Energy, Currency, & Deglobalization, Part 1

The first in a two-part series on the changing world order, its impacts on the global economy, and the future of central bank monetary policy.

Aug 25, 2022

Today’s Bitcoin Magazine Pro Issue is the first in a two-part issue (which will be completed tomorrow) on the changing world order, its impacts on the global economy, and the future of central bank monetary policy. To conclude, we will elaborate on how bitcoin might tie into the world which we are transitioning towards.

These ideas piggyback upon the ideas and writings of Zoltan Pozsar and Luke Gromen.

Part One:

The world is at war. While at first this statement may sound hyperbolic, it has become increasingly obvious that the world is in the midst of an economic war that is at the risk of turning “hot.”

Before diving into the complex elements of global geopolitics, let’s first evaluate why as market participants it is even worth our time to analyze. The most important thing to understand as an investor (more broadly a global citizen at large) is that the previous three decades were a total anomaly in the span of global history.

Following the collapse of the Soviet Union, trade mobilized on a global scale unlike anything ever seen before, as the U.S. played peacemaker patrolling trade routes with their navy. This contributed to what many now refer to as The Great Moderation.

To quote Federal Reserve History,

What Caused the Great Moderation?

“Reducing inflation and establishing basic price stability laid the foundation for the Great Moderation. But, in looking for deeper reasons, economists have generally proposed three reasons: changes in the structure of the economy, good luck, and good policy.

“Changes in the structure of the economy can reduce volatility. For example, since manufacturing tends to be volatile, the shift that occurred from manufacturing to services would tend to reduce volatility. Another structural change would be the adoption of ‘just-in-time’ inventory practices, which reduces the volatility of the inventory cycle. Similarly, advances in information technology and communications may have allowed firms to produce more efficiently and monitor their production processes more effectively, thereby reducing volatility in production—and thus in real GDP. Deregulation of many industries may have contributed to the increasing flexibility of the economy and thereby allow the economy to adjust more smoothly to shocks of various kinds, thus leading to its greater stability. Finally, more open international trade and capital flows may have helped make the economy more stable.”

To summarize, one can broadly think of The Great Moderation as a synonym for globalization on a scale never seen before. Particularly, the disinflationary environment of the previous three decades allowed for real growth to persist, and for U.S. financial assets to go parabolic off the backs of low interest rate policy and seemingly never-ending quantitative easing programs post the Great Financial Crisis.

Ever-lower levels of inflation allowed for ever-lower discount rates, supporting ever higher levels of indebtedness and leading to ever-higher asset prices.

Year-over-year inflation rate in the United States and the 10-year Treasury yield are shown below to visualize this dynamic:

To quote Credit Suisse strategist Zoltan Pozsar’s latest dispatch,

“The low inflation world had three pillars: cheap immigrant labor keeping nominal wage growth ‘stagnant’ in the U.S., cheap Chinese goods raising real wages amid stagnant nominal wages, and cheap Russian natural gas fueling German industry and Europe more broadly. Implicit in this ‘trinity’ were two giant geo-strategic and geo-economic blocks: Niall Ferguson called the first one ‘Chimerica.’ I will call the other one ‘Eurussia.’

“Both unions were a ‘heavenly match’: the EU paid euros for cheap Russian gas, the U.S. paid U.S. dollars for cheap Chinese imports, and Russia and China dutifully recycled their earnings into G7 claims. All sides were entangled commercially as well as financially, and as the old wisdom goes, if we trade, everyone benefits and so we won’t fight. But like in any marriage, that’s true only if there is harmony. Harmony is built on trust, and occasional disagreements can only be resolved peacefully provided there is trust. But when trust is gone, everything is gone.”

There are a couple massive points made here that are absolutely vital for readers to understand. The first, is that the conditions which enabled the disinflationary world of the last three decades are violently changing. The second is that in the previous world order, the major exporters of the world, namely China and Russia would recycle their earnings back into G7 claims. Particularly, because of dollar-denominated oil trade that is key to the petrodollar system, nations would “recycle” their dollars back into U.S. Treasurys.

Treasury securities, which are merely claims on future dollars with an attached interest rate, allowed for nations to store their economic surplus. This system benefited sovereign stakeholders so long as dollars, and subsequently treasuries, held their purchasing power in real terms.

Let’s revisit how the USD became linked to the energy trade and earned the nickname the petrodollar in the first place.

In Alex Gladstein’s, Uncovering the Hidden Costs of the Petrodollar, he explained how it came to be:

“Nixon floated the dollar in order to pay for the cost of a war in which he ordered more than four million tons of explosives and incendiaries dropped on cities and villages across Indochina… the debt crisis was a direct result of the need to pay for the bombs, or, to be more precise, the vast military infrastructure needed to deliver them. This was what was causing such an enormous strain on U.S. gold reserves.
“For the first time in history, the world was in a pure fiat standard. The dollars held by central banks across the globe lost their backing, and there was a geopolitical moment where U.S. dominance was called into question and where a multipolar financial world was a distinct possibility. Adding even more pressure, in 1973 the Arab petroleum exporters of OPEC decided to quadruple the price of world oil and embargo the U.S. in response to its support for Israel during the Yom Kippur War. In just a few years, a barrel of oil rose from less than $2 to nearly $12. Faced with double-digit inflation and declining global faith in the dollar, Nixon and his Secretary of State and National Security Advisor Henry Kissinger came up with an idea that would allow them to keep ‘guns and butter’ going in the post-gold standard era and alter the fate of the world.
“In 1974, they sent new Treasury Secretary William Simon to Saudi Arabia ‘to find a way to persuade a hostile kingdom to finance America’s widening deficit with its newfound petrodollar wealth.’ Simply put, a petrodollar is a U.S. dollar paid to a petroleum exporter in exchange for oil. As a Bloomberg report says, the basic framework was ‘strikingly simple.’ The U.S. would ‘buy oil from Saudi Arabia and provide the kingdom military aid and equipment. In return, the Saudis would plow billions of their petrodollar revenue back into Treasurys and finance America’s spending.’ This was the moment that the U.S. dollar was officially married to oil.”

Transitioning back to the pillars of a globalized world, participation from Russia and China was obviously a must. However, following the Great Financial Crisis, it became clear that some of the key stakeholders began to make a fuss over U.S. hegemony, which was a necessity for the system to exist, and is a necessity for the system to persist.

In 2011, Russian Prime Minister Vladimir Putin said the following about the U.S. and the dollar in regards to its role as the global reserve currency:

“They are living beyond their means and shifting a part of the weight of their problems to the world economy …
“They are living like parasites off the global economy and their monopoly of the dollar.”

This can be assumed to be one of the dominant reasons Russia began to rid itself of dollar-denominated assets (and liabilities) throughout the 2010s.

Following the invasion of Ukraine in February, G7 nations announced the freezing of Russian Central Bank assets. Remember, sovereign debt is nothing other than a promise of future payment from another nation; a liability of your counterparty.

With this move, a clear precedent was set. In our February monthly report, we said the following.

“The move essentially told all sovereign nations, especially China, ‘Your foreign exchange reserves might not be yours if you make a wrong step.’”

As geopolitical tensions heat up between nations, lines are being drawn and alliances are being formed. To further quote Pozsar’s latest piece

“Wars are also about alliances. In today’s complex conflict between the U.S. on the one hand and Russia and China on the other, the world is best described by “the enemy of my enemy is my friend”: Russia and China hold naval exercises with Iran around the Strait of Hormuz; Iran has recently hosted talks between Russia and Turkey regarding grain shipments through the Bosporus Strait; not surprisingly, the first shipment sailed to the Syrian port of Tartus, which hosts a technical support point (not a base) of the Russian Navy; even more recently, Turkey and Russia agreed to clear bilateral trade flows, including gas, in rubles.
“In this complex web of geostrategic hotspots around the Eurasian landmass, the noose is tightening for the ‘friends of my enemy’: Ukraine is under attack; Taiwan was effectively subject to a weeklong sea and air blockade recently; and South Korea is being pressured by China to uphold the ‘Three Nos’ policy, the essence of which is to end all forms of military cooperation with the U.S., while at the same time North Korea says the peninsula is on the ‘brink of war’ – the checkmate like position that Seoul finds itself in is so hard to navigate that President Yoon didn’t meet Speaker Pelosi on her stop in South Korea and opted for theater instead (‘strategic ambiguity’; ‘Our commodities, your problem’ is branching into ‘chips from our backyard, your problem’ and might also branch into ‘our straits, your problem’: the U.S. threatening Turkey with secondary sanctions for financial cooperation with Russia should be understood in light of the inconvenient geographic fact that NATO’s access to the Black Sea goes through Turkey’s Bosporus Strait.”

While speculating on the potential for hot war to break out is no exciting task, it is clear for those paying attention that geopolitical tensions are continuing to heat up, and history tells us that conflicts are rarely anything but inflationary. Not only due to the protectionist trade policies that nations take on, but also due to the supply and demand imbalance that a massive industrialization towards war requires.

“That’s why forecasts of a rapid deceleration of inflation are naively optimistic: if Pax Americana enabled globalization and globalization underwrote lowflation, the TRICKs (Turkey, Russia, Iran, China, and North Korea) trying to poke holes in the Pax means that inflation is a big risk. To understand the path of inflation from here, we will have to read more history and think about trust, trade, and Dale Copeland’s theory of trade expectations: if trust drove globalization, and globalization drove ‘The Great Moderation,’ distrust will drive de -globalization, and de -globalization ‘The Great Reflation’

“First, how do you wage wars on multiple fronts when a single front in Ukraine showed how quickly stockpiles can deplete in a war of attrition, and how slow the replacement is.”

We have already witnessed the devastating effects of the economic war being played by Putin’s Russia in a mere six months. As Russia has shut down its natural gas pipelines into Germany, Europe has been rocked to its core.

Germany, which we referred to earlier as one of the drivers of the globalization trend, with particular reliance on Russia, has seen its manufacturing sector collapse as a result of skyrocketing energy prices. Germany Producer Price (PPI) year-over-year is now at an astronomical 37.2%.

This has caused the trade balance of Germany, dubbed “The Powerhouse of Europe,” the fall below zero, meaning that Germany has become a net importer of goods for the first time since 1990.

This has sent Europe’s trade balance into its largest deficit in recorded history, as the euro has collapsed below dollar parity.

If you recall at the beginning of this piece, we referred to the conditions that gave way to The Great Moderation.

“Reducing inflation and establishing basic price stability laid the foundation for the Great Moderation.”

Similar to how excessive leverage in the financial system around mortgage-backed securities in 2008 nearly caused the global economy to implode, we are now seeing a similar dynamic play out today; however instead of financial leverage, we are dealing with the world’s “just-in-time” supply chains, a previously highlighted pillar of The Great Moderation (otherwise known as globalization).

“…Another structural change would be the adoption of ‘just-in-time’ inventory practices, which reduces the volatility of the inventory cycle.” - The Great Moderation

However, the illusion of stability and lack of volatility that these practices gave the world are coming back to rear their head.

Quoting Zoltan,

“Inventory for supply chains is what liquidity is for banks. In 2007-08, big banks ran on ‘just-in-time’ liquidity: the dominant form of liquidity was market liquidity, for which you could always sell assets into a deep market without moving prices, so you did not have to have liquidity reserves at the central bank. Similarly, big corporations today run ‘just-in-time’ supply chains for which they assume that they can always source what they need without moving the price.
“…Minsky moments (a sudden, major collapse of asset values) are triggered by excessive financial leverage, and in the context of supply chains, leverage means excessive operating leverage: in Germany, $2 trillion of value added depends on $20 billion of gas from Russia… that’s 100x leverage - more than Lehman’s.”

As shown in the chart below, just $27 billion worth of Russian natural gas exports served as an input for approximately $2 trillion worth of German manufacturing production:

Source

Energy, Currency, & Deglobalization, Part 1

The first in a two-part series on the changing world order, its impacts on the global economy, and the future of central bank monetary policy.

Not financial advice.

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