The Dollar Is In a Total War With Itself
The reincarnation of the idea of a "currency war" was reborn in its 21st century form in September 2010 when declared by Brazilian Finance Minister Guido Mantega. He stated that "advanced countries are seeking to devalue their currencies" and igniting what economists call a "beggar thy neighbor" economic policy. It was all pretty standard stuff, with Mantega more than hinting that emerging market nations wanted a part of it, too. Unfortunately, Brazil and so many other places got it.
There is very little talk of currency war today except in orthodox circles that remain impenetrable to the stark reality of 2016. Nobody wants devaluation anymore, and those who have been forced onto that roller coaster wish to get off at the earliest practicable turn. It has taken five and a half years, but the public sector's outward economic commentary has shifted from beggar-thy-neighbor to blame-thy-neighbor.
Earlier this week, Japanese Prime Minister Shinzo Abe was forced to admit what everyone already knew. The second of the scheduled tax increases was delayed for a second time, this time for a further two and a half years. That presented a problem for Abe and his Abenomics because he had previously declared that only another devastating earthquake or global crisis on par with the immediate post-Lehman panic would again stand in the way of fiscal responsibility (or as much as can be managed in this Japan). To that end, Japanese officials at last week's G-7 meeting spent most of their time and effort on trying to get the rest of the world to declare a high risk of another Lehman "moment." To be blunt, they really do think we are that stupid.
The "they" in that sentence refers to economists and the politicians who seek only their counsel. Of course, the only people in Japan who were surprised by the tacit admission that Abenomics had failed were orthodox economists and the politicians who still yield full faith to their schemes. QQE was supposed to be the masterstroke, the "stimulus" to end all stimulus. How could it possibly have failed?
It's China's fault:
"Mindful of opposition criticism that the delay is a sign his "Abenomics" stimulus policies have failed to spur growth, Abe justified the decision, saying it was needed to forestall risks posed by external factors - notably slowing Chinese growth."
Abe further noted that it wasn't just China, but that the, "biggest risk is the slowdown in emerging economies." It's a curious summation and dodge given that those emerging market nations had also seen their currencies drop like the yen.
Since April 2015, Japanese "inflation" has returned to disinflation and even deflation. The CPI has been less than 0.6% in every one of those 13 months (through the latest update for April 2016) and negative or zero in three of the past four. Excluding fresh food prices, the Japanese CPI has been no better than 0.1% over the past year and negative in six out of the past ten months, increasingly so these last two. And there are no oil prices to conveniently blame now.
When QQE was introduced in April 2013, the Bank of Japan declared two years more than sufficient "money printing" with which to break out of the "deflationary mindset" and place the Japanese economy on solid footing as described by the orthodox 2% inflation target. Instead, three years later, the CPI is, as noted above, right back at zero and less once again. Worse, however, the Bank of Japan destroyed the Japanese economy for what looks more and more like nothing at all gained.
The catalog of woe is almost unbelievable for such a lengthy stretch. We expect such conditions for recessions, but the contraction leg of business cycles are only temporary periods of predictable performance and results. Real household income (workers' households) has declined by 4.4% since April 2013; what is a slow recession that might last three years? That didn't happen in straight line, as much of the decline was measured for the middle of 2014 when the last tax hike went through. But it wasn't all due to the tax change, however, since real incomes began falling as soon as the CPI started its temporary rise. This was all part of the plan.
What wasn't planned was what happened afterward, or what didn't happen. Economists are keen to assign losers, but to temper any emotional reaction to that god-like self-actualization by declaring that, yes, some people will lose but they will be thankful for it when the full recovery arrives. Japanese households were to be the broken eggs in QQE's deliciously fantastic recovery omelet. Japanese households have never recovered from the combined blow of that burst of inflation and the tax hike. Household income dropped and never came back.
It has been even worse for real household spending, which in April 2016 was 5% less than April 2013. Spending is actually 1% less in the current month than April 2014, the month where the tax hike actually hit. That suggests, very strongly, that Japanese households have taken to more cautious spending behavior under QQE than before it. That isn't any effect of China.
And there aren't any positives elsewhere to offset the burden intentionally given to Japanese consumers. If the yen was to revive Japan Inc. through the orthodox plan of beggar-thy-neighbor it hasn't; not even close. Industrial production in April 2016 was slightly less than in April 2013 and almost 3.5% less than April 2012. Japanese exports in the twelve months up to and including April this year were 2.2% less than the twelve month total through April last year.
Japan is by no means the only country facing such defeat while blaming "global growth." As noted last month, the Federal Reserve over the past year has taken to the same tactic, continually defining the US economy as if it were in some golden age of full employment while justifying its Japanese-like reluctance to make policy decisions actually reflective of it on some unspecified "global turmoil."
Ever since the FOMC declared the economy healthy enough to undergo monetary policy normalization, the rest of the world has only wondered what these economists were talking about. The unemployment rate may now be 5% or occasionally less, but actual dollars flowing in trade are nothing like what "full employment" should be. US imports have been declining in uneven fashion since October 2014 - just when talk of successful monetary policy conclusion was heating up. That part of US trade never gets mentioned when economists suggest our current "slump" is brought to us by "overseas" problems. Instead, they only note that US exports have declined dating back to August 2014.
It is very curious that US trade on both sides would drop in such a synchronized manner. Having lasted nearly two years now, and still no end yet in sight, it isn't recession because it isn't sharp and straight. But it is happening nonetheless and doing so everywhere. It "allows" everyone to blame everyone else for their current problems, some unspecified global hit to "demand."
The timing of all this retreating trade and economy is also conspicuous in all the wrong ways, as described above. It is, of course, the "rising dollar" that on the other side of it was supposed to bring about export growth and success. I would describe the "rising dollar" as a whirlwind of destruction, but that just isn't accurate; that was the Great Recession, an utterly violent but short-lived experience of vicious economic tendencies. This is much, much worse, akin to Chinese water torture and the slow, prolonged agony of inexorableness.
Prime Minister Abe is right to point to China, but for all the wrong reasons. China is not its own economy; its "miracle" never was either. The economic condition on that side of the Pacific is a direct reflection of the global economy. If China's vast industrial capacity is suffering, and it truly is, then that can only be because of global demand for it. And that is the most stunning observation of 2016 in a world soaked thoroughly by "demand stimulus" from one side to the other and back again.
Orthodox economics is nothing if not dogmatically devoted to "aggregate demand." Each and every policy and program, all dutifully titled "stimulus" by a compliant and unquestioning media, is designed toward sparking and lifting aggregate demand. The amount of money spent or "printed" in pursuit of it is far beyond any and all comprehension; tens of trillions in all sizes and forms. The result of all that attention to demand is a shortfall of similar proportions. In other words, as "stimulus" has amounted to those tens of trillions all that has gained us is a demand shortfall of just more than ten trillion in trade alone.
The OECD reports that total global trade amounted to $22.4 trillion (chained 2010 dollars) in 2015. That sounds like an enormous sum perfectly capable of supporting a thriving global environment. Further, that represented a 26% increase over levels recorded at the prior peak in 2007. But the world economy does not work by volume alone, it works on anticipated growth. $22 trillion and a gain of 26% appear sufficient only in a vacuum; in the eight years up to 2007, global trade expanded by 74%. That works out to about 7.2% compounded, just slightly above the 6.83% long-term average annual gain in global trade from 1990 to 2007.
Such extended weakness, then, as has been the case since the onset of the Great Recession means something more serious than a severe business cycle. Had the global economy continued to follow that prior baseline expansion, global trade would have been $30 trillion in 2015, not $22.4. That nearly $8 trillion shortfall explains a great deal as to why nothing works. And it only gets larger the longer this slump continues increasing the greatest cost there is, lost compounding: the baseline for 2017 jumps to $34.3 trillion while the OECD estimates trade will only total $23.6 trillion (and that forecast is typically optimistic, meaning that actual trade by the end of 2017 is very likely to be significantly less still). The world economy is therefore facing a fourteen digit trade gap.
The world was built for that $34.3 trillion in trade, as everything about mainstream economics has been undertaken under the single general assumption that the Great Recession was cyclical. Because economists claimed it, this was reported as fact in the media and formed the basis of economic expectations in the real economy all over the world - to the intentional and determined exclusion of any other voices. The addition of such heavy and sustained "stimulus" was meant to reinforce those expectations; that given enough time the pre-2008 baseline would actually be attainable. In China, for example, all PBOC textbook action was taken in order to fill any gap between the recession and that expected recovery - where recovery is meant literally. Chinese industrial capacity remains in its pre-2008 condition, for a world where China will find rapid growth again.
Seven years after the trough of the Great Recession, there is no reasonable expectation anymore for it. Janet Yellen and the FOMC describe "full employment" but only as some intangible number. There is nothing like an economy at full employment, certainly not one consistent with these cyclical expectations. The global economy has shrunk, which means not necessarily in absolute terms but rather in its capacity for robust, sustained growth. Diminished economic capacity is the reason "stimulus" doesn't work and hasn't; it simply cannot under such conditions.
As I wrote last week, even certain economic accounts are being forced to that conclusion, albeit too late to be of any use in preventing so many policy mistakes and unsupported mainstream projections.
"The pre-2015 benchmark series showed the typical pattern of this "recovery"; a steady but slow advance that took far longer than "normal" to match the prior cycle peak. By that count, though, the US economy appeared to be at least moving solidly if unspectacularly in that direction and doing so at an increasing rate so as to be also plausibly consistent with the mainstream, FOMC narrative. Two benchmark revisions later, however, and there is no recovery in the production of consumer goods to speak of - at all. This is much, much worse than recession not just in what the economy might have been already, but what it might portend for what the economy will be."
Since the ultimate demise of Bretton Woods in 1971, global trade and activity has been undertaken with the eurodollar system's direct support. Without it, it is very likely that trade growth would have been far more muted especially from the 1980's forward. Thus, it is difficult to separate those apparent benefits from what we find now. In reality, what looked like societal gains of rapid trade expansion was an illusion of money that wasn't money.
The eurodollar is not a dollar, nor is it really a thing at all. The eurodollar is a system of capacity and standards that allows actual conduct to take place in the real world. Unlike true money, there is no store of value in a eurodollar, it is almost entirely a means to an end. With its rapid rise in the 1960's, those "ends" were focused on trade finance; that all changed in the 1990's as it took on more purely financial activities (especially hurried expansion to finance the US housing bubble).
It is perhaps the most difficult concept to grasp, how the world's reserve currency can be in some respects nothing like a currency. The idea and classification of it as a credit-based currency in many ways still falls short of capturing its complete nature, except where one might understand the full bloom of what "credit" means in this context. Wholesale finance and wholesale banking is not limited in that fashion, extending into at times the truly bizarre.
In the BIS Quarterly Review published in March 2009, authors Patrick McGuire and Goetz von Peter wrote what should be required reading for every central banker and economist around the globe. Titled, The US Dollar Shortage in Global Banking the article gave us some needed depth to the eurodollar system's blockage and dysfunction (I have referred to it on many occasions before). Among their most startling conclusions was that the collective European funding gap, their "dollar short", was at least $1.0 to $1.5 trillion at the lower bound and thus very likely much more. From that single attempted estimate we have no trouble understanding why London was the epicenter of the 2008 panic.
Even with their best effort, McGuire and von Peter could do no better than a guess with all the internal data and calculations available to them through the BIS. We simply do not know even now the true scale of this funding legacy. But it is not just quantitative in nature, as this great impediment of measurement declares; there is a qualitative component that is perhaps far more important to understanding our current circumstances and how it got this way.
For example, the paper describes the Japanese banking system as having a "long" cumulative US dollar position of about $600 billion by 2008; with much of that in holdings of US public debt including US treasuries. It was a rather unique situation, particularly as it was funded by domestic liabilities. In other words, Japanese banks were buying and holding dollar-denominated securities through "borrowing" first yen from domestic capacity. This is known as the "yen carry trade."
However, that is an incomplete view of the process. What is really being borrowed is not yen but dollars and not in the form of actual dollars or something called a eurodollar but in FX swaps. As the paper figures, Japanese banks were "short" US dollars by about $800 billion by 2008 in some various forms of cross currency derivatives; and even that is an implied level reconstructed from aggregate bank balance sheet reports rather than specific and specified trade totals. That means we don't really know how heavily Japanese banks were using swaps to fund their "dollar short" or gap, only that they undoubtedly were.
That leaves incomplete all the rest beyond. Where did those swap-delivered "dollars" come from? Where did the go once the Japanese "possessed" them? The BIS publication suggests that Japanese banks were long primarily US treasuries and public debt, but it doesn't take too much imagination to ply further into the depths of legitimate possibilities afforded via a non-currency currency. To start with, the same paper also calculates that US banks had "borrowed" about $800 billion from foreign "dollar" sources to import into the US.
The heavy presence of UST's in possession of Japanese banks might indicate the vanilla carry trade proposition, but it also at least proposes the idea of further "dollar" activities in derivatives (since UST's are the bedrock of derivative collateral). We can only speculate, but it is not to my mind unreasonable to think that Japanese banks having obtained dollar balances through swaps financed by yen deposits (or bank reserves, as under the numerous QE's and now QQE) were using them to fund other activities - including Japanese productive expansion into the Chinese mainland (offshoring).
That is the eurodollar in essence; a means to an end. Japanese banks would have needed "dollars" to finance this direct investment in China in what would have looked like "hot money" flowing in. The Chinese, by turn, would have also needed the "dollars" even though the mainstream believes they had already built a considerable stockpile of "reserves." Chinese banks need "dollars" from the private eurodollar market to finance China's import activities because any "dollars" Chinese export firms obtain are shipped directly to the PBOC to "finance" internal RMB expansion (the PBOC's balance sheet is something of a contradiction; FX assets for the basis of internal Chinese bank reserves). The thread of the eurodollar is sewn into almost every financial reach around the world.
The bottom line is that these various entities in whole and in their parts are not using "dollars" for the sake of dollars but rather to create the capacity by which all these different things can get done; the eurodollar is essentially a common language with which to undertake real and financial effort across vastly different systems. It is the purest sense of money even if limited to only this one single function - medium of exchange.
What happens, then, when this unique and esoteric form of money suddenly becomes far less available and obtainable? We don't have to wonder because it has already happened; once in the form of a sharp, short-term disruption and another in what is really a single long-term retreat. Global banks all over the world, those largest money center banks that were once oriented toward nothing but rapid expansion and growth, are now seeking only exit. Enlargement is no longer the mission, as efficiency has overtaken it which really just means getting out. As McGuire and von Peter wrote in March 2009:
"Taken together, [comprehensive wholesale activities] thus show that several European banking systems expanded their long US dollar positions significantly after 2000, and funded them primarily by borrowing in their domestic currency from home country residents. This is consistent with European universal banks using their retail banking arms to fund the expansion of investment banking activities, which have a large dollar component and are concentrated in major financial centres."
In 2016, banks are acting out in the opposite direction; they are winding down their investment banking and FICC operations all throughout the eurodollar system, but especially in their derivative books. The direct consequence is the diminished capacity to continue eurodollar systemic stability, let alone growth. As a result of vastly reduced monetary capacity for global finance, would anyone really be surprised to then find a similar reduced capacity for the global economy?
While the eurodollar system especially after 1995 found a new "love" in terms of raw financialism, this does not mean that it left behind its role in funding global trade. Quite the contrary, eurodollars continued to be the backbone of rising trade and the economic "miracles" of China, Brazil and any number of producer and resource countries that fully believed they were creating actual economic and societal gains. As the eurodollar increasingly disappears in all its forms and capacities, these nations are now experiencing what happens whenever anything of demand becomes scarce - its "value", or at least its market price, rises. In other words, the rising cost of connecting to the eurodollar system shows up as a "rising dollar" against the rest of the world's currencies all falling in synchronized fashion.
It therefore transforms what was thought to be beggar-thy-neighbor into blame-thy-neighbor since no orthodox perspective can see the reality; to them it's all just some mysterious global problem. As I wrote on August 14 last year, just a few days after the Chinese shockingly "devalued" the yuan,
"There is no currency war save one: the "dollar" is in a total war with itself, meaning everything will be a casualty at some point. The list of central banks falling victim grows bigger."
Indeed. Only now are we starting to figure the true economic costs of all that because the mainstream remains committed to the idea none of this is possible. To them, the world just needs a little more of the right kind of "stimulus", as if pumping the Hindenburg with more hydrogen would have gotten it safely to the ground after it had erupted in conflagration. The answer to great instability is not more of it, even if that "stimulus" were to actually be of the right type and category. The eurodollar system effectively ended on August 9, 2007, a fact the global economy only continues to confirm.
