionally at least, the US establishment is still
virulently anti-gold.
As Figure 2 above clearly shows, the link
between commodity prices and gold has endured through it all. It is this
factor that completely escapes popular analysis with every commodity
analyst assuming in their calculations a constant objective value for
the dollar and other currencies, with price subjectivity confined to the
commodity alone. The use of charts and other methods of forecasting
commodity prices assume as an iron rule that price changes in
transactions come only from fluctuations in commodity values.
The
truth behind prices measured in unbacked currencies is demonstrated by
the cost of oil priced in gold having declined about 30% since the
1960s. That is reasonable given new extraction technologies and is
consistent with prices tending to ease over time under a gold standard.
It is only in fiat currencies that prices have soared. Clearly, gold is
considerably more objective for transaction purposes than fiat
currencies, which are definitely not.
Therefore, if, as the chart
in the tweet below suggests, the dollar price of oil doubles from here,
it will only be because at the margin people prefer oil to dollars — not
because they want oil beyond their immediate needs, but because they
want dollars less.
China
recognised these dynamics following the Fed’s monetary policies of
March 2020, when it reduced its funds rate to the zero bound and
instituted QE at $120bn every month. The signal concerning the dollar’s
future debasement was clear, and China began to stockpile oil,
commodities, and food — just to get rid of dollars. This contributed to
the rise in dollar commodity prices, which commenced from that moment,
despite falling demand due to covid and supply chain problems. The
effect of dollar debasement is reflected in Figure 3, which is of a
popular commodity tracking ETF.
A
better understanding would be to regard the increase in the value of
this commodity basket not as a near doubling since March 2020, but as a
near halving of the dollar’s purchasing power with respect to it.
Furthermore,
the Chinese have been prescient enough to accumulate stocks of grains.
The result is that 20% of the world’s population has access to 70% of
the word’s maize stocks, 60% of rice, 50% of wheat and 35% of soybeans.
The other 80% of the world’s population will almost certainly face acute
shortages this year as exports of grain and fertiliser from
Ukraine/Russia effectively cease.
China’s actions show that she
has to a degree already tied her currency to commodities, recognising
the dollar would lose purchasing power. And this is partially reflected
in the yuan’s exchange rate against the US dollar, which since May 2020
has gained over 11%.
Implications for the dollar, euro and yen
In
this article the close relationship between gold, oil, and wider
commodities has been shown. It appears that Russia has found a way of
tying her currency not to the dollar, but to commodities through gold,
and that China has effectively been doing the same thing for two years
without the gold link. The logic is to escape the consequences of
currency and credit expansion for the dollar and other Western
currencies as their purchasing power is undermined. And the use of a
gold peg is an interesting development in this context.
We should
bear in mind that according to the US Treasury TIC system foreigners own
$33.24 trillion of financial securities and short-term assets including
bank deposits. That is in addition to a few trillion, perhaps, in
Eurodollars not recorded in the TIC statistics. These funds are only
there in such quantities because of the financialisation of Western
currencies, a situation we now expect to end. A change in the world’s
currency order towards Pozsar’s Bretton Woods III can be expected to a
substantial impact on these funds.
To prevent foreign selling of
the $6.97 trillion of short-term securities and cash, interest rates
would have to be raised not just to tackle rising consumer prices (a
Keynesian misunderstanding about the economic role of interest rates,
disproved by Gibson’s paradox) but to protect the currency on the
foreign exchanges, particularly relative to the rouble and the yuan.
Unfortunately, sufficiently high interest rates to encourage short-term
money and deposits to stay would destabilise the values of the foreign
owned $26.27 trillion in long-term securities — bonds and equities.
As
the manager of US dollar interest rates, the dilemma for the Fed is
made more acute by sanctions against Russia exposing the weakness of the
dollar’s position. The fall in its purchasing power is magnified by
soaring dollar prices for commodities, and the rise in consumer prices
will be greater and sooner as a result. It is becoming possible to argue
convincingly that interest rates for one-year dollar deposits should
soon be in double figures, rather than the three per cent or so argued
by monetary policy hawks. Whatever the numbers turn out to be, the
consequences are bound to be catastrophic for financial assets and for
the future of financially oriented currencies where financial assets are
the principal form of collateral.
It appears that Bretton Woods
II is indeed over. That being the case, America will find it virtually
impossible to retain the international capital flows which have allowed
it to finance the twin deficits — the budget and trade gaps. And as
securities’ values fall with rising interest rates, unless the US
Government takes a very sharp knife to its spending at a time of
stagnating or falling economic activity, the Fed will have to step up
with enhanced QE.
The excuse that QE stimulates the economy will
have been worn out and exposed for what it is: the debasement of the
currency as a means of hidden taxation. And the foreign capital that
manages to escape from a dollar crisis is likely to seek a home
elsewhere. But the other two major currencies in the dollar’s camp, the
euro and yen, start from an even worse position. These are shown in
Figure 4. With their purchasing power visibly collapsing the ECB and the
Bank of Japan still have negative interest rates, seemingly trapped
under the zero bound. Policy makers find themselves torn between the
Scylla of consumer price inflation and the Charybdis of declining
economic activity. A further problem is that these central banks have
become substantial investors in government and other bonds (the BOJ even
has equity ETFs on board) and rising bond yields are playing havoc with
their balance sheets, wiping out their equity requiring a systemic
recapitalisation.
Not
only are the ECB and BOJ technically bankrupt without massive capital
injections, but their commercial banking networks are hugely
overleveraged with their global systemically important banks — their
G-SIBs — having assets relative to equity averaging over twenty times.
And unlike the Brazilian real, the Mexican peso and even the South
African rand, the yen and the euro are sliding against the dollar.
The
response from the BOJ is one of desperately hanging on to current
policies. It is rigging the market by capping the yield on the 10-year
JGB at 0.25%, which is where it is now.
These currency
developments are indicative of great upheavals and an approaching
crisis. Financial bubbles are undoubtedly about to burst sinking fiat
financial values and all that sail with them. Government bonds will be
yesterday’s story because neither China nor Russia, whose currencies can
be expected to survive the transition from financial to commodity
orientation, run large budget deficits. That, indeed, will be part of
their strength.
The financial war, so long predicted and described
in my essays for Goldmoney, appears to be reaching its climax. At the
end it has boiled down to who understands money and currencies best. Led
by America, the West has ignored the legal definition of money,
substituting fiat dollars for it instead. Monetary policy lost its
anchor in realism, drifting on a sea of crackpot inflationary beliefs
instead.
But Russia and China have not made the same mistake.
China played along with the Keynesian game while it suited them.
Consequently, while Russia may be struggling militarily, unless a
miracle occurs the West seems bound to lose the financial war and we
are, indeed, transiting into Pozsar’s Bretton Woods III.
