The Arrival of the Economic Winter

 The economy is a social phenomenon and as such maintains biases inherent to human nature.

Nothing as human as the relationship we have with natural cycles that have always accompanied us. Cycles of sowing in autumn and harvesting in summer, cycles of cold that force us to take shelter and other warmer ones that encourage us to go out and explore the world.

This is why I wrote this metaphorical exercise comparing the seasons of the year with the recent history of money, especially the North American dollar, the world's reserve currency.

According to my analysis, we are currently living in the economic autumn, which began with the Subprime crisis of 2007-2008. The economic and geopolitical events taking place right now in the world indicate that the change of economic season towards winter will be faster and more convulsive than previous ones.

To understand what we are talking about, I am going to define some moments that marked the past of our monetary system in the previous seasons.

Spring

Almost at the end of World War II, after "D-Day", the Allied invasion on the beaches of Normandy in June 1944, the Allied countries could already predict that the war was going to be won against the Nazis. So they decided to meet to found the new world economic order that would be the pillar of growth and reconstruction of a world devastated by years of conflict.

In July 1944, all the financial representatives of the countries met in the town of Bretton Woods, New Hampshire, United States, to define the mechanisms of how the world would function from the end of the war onwards.

At this meeting it was defined that the economic pillar and champion of the world would be the United States of America, both for its outstanding industrial capacity, for its ability to project its power to any part of the world and for its large gold reserves. No country at the time could compare with the stability and robustness of the US economy. 

For these reasons, from this date onwards the US dollar would become the world's reserve currency, replacing the pound sterling, allowing world trade to transact with a single and stable financial backing.

Postwar growth can be described as unprecedented. The reconstruction of the countries was an enhancer not only of industry, but also of technological innovation and demographic growth.

All nations began to feel the impact, with new technologies that began to transform people's lives. 

The transistor, which enhanced miniaturization and the beginning of the digitalization of information; television, revolutionizing communications; jet airliners, which made travel faster and more popular; nuclear energy, which offered almost unlimited power to illuminate our increasingly electric dependent society; the space race, which took us off our own planet for the first time, directing our future as a species towards the stars.

Summer

Already towards the end of the 1960s, a notable economic imbalance was developing in the world, with a US economy that required more and more raw materials to feed its thriving industry. 

Large quantities of iron, copper, oil, rubber and other commodities produced throughout the world were traveling to the US and being exchanged for dollars.

The US dollar at the time could be printed in limited quantities. The restriction to greater volume of commercial exchanges was the existence of gold reserves in the United States, something that constrained the growth demanded by the economy, since, according to the Bretton Woods agreement, each dollar in existence had to be be backed with an equivalent amount of gold in Fort Knox vaults.

During this time, precious metal exchanges were carried out at home, that is, when a country sold something to the United States, it received payment in US dollars, which in turn were backed by physical gold. This meant that if the counterparty wanted to redeem or exchange their dollars for gold, they could do so, since their dollars had a fixed physical backing.

To avoid having to export every ounce of gold each time this happened, within the Fort Knox vaults themselves, the physical bars were relabeled with their new owners, but without moving them outside the premises where they were housed. By definition, gold changed hands over time, but in practice the metal did not move, it continued to be housed in United States territory.

France, then led by President Charles De Gaulle, showed some suspicion towards this scheme. So he began to request that the metal belonging to France physically moved to be kept in its own vaults in French territory. 

This resulted in a series of voyages by French warships that picked up gold shipments in US ports to take them across the Atlantic to French ports and from there to the central bank of France. 

Other countries showed interest in exercising this right and began to request that the gold they owned be physically shipped.

The US government began to perceive the risk that, at some point in the future, its gold reserves would be exhausted, which would bring about the end of the economic model with the dollar as a reserve currency. This could not be allowed, as it would be seen as a self-inflicted wound to the economic model, which would put the US's strategic enemies, the Soviet Union and China, on notice of a potential weakness.

For this reason, on August 15, 1971, US President Richard Nixon in a televised message announced the "temporary" suspension of the convertibility of the dollar and gold, until some global trade imbalances were resolved.

The detachment between the US dollar and gold remains to this day.

The signatories of Bretton Woods accepted the change in the agreement, more than anything because the United States had demonstrated an outstanding growth and economic strength, in addition to maintaining a relevant military power that kept its lead position in the Western world.

But the dollar couldn't go from being backed by gold to being backed by nothing overnight without someone complaining. 

For this reason, before dissident voices arose, an agreement was sought with Saudi Arabia, the world's largest oil producer and president of OPEC (Organization of the Petroleum Exporting Countries), so that it would begin to demand that all crude oil exports be carried out exclusively with US dollars, obtaining in return the explicit promise that the US would politically and militarily protect the Al Saud dynasty to remain in power and to protect the country against all potential enemies if necessary.

Once the agreement with Saudi Arabia was reached, the new petrodollar standard emerged, which since then forced each country to have large amounts of dollars to acquire the fuel necessary to cover the energy needs of their growing economies.

Although gold and oil are non-renewable goods, unlike gold, oil is a good that is highly demanded and consumed, of which it is not known how many reserves remain under the ground. 

This demand for oil, necessary for the development of countries, implied at the same time an equivalent and increasing demand for dollars.

Technically, since the end of dollar-gold convertibility, the US dollar no longer had a limitation to be printed, so from the 1970s until today the monetary base of the US dollar (how many dollars exist in circulation) has grown exponentially. 

It is important to define that this change in the monetary system converted the US dollar into a fiduciary currency, that is, its value is derived from a promise of future payment, which is the definition of credit. By extension all world's legal tender currencies are fiat since then.

The sheer amount of currency printed in the decades since 1971 has fueled unprecedented global economic growth, something like an economic summer.

The low interest rates at which central banks have granted credit have fostered growth at a global level. It has allowed many developing countries to escape poverty, for large infrastructure projects to be carried out, for capital investment in innovations that surprise us, for millions of families to have access to their own home, but, on the other hand, easy credit has also made it possible to finance wars and arms races that otherwise would not have occurred.

The rise of digital technologies has also made the printed production of currency less and less necessary, since banks now maintain their reserves as digits in a database. It is estimated that only 5% of the planet's money is in physical form as bills and coins.

Autumn

According to what I pointed out in a previous article (1), the Subprime crisis that occurred in 2007-2008 was a most important economic event than we could assume.

According to this analysis, it is at this moment that something broke in the prevailing economic model due, mainly, to the excess debt generated in previous decades, thanks to the cheap credit granted by the central banks (especially the Fed, Federal Reserve of the United States). 

Data indicates that it is at this time that the world's central banks had to apply emergency measures to prevent the entire financial system from collapsing.

It is at the beginning of this crisis that something stopped working and the Fed activated the only weapons it had available; print money like crazy (2) and lower rates to almost zero (3).

In short, thanks to the actions of the central banks, an immense financial hole that could be seen coming was filled with freshly printed money. This situation was imitated by most of the world's central banks to a greater or lesser extent.

The Fed has tried over the years to overcome this major bump in the road, but with less than encouraging results. The result is higher distrust between commercial banks, with increased rates and greater safeguards when issuing credit.

Recently he Fed has had to come out to help banks at risk of bankruptcy. Other institutions have failed almost unexpectedly during 2023, including Silicon Valley Bank (4), one of the largest bankruptcies since the Subprime crisis.

On the other hand, the conglomerate of BRICS countries (Brazil, Russia, India, China and South Africa) continues to grow, threatening the hegemony of the dollar, even managing to strengthen trade agreements with Saudi Arabia (5) (which is now a member of BRICS along with the United Arab Emirates, Egypt, Ethiopia and Iran). 

Saudi Arabia remains the counterpart to maintain the petrodollar standard.

Among others, the following are the most influential factors at the beginning of the economic fall.

Fiat currency without physical backing

Higher monetary inflation

Fragility and mistrust of the financial system

Threats to the petrodollar system

These destabilizing factors are already present in the world's economy and geopolitics. The more they develop or deepen, the more likely it is that we will move on to the next season.

Winter

This economic season is in the future, therefore, what is proposed below is pure fiction, however there are several real threats to the current monetary system.

Even if the vultures fly around, the petrodollar system will not be easily overthrown. The United States is the world's largest economy. The US dollar maintains the largest amount of reserves abroad (6), surpassing all other currencies and, at the same time the US is the largest global military power. 

The US will not allow its enemies to take advantage of its apparent weaknesses.

Although we do not know exactly how this change of season could occur, in our hypothesis we will propose three scenarios that can influence the fall of the North American dollar from its current status and lead us to a new monetary system, to a new paradigm that will not be free of storms, hail, floods or waterspouts typical of the harshest season of the year, metaphorically speaking.

1) An external geopolitical event

In this hypothetical analysis we are going to go a little further than the obvious, simply because there is no more effective attack than one that is unexpected by the opponent.

Due to the strategic position of the US dollar as the world's reserve currency, both friends and enemies of the US have to use it for their transactions. 

Furthermore, the petrodollar standard that the United States maintains with Saudi Arabia forces each country to collect dollars locally and abroad for its crude oil purchases. This does not happen with any other currency.

If we understand that the enemies of the United States have the secret desire to end its global hegemony as a superpower, attacking its greatest asset, which is the dollar's world's reserve currency status, then we could assume that these enemies would be plotting multiple actions to target it at the right time to obtain the greatest results. Something like a masterstroke. 

This blow could affect the credibility of the United States to defend itself or its closest allies. In economic terms, credibility is the difference between power and oblivion.

Things have remained stable for decades for the dollar, but this has begun to change. 

At the end of 2023, China and Saudi Arabia reached an agreement to exchange oil in yuan (China's currency). This means that China achieves important progress in its strategy of de-dollarization of its economy.

If the BRICS countries (of which China is a part) manage to move in this same direction, they would promote the de-dollarization of 32% of the world's GDP and 40% of the global population (more than 3.2 billion people).

To achieve any relevant impact, the de-dollarization of the BRICS countries should be linked to the sale of most of the treasury bonds (US debt) that they hold as reserves.

China alone holds something like eight hundred billion dollars ($800,000,000,000.00) in US treasury bonds.

Selling all that amount of bonds in the market at once would be a big blow for the United States, which would see its debt become more expensive and the dollar devalued, but it would also be a big blow for whoever is selling, since in exchange it would receive dollars, which they would have to sell quickly at a devalued price.

As long as the United States is the strongest economy in the world, it is not advisable to sell the bonds it owns, on the contrary, these are insurance against the ups and downs of the economy.

That is unless, somehow, the credibility of the United States begins to fade, which would mean that the intrinsic value of each bond begins to fade as well. This brings us to our second scenario.

2) An internal social/political event

Given the political polarization prevailing in recent years, the United States is increasingly seen as a scenario where two increasingly harsh ideological bases confront each other, the Democrats and the Republicans. 

Both sides have maintained historical rivalries within the democratic framework, but in recent years these rivalries have become more visceral, with incitement to hatred and disqualifications from all sides. The possibility exists for the outbreak of a second civil war (the original was the Civil War between 1861 and 1865, between the Confederates and the Union).

The United States of America is a federation, that is, the union of self-administered states, governed by a central federal administration based in Washington D.C. (which is not a state itself, but an administrative district). There are states that have rhetorically threatened in the past to secede from the union. That situation has been exacerbated now that there are disputes between Texas and the federal government over immigration policy. This situation has stressed the relationship with several border states.

In the event that an event similar to the Civil War broke out, it is most likely that the states that seek independence would stop using the dollar (created by the Federal Reserve) to begin using another currency that represented them better (created by themselves).

This hypothetical separation of some US would mean a tremendous blow to the credibility of the United States of America, not only as a political and military power, but also an economic one.

If the Fed loses control and credibility of the hypothetical breakaway states of the American Union, it is to be expected that the rest of the world will quickly reach the same conclusions, de facto ending the US dollar as the world's reserve currency.

To make a stationary object change its position, it is necessary to apply energy. This is one of the laws of thermodynamics. Getting the dollar out of its current status will require someone to apply enough energy to get it out of its current position. Here comes our third hypothetical scenario.

3) A multidimensional event

In this scenario, the enemies of the dollar are taking actions to de-dollarize their economies, as we already are seeing with the BRICS countries, 

But, to this set of foreign hostile actions, an internal action is to be added. 

This is an overthrow that the US financial system itself would carry out to destroy the credibility of the dollar in a premeditated manner.

But what could motivate the owners of the world's largest economy to plan a kind of economic suicide, especially when there are enemies at the door?

According to the Greek mythical figure of the Phoenix, sometimes the old is to be destroyed in order to be reborn from its ashes. Following this rhetorical image, it is possible that those who manage the world's financial machinery have already foreseen the death of the dollar system.

The natural evolution of events has worn away what emerged as a response to the reconstruction of the world after the Second World War.

Events such as detachment from the gold standard, converting the dollar into a fiat currency, attaching the dollar to oil, quantitative easing during the Suprime crisis and the excessive printing of recent post-Covid years have been monetary stages that have been burning, until there is nothing left to burn but itself.

If the dollar standard is coming to its natural end and those who control the world's economy know it, then it is likely that they have already prepared the final act, which would come quickly and unexpectedly for most, but would act as a form of controlled demolition leading to things to where a few powerful characters can maintain control. A creative destruction that brings about a new system. A new system ready to come into operation once the old system has stopped working.

Triggers of such an event could be several: a war, internal or external; a large-scale attack, whether physical or cyber, a geophysical event such as the explosion of a megavolcano like Yellowstone or a big earthquake that affects large parts of the country.

The success or failure of a multidimensional event against the US dollar will ultimately be determined by the market, the final barometer of the economy.

Faced with these hypothetical events, global investors would remain fixed to their screens, watching events as they unfold. 

It is most likely that at the beginning the dollar would strengthen since billions of euros, yens, yuans, francs and pounds, in addition to bonds, financial derivatives and stocks would flee to a liquid refuge like the dollar, something for which the dollar has always been used for.

The status quo will remain as long as gold and silver do not begin a robust climb.

But since all this would be planned in advance, as hours and days go by, the psychological barriers in the price of precious metals and perhaps also bitcoin will begin to break, with new maximum prices hour after hour.

If this escalation becomes unstoppable, the dollar will begin to retreat and just as quickly as it strengthened, it will begin to fall in value at astonishing speeds.

It will only be up to the Fed to apply a communication containment strategy on the market, since each bad news could become a new nail in the coffin of the dollar and consequently all the world's fiat currencies.

Conclusion

This essay has mixed some monetary history with fiction about what may happen in the future with the US dollar as the world's reserve currency.

No one really knows what will happen to the efforts of US enemies to unseat the dollar from its current status. What is certain is that the dollar standard will pass one day, as all previous monetary standards have and one day we will all see ourselves adopting a new model.

We can only hope for this transition from the old to the new monetary system to be more peaceful than violent.

Blessings,

Luis Leighton

1) https://www.linkedin.com/pulse/strange-case-economic-fall-luis-leighton-carvajal-/

2) https://fred.stlouisfed.org/series/BOGMBASE

3) https://fred.stlouisfed.org/series/FEDFUNDS

(4) https://www.bbc.com/mundo/noticias-64910472

(5) https://elpais.com/internacional/2023-08-24/el-grupo-de-los-brics-invita-a-iran-arabia-saudi-y-otros-cuatro-paises-a-unirse-al-grupo.html

(6) https://data.imf.org/?sk=e6a5f467-c14b-4aa8-9f6d-5a09ec4e62a4