Wall Street doesn’t get why the dollar’s in trouble

They don't understand Japanese zombies

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Last week Goldman Sachs officially warned that the dollar is in danger of losing its reserve currency status.

The note came on Tuesday, and by Friday, July had ended with the biggest drop in the dollar index in 10 years -- a 4.9% decline. This slide is the flip side to gold’s historic rally, crossing $2,000 an ounce yesterday, with the second largest rate of gold-related fund inflows ever coming last week. This rush into the ultimate safe haven is an ominous sign for the economy.

And yet most observers miss the point entirely, letting bad ideology color their analysis, missing the real risks at hand.  

Goldman’s primary fears are of “debasement,” the worry that Federal Reserve easing actions will cause inflation “after economic activity has normalized.” Fiscal stimulus worries them too -- Fitch Ratings issued a negative outlook for U.S. government credit because of a “deterioration of U.S. public finances and the absence of a credible fiscal consolidation plan.” 

But 10-year Treasury yields are at their lowest level ever, and interest rates are supposed to be the equilibrium price at which all savings get invested. Near-zero interest rates indicate market expectations for non-existent risk-adjusted returns over the next decade. 

So how could prices get bid up enough to risk inflation in those conditions? Increasing debt and easing monetary policy, analysts believe, will oversupply the money market and thus drive down money’s price, causing inflation. 

Japan’s “Lost Score” -- formerly the “Lost Decade” before it ended up lasting 20 years -- provides an important counterexample to this idea. Japan’s government debt-to-GDP ratio increased 370% over this period with virtually no inflation. Decades of quantitative easing and a swelling money supply has likewise done nothing to raise prices or growth. 

Goldman, Fitch, and others forget the Japanese experience because they believe that at a given level of economic production, the money supply determines prices. If the Fed and Congress print a bunch of money, we’ll get inflation when activity and production rebound. 

But the truth is the other way around -- the level of production determines the money supply. When businesses produce more commodities, money gets pulled out of savings, banks lend more, and less productive assets get liquidated. Gold’s current rally is the reverse of this, the economic equivalent of putting money into a hole in the ground. 

Japan shows that money printing not only doesn’t cause inflation, it actually blocks the very “normalization” of productive activity the analysts assume is on the way. Japanese debt policies created an ecosystem of “zombie” firms -- companies whose incomes can barely service their debt obligations without ever paying them down, surviving only on continued easy credit and bailouts. Their prevalence depresses productivity, business formation, investment, and ultimately deflates prices. 

Even before COVID-19 at least 18% of U.S. firms met the zombie definition, drains into which increased liquidity can sink. New Fed and congressional largesse will likely prop up even more non-productive companies, suppressing activity and making deflation and depression much more likely. 

Average rates of profit will stay in decline, investment will stay on the sidelines, jobs will remain scarce, and needs will go unmet. The bottom line: increasing conflict and instability. 

This is the real source of potential inflation. “Debasement” fears reflect monetary theory locked in an era when governments would add less valuable metals to their coins in order to stretch their budgets, diluting the value of the money supply. 

But now money is backed by power, not a specific commodity, and U.S. political power is clearly in free fall. Speculation about cancelled elections, inability to execute basic pandemic response tasks, withdrawal from strategic military positions, and the failure to land upon a consensus relief policy are all symptoms of this breakdown. 

Worse yet, Japan has survived decades of stagnation with the help of much healthier export markets. The only place the United States might be able to turn: China, which is aggressively building out their consumer base. How does this square with growing hostility to the People’s Republic? It doesn’t, and the lack of any strategy other than money printing and hoping for the best is at the core of the dollar downgrade. 

The silver lining: doing the same thing policymakers have always done and hoping for different results should accelerate the end of a system that has failed the vast majority of humanity for a long, long time. What we replace it with is up to us -- anything is possible.

Disclaimer

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