We shall not grow wiser before we learn that much that we have done was very foolish – Friedrich August von Hayek
In the first installment of this series, I discussed my belief that China lacks the level of US dollar reserves that are reported in their Currency Reserve Account. Here’s a link: https://www.zerohedge.com/news/2024-06-04/has-china-run-out-dollars In this piece, I would like to discuss the implications of what happens to the Eurodollar market when China ultimately marks to market.
As some have pointed out in the comments section, the CCP has amassed a sizable pile of gold the LME has allowed them to accumulate at a discount over the past fifteen years. In recent years, that gold position has been supplemented by supplying Russia in their conflict with Ukraine. Regardless, while I consider it a smart move, Xi Jinping is reputed to believe that he can use this gold to turn the world into a Communist state with China at the top. It’s not going to happen. It takes more than gold and low-end manufacturing to be the Global Alpha.
China is going to decline because they never developed the necessary competitive advantages to move up the value-added spectrum. Additionally, the extraordinary corruption of the Marxist system represents both a frictional cost and a deterrence against merit such that their best and brightest are stunted in favor of CCP cronies. Just look at what they’ve done to Alibaba.
For the past twenty years, I have fervently believed that turning China into a leading cog in the global economic machinery would prove to be a fatal mistake. By centralizing low-end manufacturing in China, we have distorted the supply/demand balance of the entire global economy such that a declining China will export disinflation in some product categories and dramatically higher prices in others. Ultimately, it’s going to take a long time for asset markets to stabilize. This will prove to be a global problem and possibly the end of the Eurodollar.
The Dollar in Excess and Scarce – Concurrently
I think that I am intrigued by paradoxes. If something seems to be a paradox, it has something deeper, something worth exploring – Roger Penrose
I believe the combination of Congress and the Federal Reserve are to blame for our domestic inflation. More precisely, Congress is responsible for price inflation with help from the Fed while the Fed is responsible for the asset price inflation since the year 2000. Congress allowed the sharp rise in transfer payments which are the true cause of price inflation. The Fed merely abetted the crime.
The paradox of the dollar is that it can be both abundant and scarce at the same time. If we simply call them the dollar and the Eurodollar, it helps in understanding this unique dynamic. In the US, the dollar is subject to our domestic banking laws and leverage limitations plus the impact of Federal Deposit Insurance premiums. The Eurodollar is outside the US banking system and enjoys limited regulation, making them two different currencies in practice. It’s for these reasons that nobody, not even the Fed, knows how many Eurodollars are actually in existence.
The simplest way to describe the difference is that dollars become Eurodollars when they leave the US either through trade, transfer, or investment. My favorite fun-fact is that the Soviet Union created the Eurodollar by depositing US dollars received from oil exports into a European bank, fearing asset appropriation which is precisely what’s happening to Russian oligarchs today.
Over the following decades, the Eurodollar market grew through the petrodollar trade and from multinational companies keeping deposits outside the US banking system – and the IRS. It also grew from wealthy Americans moving their savings offshore for various reasons. The last estimate I saw of the size of the Eurodollar market was from JP Morgan and they think it’s roughly the same size as our domestic money supply.
These are the reasons why I don’t view the US dollar the way I view other currencies; it’s like nothing the world has ever seen before. The dollar/Eurodollar are somewhat akin to twins separated at birth with one living in the US and the other loosely tied to London – kind of like the movie the “Parent Trap.” One is the lifeblood of the USA while the other is the lifeblood of the global economy.
The domestic dollar is in great excess thanks to the socialist tumor that has been growing in Washington since the 1960’s but the Eurodollar has been on a diet since 2014 thanks to the viability of shale oil. The US doesn’t need to import oil like we did from the 1970’s into the early 2010’s and that is the biggest issue that is hurting the global economy. Liquified natural gas (LNG) exports make it worse by draining dollars from the global economy.
Since Eurodollar deposits are lightly regulated, banks and funds have been able to invest those dollars aggressively into emerging economies. The bald truth is that the Eurodollar market built China and now China is in the process of destroying the Eurodollar thanks to ridiculously bad investing. Once a bad investment is written down to salvage value, the difference between the face value of the loan and the salvage value deflates bank assets.
I believe the combination of the US’s energy self-reliance and China’s abysmal investment decisions have made the Eurodollar scarce and that is why the US dollar has been strong since 2014 despite domestic profligacy. This chart doesn’t lie and I strongly suspect that Janet Yellen would love to see the dollar cheapen from here. Notice the jump in 2014!
The chart above measures the value of the Eurodollar, not the domestic dollar. You won’t find confirmation of this delineation elsewhere because it’s based on my own thirty years of work but it squares the circle of our current problem of excess and scarcity. That said, Jeffrey Snider of Eurodollar University does a masterful job of following this critical market.
A New Reserve Currency?
People are very open to new things – as long as they are exactly like the old ones – Charles Kettering
We are at the end of the post-WWII “Pax Americana” and I fervently believe that we’re going to look back and miss it. Compared to ancient history, things have never been better but in relative terms, man was never meant to live his life in the Garden of Eden. Man always creates problems where none exist.
The Eurodollar system is broken thanks to China and the rest of the emerging markets who borrowed heavily in dollars following the start of quantitative easing. The projects that were meant to generate the returns to service the dollar-denominated debt are largely worthless whether it’s China’s BRI, Egypt’s new Cairo, Dubai’s islands, or even infrastructure for electric vehicles.
Domestically, QE worked somewhat but I suspect that it only bought time to make the problems bigger in the US economy and a bigger bout of deflation in the end. Greenspan/Bernanke/Yellen/Powell have created a moral hazard of extraordinary dimensions with only Nvidia keeping it from imploding. They will ultimately cobble together a combination of inflation and economic depression to redirect our domestic economy onto a new path.
The problem is the Eurodollar market because the Fed has no open mechanism for reflating the Eurodollar banks other than swap arrangements. It’s conceivable that the US dollar spikes so much that US dollar holders go on a buying spree around the world allowing our domestic excesses to spread abroad. It’s something to consider, but I don’t imagine foreign governments being open to carpet baggers, especially China.
Ethereum and Bitcoin make some sense but they lack the deep financial markets that would allow them to be broadly used. That said, I’m warming to them but I haven’t figured out how they can be used for global trade nor how they can be employed without destroying the global banking system.
Whatever system emerges from the wreckage, the US will still reign supreme because our military is the only one capable of maintaining the oceans for global trade. China’s military looks good on paper but it’s only for show. Russia has been downgraded to merely a regional power. Neither country has the logistics capability to extend power anywhere.
The caveat to the US reigning supreme is nuclear war where NATO is increasing the probability of this unimaginable horror. Xi also seems capable of such an epic blunder but the US Pacific Command, along with Japan, UK, and Australia are doing a credible job of hemming China in without getting too close. NATO, on the other hand, is attempting to corner a dangerous animal.
The IMF is always a possibility but Washington and Wall Street wouldn’t allow it. A new gold standard sounds good but it would entail massive deflation, starvation, and poverty on a scale that is unthinkable. That ship sailed in the 1960’s. This leaves the dollar until something better comes along.
Conclusion
A claim for equality of material position can be met only by a government with totalitarian powers – Friedrich August von Hayek
I don’t know what the future holds but I won’t be prepared to face it without an objective understanding of the situation as it really is. Accepting the two-headed nature of the US dollar is a worthwhile first step. It allows us to set aside the impractical and impossible as potential paths.
The second step is to acknowledge that power never cedes power without a fight. The folks who got us into this mess are the ones attempting to limit our freedoms as a means towards re-shaping the mess to their liking. Globalists want to centralize, socialists want to control, and Marxists want to confiscate. AI is the technology to help them get what they want.
The US economy, with all of its flaws, is still the best structured economy in the world in which to transition from the old cycle to the new cycle. We’ve got oil, gas, food, metals, semiconductor technology, and a mature infrastructure. This implies that we are not as materially dependent as other nations but we’ll still need to restructure for the next cycle. I believe it will involve some form of financial repression including 0% interest rates.
Governments have chosen inflation to wipe out past mistakes going back to the Ancient Greeks but without a transmission mechanism to turn dollars into Eurodollars, the global economy is facing severe deflation. This is where centralizing the global manufacturing system in Southeast Asia draws blood. Economies of scale turn into dis-economies of scale when revenue declines. Global companies that look solid today could become zombies in short order when deflation takes hold, especially if they are capitalized with debt as in China. I suspect we are getting closer.
If the dollar suddenly pops in currency markets, it means it’s time to put your seat in the upright position and make sure your seat-belt is securely fashioned.
