Size Matters

The primacy of any Empire is dependent on the absolute size of its economy and the global acceptance of its currency as storehouse of value.  The US has matched both criteria and become the undisputed leader of the world since the end of WWI and even more so since WWII.  Nazi Germany, Imperial Japan and the USSR foolishly tried to challenge America and have been regretting it ever since. Tellingly, none of them had the economic or monetary muscle to compare with the American giant.

It took five years of disastrous war and two nuclear bombs to destroy the Axis, while the USSR caved in when its military spending rose so much as a percentage of its weak economy that it could not provide its people with even basic necessities.  But, times change..

Today, the world's oldest empire is rising once again to reclaim its premier position.  Within a very short time China's economy has grown tenfold in relative terms, from 7% to 70% of US GDP (Chart 1).  In just 10 years, from 2005 to 2015, the rise was an astonishing 40 percentage points from 20% to 60%.  China is now on track to surpass the US as the world's largest economy within  a few more years.

Chart 1

This leaves China to fulfill the next criterion for supremacy - global acceptance of the yuan.  This is trickier, since the US dollar is still very much the world's single reference currency and Treasury bonds enjoy universal acceptance as the safest investment possible. The reasons go beyond the absolute size of the American economy;  for example, the dollar's link to crude oil transactions, particularly Saudi crude exports, is well established. In addition, the strong social and political ties of the US with its Western allies, the common cultural background and the common history, all create a strong foundation of trust, which is absolutely essential for the dollar's acceptance.

But, all good things eventually come to an end.  Let's look at the yuan a little closer.  Its value is tightly controlled by the Chinese government, though less so as time passes (Chart 2).  As the Chinese economy becomes ever larger and further exposed to global competition, the yuan will, by necessity, become freely tradable in the global FX market - it's only a matter of time.

Chart 2

The US has been trying to swim against the tide, attempting to maintain its relative position in the world by imposing all sorts of import tariffs, restrictions and outright sanctions. Donald Trump, in particular, used a very heavy populist hand, playing to his nativist audience, but early indications are that the Biden administration is not backing off either - at least in substance, if not in public rhetoric.

Which brings us to the real substance of the matter: money and debt. Faced with the COVID crisis the US has issued trillions in new debt to finance sending "free" money to every American. Almost in its entirety, this debt has been purchased by the Fed, i.e. the central bank has "printed" trillions of new dollars which flooded the system and expanded money supply in unprecedented fashion (see previous post). All other things equal, higher debt and increased money supply should weaken the position of the dollar.  However, given that the ECB is doing much the same thing in the EU, the relative value of the dollar against the euro has remained the same.  

But what about China?  Tellingly, ever since the COVID crisis the dollar has lost 10.4% against the yuan (Chart 2). China dealt with the pandemic immediately and decisively, allowing it to resume robust economic activity within just a few months.  By contrast, the US is still 100% dependent on even more debt and money printing (Mr. Biden is about to make things much worse with his $1.9 trillion plan), further weakening the dollar's present and future prospects as global reserve currency. As if all this was not enough, the money has gone to create a massive stockmarket speculative bubble which, when it bursts, will cause massive economic pain in the real economy.

Drawing a parallel to the USSR's sudden collapse, the US is "asking for it".  Despite loud and clear  warnings from experts such as Summers, Dalio and Grantham, Fed officials think everything is ok because inflation is still low, while the Treasury is lulled by the presently low cost of annual debt service for its gargantuan debt.

But...and there are two very big buts.. global inflation and interest rates can come roaring back, no matter what the Fed/ECB and Treasury do - with their heads in the sand, they are both in denial.  And what will China do at that point? Will it play possum, or will it make a play for global dominance? 

The US (and the EU, secondarily) need to act proactively.  The Fed has to start acting like a real independent central bank whose main function is to protect the nation's currency, and the Treasury has to start acting in a fiscally responsible manner. To wit: stop printing money and start raising taxes.

Otherwise, as Mr. Biden just said, China will eat our lunch.