Original Article By “Quoth The Raven” At ZeroHedge.com
Friend of Fringe Finance Lawrence Lepard released his most recent investor letter a few days ago with his updated take on the seismic changes occurring in monetary policy globally as a result of the Russia/Ukraine conflict.
He takes us through history as to how this landscape has changed in the past, and what could be coming in years ahead.
Larry had joined me for several interviews last year and I believe him to truly be one of the muted voices that the investing community would be better off for considering. He’s the type of voice that gets little coverage in the mainstream media, which, in my opinion, makes him someone worth listening to twice as closely.
Larry was kind enough to allow me to share his most recent thoughts. Part 2 is below and Part 1 can be found at this link.
In Part 1, Larry reminded us of the history and structure of the world monetary system, starting in 1944 and ending in 1980, and how he uses that to make his investment decisions.
In Part 2, he picks up around 1980 and discusses current problems the Fed has.
1980-Present Gold Market
In the chart below, you can see the effect that Paul Volcker’s policies had on the dollar price of gold. By pushing interest rates up to 20%, he managed to cool inflation and ultimately stop it. This brought the gold price back to the $260 to $400 range where it lived for quite some time.
The 1980’s and 1990s were marked by a period of dis-inflation and ultimately deflation given technological innovations and productivity gains from Microsoft, Intel and the like in the 1980s, and then the Internet in the 1990s. Also, the impact of China’s entry into the world economy and the construction of its low labor cost manufacturing base helped create deflationary forces that masked the underlying monetary inflation that was taking place as we printed money.
In 1998, we saw the failure of Russia and LTCM. This led to a more activist Fed (and the famous “Fed Put”) that helped to fuel the Dotcom bubble which burst in March 2000. This marked the low of the gold price at approximately $260 per ounce in late 2000. When the Dotcom bubble burst, the Fed reacted aggressively by lowering interest rates to 1% and by adding enormous monetary accommodation. Furthermore, in November 2002 Fed Chairman Ben Bernanke delivered his epic “the US Government has a technology speech”. Bernanke’s money quote was:
“What has this got to do with monetary policy? Like gold, US dollars have value only to the extent that they are strictly limited in supply. But the US government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many US dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the US government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”
In essence, Bernanke said that US monetary policy had changed, and corrective deflationary downturns were no longer allowed. When you add this to the very low (1.00%-1.50%) Fed Funds rate that he instituted after the Dotcom bubble burst, he helped to blow the US housing bubble.
We can see why gold rallied steadily from $260 per ounce in 2000 to $1,900 in 2011. Post 2011, the Fed implemented Operation Twist, which masked the inflation, and the Fed was able to orchestrate a major correction in the price of gold from $1,900 to $1,050 in December of 2015. The discovery of shale oil and fracking also helped greatly in this effort since the oil price is such a good indicator of inflation.
Bretton Woods II: The Petrodollar and Reserve Currency Status
Against this backdrop, it is helpful to understand the benefits and implications of being the “global reserve currency”. Soon after Nixon abandoned the gold standard in 1971, the US took carefully measured steps to secure the dollar as the global reserve currency.
Recognizing that oil was (and remains) the world’s largest and most important commodity, in the early 1970’s, Henry Kissinger went to Saudi Arabia, the world’s largest oil producer, and reached an agreement. The US would provide the Saudis with military support if the Saudis would sell their oil in US dollars, only. William Simon, the bond salesman from Salomon Brothers, became Treasury Secretary and helped convince the Saudis to park their dollars in the US Treasury market.
The post 1971 monetary environment, where the dollar is still the world’s reserve currency, no longer backed by gold but rather is backed by the GLOBAL need for dollars to purchase oil, is now called the PetroDollar standard, or some refer to it as Bretton Woods II. This system has benefited the US greatly by creating (i) an artificial demand for US dollars, thus ensuring a strong dollar; and (ii) when commodity/goods sellers received dollar revenues, they “recycled” those dollar cash assets back into the purchase of US Treasury bonds. Thus, this PetroDollar system financed our deficits and led to a higher living standard (albeit on credit) for Americans. It enabled us to consume more than we produce in the way that many drug addicts are enabled.
Problems With the Bretton Woods/Petrodollar System: “Triffin’s Dilemma”
As early as 1944, some people saw problems with the post-WWII Bretton Woods system. Robert Triffin was an Economist who taught at Harvard and Yale. In 1959, Triffin testified before Congress and warned that the Bretton Woods monetary system was seriously flawed. He warned that by using the dollar as the international reserve currency, it required the US monetary system to run deficits in order to supply the world with financial liquidity. He predicted that the system would not be able to maintain liquidity AND confidence in the dollar at the same time. He was ignored.
However, in 1971, his theory proved to be true when Nixon was forced to abandon the gold standard given foreign nations’ concern about US budget deficits (from the Vietnam War and large safety net expenditures). In fact, the theory is still true today even though we are no longer on the gold standard. Since 1971, we have observed that when the dollar is too strong (not enough dollars being printed) things break financially in other parts of the world. This imbalance between US domestic needs and world financial system needs is a problem that can only be solved by going to a neutral reserve currency like gold. (Although it does not have to be gold).
Ironically, John Maynard Keynes, at the Bretton Woods conference in 1944, had previously recognized this problem. He suggested that the solution was to adopt a neutral reserve currency among large nations to be called the Bancor. It would have included a basket of commodities and currencies and therefore it would fluctuate as needed in national currency terms to keep trade and commerce in balance. Sadly, this idea was not adopted in favor of the system that we now have.
The current fiat system has led to huge dollar imbalances and has enabled the US to live beyond its means at the expense of the rest of the world given our ability to borrow debt so cheaply. While Russia’s move into the Ukraine has strategic rationale for Russia including access to ports and commodities, we believe that this monetary issue is also a reason for Russia’s actions.
Indeed, as early as 2009, China and Russian Central Bankers complained openly and critiqued the PetroDollar system and the issues of US deficits and dollar debasement, given the Fed’s actions post the 2008 GFC crisis (i.e., Bank bailouts). Here is a 2009 comment from a Chinese Central Banker:
“The desirable goal of reforming the international monetary system, therefore, is to create an international reserve currency that is disconnected from individual nations and is able to remain stable in the long run, thus removing the inherent deficiencies caused by using credit-based national currencies……A super-sovereign reserve currency not only eliminates the inherent risks of credit
based sovereign currency, but also makes it possible to manage global liquidity. A super-sovereign reserve currency managed by a global institution could be used to both create and control the global liquidity. And when a country’s currency is no longer used as the yardstick for global trade and as the benchmark for other currencies, the exchange rate policy of the country would be far more effective in adjusting economic imbalances.”
–Reform the International Monetary System, Zhou Xiaochuan, PBOC – 3/23/0944
In our opinion, the dollar will need to be replaced by a neutral reserve currency when the upcoming currency reset takes place. Credit Suisse’ Zoltan Pozsar has written extensively about exactly this in what he calls the new Bretton Woods III system that in effect Putin has just created.
Bretton Woods III: Why The Petrodollar Just Died In 2022
The current events of Q1 2022 are enormously important and have yet to be fully absorbed by many market participants, in our opinion. The Western sanctions and seizure of Russian FX reserves are nothing short of a monetary earthquake.
The last comparable event was…(READ THIS FULL ANALYSIS HERE).
