Over the past month, for me at least, ‘the Fed’ has meant Roger Federer. He was the star of one of the greatest Aussie Opens ever. But with the tennis stars departing for the US and then the clay courts of Europe, ‘the Fed’ once again means the Federal Reserve — the US central bank.
Overnight, the Fed decided to keep interest rates on hold. However, it did note that business and consumer confidence was improving, and that it expects the rate of inflation to continue to increase. As such, it remains on course for further interest rate rises this year…it’s just not saying when.
So, standard Fed fare, really. That is, expect more rate rises, but don’t ask us about the timing. We don’t really know.
And how would they? The Marriner Eccles Building, where the Fed lives, may be full of PhD economists. But they have no better idea than the rest of us of how to manage a complex economy with 320 million people making decisions.
The best you can hope for is that the Fed becomes less relevant for markets this year. That will be a sign that the US economy is slowly coming off state support.
But it seems as though concern about Trump and his team will quickly fill any void. Yesterday, I mentioned how one of Trump’s trade advisers, Peter Navarro, accused Germany of taking advantage of an undervalued currency to gain trade benefits.
Navarro appears to think that trade surpluses are good and deficits are bad. He wants to rebuild America’s industrial base and see a return to trade surpluses.
But if that were to happen, it would be very, very bad for the global economy.
Let me explain…
Following the Second World War, Europe and Japan were busted. They had to be completely rebuilt.
The conference at Bretton Woods decided on a post-war monetary architecture. While John Maynard Keynes did his best to negotiate on behalf of the British, Harry Dexter White won the economic battle for the US.
The outcome was that the US dollar — while still tied to gold — would be the world’s reserve currency. Everyone knew that it was a sweet deal for the US. Especially Keynes.
I’ll get to the significance of that in a moment.
In the decade or two after the war, the US became a manufacturing giant as it resupplied Europe and Japan. As a result, the US acquired a great quantity of gold.
But Europe (especially West Germany) and Japan soon built a manufacturing base. And they used it to rebuild their capital and savings. They had no choice but to do this. The war had crippled both nations.
As these manufacturing industries began to compete with the US, the US began to increase its consumption relative to its production. This meant gold began to flow out of the US and back to Europe.
Now, at this point, the US could have lifted its game to compete with Germany, the rest of Europe, and to a lesser extent Japan. But it took the easy option and used the advantage it gained from the Bretton Woods conference. That is, it asserted the dominance of the US dollar. It said the dollar was as good as gold, without being linked to gold.
So in 1971 the US went off the gold standard. This stopped the flow of gold to Europe, and Germany in particular.
But it didn’t stop US trade deficits. Instead of gold though, US dollars flowed to Europe. And then when Japan’s export machine rose during the 1970s and 80s, dollars flowed into Japan.
They flowed so fast it caused a massive bubble and bust in 1989, a trauma that the Japanese economy has never really recovered from.
Next up came the export powerhouses of Asia — dubbed the Asian Tigers in the 1990s. US dollars flowed into these economies as US consumption ratcheted up even more. And like in Japan, it eventually caused problems. This problem became known as the 1997 Asian crisis.
Then China picked up the baton — and ran hard. It built a manufacturing and export machine based on US consumption, gaining ‘hard currency’ US dollars in return.
Harry Dexter White’s victory at Bretton Woods is the gift that keeps on giving. That is, the US simply has to produce dollars, and it gets goods in return. The cost of producing these dollars is infinitesimal.
Why do other nations do it?
Well, the ‘system’ turns these dollars (which are really US debt) into assets in the hands of foreign central banks. These assets form the capital base of the domestic banking systems, and credit is created on top of this base.
The people who manage the ‘system’ in all countries — bankers, politicians, lawyers etc — benefit enormously from it. They get rich easily. Which is why the system endures.
Now, Trump adviser Peter Navarro wants to reverse this 70-year trend. He wants the US to produce more than it consumes. That means, instead of dollars (debt) flowing out into the world, greenbacks would come flooding back in.
US debt would start to fall. Foreign central bank coffers would begin to empty.
What do you think this would do to the global economy?
It would be massively deflationary! As I pointed out last week, in the system we operate in, debt equals money. If the US starts to pay down debt, money disappears.
When money disappears, asset prices fall.
So Peter Navarro better brush up on his monetary history. Because the global economy has spent the best part of 70 years structuring itself around a US economy that consumes more than it produces. Reversing that will cause havoc.
Actually, I should include other Anglo economies in the mix as well. Both Britain and Australia have long running trade and current account deficits. They consume more than they produce. Other countries, like Japan, China and the rest of Asia, as well as most of Europe, produce more than they consume.
For better or worse, that is how the world has evolved since the Second World War. It tried to adjust during the crisis of 2008, but that was short lived.
The only way to stop this trend without causing a major crisis is to bring gold back into the system as an official measure of value. Nothing will change while the US dollar holds the mantle of world’s reserve currency.
This is why Jim Rickards reckons gold will have a value of US$10,000 an ounce after the reset. Gold needs to rise this far to absorb all the post-war dollars that have been created.
But that’s another story entirely. To get a start, I highly recommend getting your hands on Jim’s latest book, The Road to Ruin. Get your copy here.
For Markets and Money
Editor’s Note: This article was originally published in Money Morning.