Irresistible Force vs. Immovable Object
Financial Versus Price Stability in a World of Fiat Money
The recent collapse of Silicon Valley Bank (SVB) is simply a prelude to the ultimate day of reckoning which the global financial system must one day eventually confront. Unfortunately, the stage has been set for the ultimate monetary battle, one which pits price and financial stability against one another. The stakes of this battle could not be higher. Global economic health, the post-World War II international order and the future of the U.S. dollar as world reserve currency all hang in the balance.
The Irresistible Force-Financial Stability
Fifteen years of loose monetary policy has fostered an addiction to cheap money. Without consciously intending to do so, governments and central banks around the world have created a financial system wholly dependent on easy credit and an ever-expanding money supply. This addiction has been deeply embedded in the world’s capital markets as well as in the real economy. Sustained periods of relatively high interest rates can no longer be tolerated by this addicted system.
The collapse of SVB is simply a withdrawal symptom of this addiction. In summary, SVB bought bonds that mature years in the future in a search for yield. These asset purchases were funded with short-term liabilities, i.e., deposits. While the assets themselves—securities such as U.S. Treasuries and agency-insured mortgages—are not risky from a credit perspective, they do carry significant duration risk. Duration or interest rate risk is just another way of saying that if interest rates rise, these assets will be worth less than their purchase price. In other words, they will trade at a discount or below par value.
For example, what SVP paid $1,000 for two years ago may now be worth $900 despite the fact that the asset will do exactly what it promised to do, such as pay 2% interest for the next ten years and then repay the entire principal amount of $1,000. This asset must be discounted from its original price of $1,000 to reflect the fact that one can now buy a similar asset but with a significantly higher interest rate for the same $1,000 purchase price.
This phenomenon of borrowing from depositors on a short-term basis and then lending to the U.S. government on a long-term basis at low interest rates is but one example of the widespread addiction to cheap money embedded within the modern economy. Other examples of this addiction include much of the venture capital (VC) ecosystem—a major driver of jobs and economic growth over the past twenty plus years. The VC ecosystem has been able to fund thousands of large and risky bets with cheap money. Many of these bets can fail because of this money’s previously low cost. Now that that money is more valuable over time, the VC ecosystem must reduce those bets in order to ensure that the profits from a select few major wins will cover its numerous losses.
Beyond technology firms and the broader VC community, low rates have also been a primary driver of growth in real estate, education, auto sales and consumer discretionary spending. Indirectly, low rates have helped fuel growth in all other sectors of the economy. Companies in the industrial space, for example, often must invest massive amounts of money for years before seeing a return on investment. The hurdle rate for profitable projects is low during a time of free money. Thus, as interest rates rise, one can expect less economic activity across the board.
However, perhaps the greatest cost to higher rates is on the world’s largest borrower and spender—the U.S. Treasury. Rising rates will require a larger percent of government expenditures around the world to go towards debt service, i.e., paying interest on their bonds. For the United States alone, this interest expense is expected to triple from around $400 billion in 2022 to over $1.2 trillion in 2032. As more and more tax revenues go to debt service, the other services that governments provide will suffer or continue to drive-up interest expense even more.
All of the above-mentioned factors support the conclusion that the modern economy is wholly dependent on low rates. Without them, like a shivering alcoholic in need of a drink, death is a real possibility. Over the past forty years, that drink has always been available in the form of more debt. The irresistible force of financial stability has demanded the bar tab be kept open with relatively small consequences. Recently, however, this force has been drawing closer to an immovable object.
The Immovable Object-Price Stability
Rampant and severe inflation has precipitated both the downfall of major empires as well as the greatest humanitarian crises in human history, most recently World War II where Germans famously needed wheelbarrows of cash to buy a loaf of bread. It is absolutely imperative, therefore, that inflation expectations be kept in check especially regarding the world’s reserve currency, the U.S. dollar (USD). USD acts not only as the coin of the realm for America but also for the world. Most international trade whether between Chile and China or South Africa and South Korea is conducted in USD. While most of the world’s central banks formerly held their reserves in gold, they now hold much more USD than the yellow metal.
As Milton Friedman famously said in 1963, “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” What does this mean? In essence, all things being equal, the more money the government creates through the issuance of debt, the more inflation will grow. The world has just recently begun to see the effects of a decades-long and astronomical increase in the money supply. Inflation that was branded as supply chain-specific and transitory has proven longer lasting and more entrenched than most economists originally believed.
The solution to inflation is a reduction in the money supply or the rate of growth of that supply. This has been precisely the result of recent monetary tightening efforts by the Federal Reserve System, European Central Bank and other monetary authorities around the world. It has had its desired effect, and inflation has come down from generationally high levels. However, that fight must now be muted if not frozen or even reversed as higher interest rates have threatened financial stability in the banking system. Simply put, the Fed must reduce its rate-hiking enthusiasm.
The Ultimate Battle-Financial vs. Price Stability
Ultimately, the irresistible force of financial stability is drawing closer to its confrontation with the immovable object of price stability. As mentioned above, the stakes of this forthcoming battle are nothing less than global economic health, the post-World War II international order and the future of the U.S. dollar as world reserve currency.
As World War II drew to a close in 1944, the victors met in picturesque Bretton Woods, New Hampshire to hash out the post-war economic order. At the top of their monetary pyramid was gold followed by the U.S. dollar. The dollar would be pegged to gold at $35 per ounce and all other major currencies would be de facto pegged to gold via their exchange rate with USD. However, in 1971, President Nixon faced inflation as the market price of gold crept ever higher past the $35 peg. He had no choice but to remove gold from the top of the monetary pyramid and replace it with U.S. Treasury bonds, the current monetary standard.
As the SVB bank collapse showed, deposits in banks are not money. Only printed Federal Reserve Notes and claims on the U.S. Treasury via U.S. government bonds are real money in today’s world. Everything else is at least one if not multiple rungs lower in the monetary hierarchy. This faith in the almighty dollar is built on global acceptance of USD as a means of transaction. But what would happen if this faith were compromised by either financial instability, price instability or a powerful combination of both? The world is getting a sneak preview of it right now. Two of the best performing assets since the collapse of SVB have been gold and Bitcoin. The former has served atop the monetary pyramid before; the latter, many hope, will take the place that gold held and that USD now commands.
While it is too early to contend that this final battle is taking place now, events such as the SVB collapse can be seen as minor skirmishes previewing the main event. Eventually, the world’s addiction to easy money will unleash an even more powerful bout with inflation that will threaten faith in USD itself. If USD cannot be trusted to maintain some semblance of price stability, financial instability will follow. The death of the dollar is a more real possibility now than at any other time since the 1860s when the U.S. government issued copious amounts of paper unbacked by the real money of the era, gold.
The philosopher asks, “What happens when an irresistible force meets an unmovable object?” Unfortunately, there is no answer to this dilemma. One can only imagine that the result will be destruction and chaos. The world may be able to delay, but it cannot avoid this confrontation. Ultimately, a new monetary order must emerge.