Reserve currency blues

Should I care?

In 1982 my dreams of youthful financial success were dashed on the rocky shoals of an unreasonable US Federal Reserve. Using massive leverage, I had bought a small apartment building with the intention of converting it to a strata corporation and selling off all but one unit which I would own as a ski condo. It was a fool proof plan, expertly executed at just the wrong time. As I prepared to sell my new strata lots, interest rates soared to over twenty percent, the condo market collapsed and the bank which held my mortgage went into competition and stole all of my tenants. A perfect storm of misery.

In September of 2008, I was involved in a small mining exploration company, and we had just drilled a discovery hole indicating that our mineral claims held enough gold and silver resources to develop a profitable mine (which is currently in operation). At the point of signing for financing to drill out the resource and develop the mine, Lehman Brothers Holdings collapsed and with it my mid career dreams of financial success. Another foolproof plan, expertly executed at just the wrong time. There is a pattern being established here.

Making money is very difficult because “timing is everything” and I seem to have an unerring ability to spot all the wrong times. All this to say that I have some sympathy for the owners and management of the Silicon Valley Bank (SVB). They had hit a market niche at the right time, took in enormous sums of deposits and were lending to some of the fastest growing companies in the world. In fact, they were drowning in an embarrassment of riches and needed a safe way to warehouse all of their money. So, they invested in US bonds and treasury bills. Unfortunately, their investments were made when interest rates were low just before the interest rates exploded upwards. A foolproof plan, expertly executed at just the wrong time.

This is what is called a bond price curve and it indicates what a prudent investor is willing to pay for a $1,000 bond for a given period at different interest rates.

When the SVB bonds were purchased, interest rates (the bond yield) were at half a percent indicating that the price of the bonds was about $1,400 (for this case). With interest rates at five percent, that same bond is now worth only $1,000. Congratulations SVB, you just lost thirty percent of your investment (400/1400). This is a problem for the bank because now it does not have enough cash and cash equivalents to meet the reserve criteria for the banking inspectors. The reserve criteria states that for every $100 the bank lends, it must have $25 in deposit accounts or investments (I am using 25% as an illustration. It might be different in the US).

But the banking inspectors were not paying attention and so the Silicon Valley bankers were able to try and skate through the problem hoping to raise more money or have interest rates fall so that the loss on the bonds was not so high. Thanks to a nervous finance industry and people like Peter Thiel screaming “Fire!” in that particular crowded theatre, the bottom fell out for SVB. They were joined by a few others over the weekend.

Unlike in 2008, the bond and shareholders of the SVB were not bailed out. They lost everything and so I feel some kinship with them. It sucks to lose the deposit on the Leer jet. Instead, the federal agency that guarantees bank deposits up to $250,000, magnanimously agreed to guarantee bank deposits up to infinity. Actually, we don’t know how high because no one from the agency is saying what they have in mind.

Then we find out that the Federal Reserve will lend money to the failing banks based on the book rather than market value of their bond assets. So the bonds that the market values at $1,000 are suddenly worth $1,400 to the Fed. Is this a bail out? Is this a necessary bail out? If you believe that every small bank in the US was in a similar position, then perhaps this backstop was necessary to prevent a massive run on banks that might spread and destroy the world’s financial system. That is not my view, but no one thought to ask me.

Whatever the utility of bank bail outs, this is getting old. Twice in fifteen years the actions of the Wall Street idiot savants have threatened to destroy the world financial system. Here is a graphic showing the bank failures in the United States since the year 2000.

Does it seem to you, as it does to me, that this is rather a lot of bank failures and perhaps there need to be some structural changes so that I don’t have to suffer through more seasons of financial hubris, greed and stupidity? Would you agree that no one learns anything when the system is rigged to privatize the gains but socialize the losses of these criminals?

I don’t remember anyone rushing in to buy the apartment at my book value rather than the market value (fifty percent of the book value), so why are Silicon Valley corporations (the depositors), many of whose shareholders are from nefarious parts of the world, being bailed out? I got spanked, why shouldn’t they get spanked? Fear of not being able to make a payroll? Why didn’t they buy more deposit insurance if they are such good stewards of their employee’s earnings? Besides, if I was able to recapture the time value of money that I have lost from missed paycheques, I wouldn’t need to lament the consequences of my poor investment timing.

Sorry, the banking system in the US is broken because it is gamed by corrupt and greedy oligarchs. Fortunately, the Canadian banking system is not broken by corruption so our financial boat will be rocked rather aggressively, but not to the point of capsizing. But people around the world are watching this nonsense.

Currently the US dollar is considered the “reserve currency of the international financial system”. That is an enormous benefit to the US Treasury, but it comes with obligations such as the one made famous by President Obama, “Don’t do stupid sh#t!” For the past thirty years the elite idiot savants (I love that term) have been allowed to “just about but not quite” destroy the US economy thereby inflicting untold collateral damage on the economies of other countries around the world. Like me, people in those countries are getting tired of this. And they are beginning to ask the awkward question,

“Do we really need to be stockpiling US dollars in order to defend our economy and currency? I wonder if we could get the same defensive support by buying… let’s see… gold? Or Chinese yuan? Or a basket of currencies managed by countries whose first letters spell BRICS?”

The US Federal Reserve has printed almost eight trillion dollars since 2008 (Quantitative Easing) and much of that money has been dutifully bought and stored in the treasuries of countries around the world. That is why inflation in the United States is less than a bajillion percent. What happens if those countries decide to sell off those US bonds? What happens if nobody wants to buy new US bonds? Can the Federal Reserve just print up more money? The proponents of Modern Monetary Theory think so and that is why they were surprised by the current inflation. I have written about this before (here) and mentioned a con artist (John Law) who resembles the current Prime Minister of a particular country. It is worth reviewing this stuff because time lines to a bigger financial mess are shortening.

The people who are watching the banking nonsense today are noticing the following.

• For the first time ever, a belligerent country (Russia) had its foreign reserves embargoed. This never happened to Germany during World War II.

• Russia’s economy is growing more than the economy of the United States because, among other things, Russia isolated itself from the US financial system.

• Russia can reach any city in Europe and the continental United States with hypersonic missiles tipped with conventional war heads. The United States does not have this technology. The Russian defense budget has generally been under $100 billion per year and the US defense budget has generally been $800 billion per year.

• Russia can produce and fire shells at more than six times the rate that the United States can produce and ship shells to Ukraine. Russia’s war capacity is internal, integrated and very large. The United States has a very limited capacity to produce war materiel and a much-diminished military.

• China and Saudi Arabia are buying and selling oil in Chinese currency and not US dollars. The American petrodollar was established to ensure that Saudi Arabia was protected by the US military in exchange for adequate oil supplies nominated in American currency. That was then, this is now apparently.

• China has made a peace proposal to end the Ukraine war. Ukraine is a key part of the Chinese Belt and Road initiative, and they want the war over. The US has sniffed at the peace proposal and rejected it without offering a proposal of its own.

• China, Iran and Saudi Arabia have signed a limited trade agreement. Saudi Arabia and Iran had been mortal enemies for over fifty years.

• Failed Swiss banks are sold under terms that have little relationship to what, yesterday, were the laws of the “international rules-based order”.

• The US has been accused of blowing up the Nord Stream pipelines. Sweden completed an investigation into the incident but refuses to make its findings public.

• The US military is focused on diversity and equity even as it can’t fill the emptying ranks of its military divisions. The world watched a Chinese balloon sail over the continental United States and then as the US shot it down with an advanced fighter jet and $500,000 missile. Bizarre doesn’t come close to describing that week of nuttiness.

Am I an ardent supporter of Russia and China over the US? Not even close. I just want a few more proofs of life from the US government. These examples are not exactly saying, “I am America, I am strong!”

I once visited a private zoo in Cairns, Australia and the owner demonstrated how fruit bats exist in balanced aggression. He threw an apple into the cage and the biggest bat immediately drove off the little bats to take the apple. The little bats all attacked the big bat while his mouth was clamped over the apple and when he tired of being bitten by them, he dropped the apple to attack the little bats again. This allowed a bunch of small bats to bite off chunks of the apple causing the big bat to grab the apple again and the cycle repeated. By the time the big bat got his apple to a safe corner, the little bats were full of apple, and he got to eat the core. I found it very instructive.

The United States must project strength or smaller countries will nibble away at its advantages. “Projecting strength” is a doctrinal policy that is not universally defined. The Biden White House defines strength differently than the Obama or Trump White Houses. I argue that Mr. Biden’s idea of strength is woefully inadequate if he wants more than the apple core. Countries around the world look at the United States today and see a nation weakened by its internal conflict and whose red lines can be safely ignored. Strong nations have strong currencies. Weak nations have banking crises and weakening currencies.

If I am right, then the best point of attack for the “small bats” will be against the US reserve currency status. Once that is gone, the world will be multipolar again. Is a multipolar world inherently stable? Sadly no. Worse, for this sad story, is that the historical record for keeping reserve currency status is not good.

But what does loss of reserve currency status look like? It would mean that the vast reservoir of US dollars in the treasuries of other countries would diminish along with a desire to buy US dollar-denominated debt. All of those dollars and that debt will come back to the US banking system creating high inflation and financial weakness. American government budgets would either be balanced, or inflation would burn uncontrollably. With a balanced budget, the Washington bureaucracy would have to shrink, and the US military would have to finally account for its expenditures. The US would no longer be the world’s policeman and gone would be its penchant for starting stupid, endless wars around the world.

Is the American military and its underlying economy in imminent danger? I don’t think so. I am guessing that no other nation really wants to poke a stick at the US, but weakness is being smelled and topics that couldn’t have been broached even five years ago are now being discussed openly. That is a worrisome sign to me and I prefer not to speculate on the type of world we will have if the US loses its reserve currency status.

My hope is that the idiot savants get replaced by adults and the US returns to being the benign policeman that operates quietly, professionally, and mostly altruistically in a conflict prone world. I am tired of wealthy, dumb people doing stupid sh#t and making me cranky. I am reminded of something a famous person once said, “Do not be deceived. God will not be mocked.” Justice counts.