The Three Phases of Dollar Collapse

I’m continually struck by how surprised and delighted everyone seems to be about the nominal gains in asset prices we’ve all experienced since March 2020. Even Bitcoiners (Anthony Pompliano is one in particular that I can recall offhand) continue to show amazement that the S&P 500 continues to print fresh all time highs month after month. Talk of “the mother of all bubbles” is everywhere in the value investing community. I think, while technically correct, this misses the point entirely. We’re currently in phase 2 of a three phase currency collapse and this “bubble” is expected. The mean reversion, the correction, will not come in the form of a stock market fire sale — and people who do not realise this are going to be crushed.

All of the same usual suspects (folks like Peter Schiff who have been short in the market ever since 2008) cry out about the imminent fall of the sky and continue to bleat on the regular about how it’ll all come crashing down to reality. I used to follow this cohort of folks pretty closely in the years after 2008. Coming to age and just starting to “save” for retirement around that time, I was extremely cautious. Surely the destruction was imminent, best to be very conservative in the market and have cash ready to gobble up the wreckage when it occurs.

Alas, it took me a long time to figure out that this was a terrible, ideology-driven investing strategy. I missed out on a decent amount of appreciation during the early to mid 2010s. Realising the Fed has been artificially manipulating things doesn’t mean you have to fight them for ideological reasons. Doing so is a path to the poor house, doubly so as we go forward in the collapsing paradigm. So thanks for that, Peter Schiff & Co. lol

No, what we have today, in my opinion, is very clearly a currency problem rather than a valuation problem. Schiff & Co.’s position is rather like that of the stone age humans who observed that every time they sacrifice a young person, the sun rises. Yes, assets are valued at crazy multiples to earnings (or based on future expected earnings) — IF your denominator is sound.

And so with that let’s briefly dive into what I, a complete amateur observer, consider to be the playing out of the death of the fiat currency regime — with three distinct phases.

Phase One — Destruction Averted

Let’s time travel back to 2006. I am a young, impressionable lad, curious about the world. And as a curious young lad, what better way to start my day than opening the newspaper (because they were still only analogue, physical items in those days).

I would read the front page (above and below the fold!) and then flick to the sports section to read up on all that had happened the previous day. Interestingly, our paper usually placed the classifieds at the end of the sports section (probably because they knew everyone like me would end their newspaper adventure in this section). I began to take note at the time that the house and real estate listings were starting to creep up well above what my family had paid for our house just a few years earlier.

And they just kept going up. What would have been a $300,000 house in 2002 was now a $550,000 house in 2006. By the peak in 2007, you could easily sell that same house for about $750,000. And at the time, I remember discussing these things with my parents over breakfast. “This is insane, these people haven’t improved their properties enough to justify these prices, right?” I would say. “Well, perhaps the land is in greater demand. After all, everyone wants to move here these days and we were lucky to get in first,” my parents would reply.

And to be fair, that’s a reasonable assumption to make absent the facts. However, I continued to hold the sneaking suspicion that something was wrong. What I now know, but didn’t at the time, is that an incredible bubble had formed in real estate in the mid 2000s thanks to a combination of factors, mostly stemming from various government policies at the time. The goal of home ownership for most Americans is a noble one, but the road to hell is often paved with good intentions. Sometimes the road isn’t paved at all and your leaders insist a road exists when clearly it doesn’t.

I won’t go into detail here as there are many analyses out there that do a far better job than I could ever do of explaining the facts and structural components of the housing market collapse and 2008 recession. What we will discuss is how this time was different.

The Fed, traditionally, has a few mandates. Stable prices and stable employment through the manipulation of the money supply are the big ones (interestingly, the 1913 charter for the Fed is absent anything about a constant rate of inflation. Funny that).

It is not an exaggeration to say that had the Fed and Congress not done what they had done through extraordinary intervention in the form of TARP (the “Troubled Asset Relief Program”), Quantitative Easing (QE), and other such programs, the international banking system would have collapsed. With how interconnected everything is in trade and finance, this would have been economic nuclear winter. Where the debate lies, I believe, is whether staving off the pain of 2008 was worth the future pain we are headed towards.

And thus, we get Phase One of the collapse — the initial crisis and the response in the years that followed. Phase One, for me, lasts from 2008 to 2020. This period of time is characterised by policies that essentially kept the world economy floating above a thin line of destruction. Think of a person that is treading water above the Marianas Trench. Eventually, they get tired and begin to lose the ability to keep their head above water. In comes the Fed and Congress with inflatable water wings for this poor person to use to remain afloat. It works for a time, but these do not retain the air needed for buoyancy and the person is forever shadowed with the threat of drowning should the Fed and Congress not continue to push fresh air into the water wings.

It’s certainly not a perfect analogy in terms of a 1:1 comparison, but you get the idea. When the Fed started to taper off in 2014, culminating in the beginning of an actual unwinding of their balance sheet in late 2017, the market couldn’t manage to float on its own. The Fed was essentially deliberately removing air from the water wings keeping everything afloat. While the “correct” thing to do from a traditional macroeconomic perspective, it completely disregards the fact that the Marianas Trench (i.e. global banking system collapse) was always still lurking beneath the surface. The end of unwinding the Fed’s balance sheet isn’t solvency, it’s destruction. There was never a way for us to escape the cleansing fire of the collapse, it had just been put off. And meanwhile, more and more things begin to start draining the life-saving air in the flotation devices.

Phase Two — Currency Debasement

When Phase Two began is to me an open question. It sort of begins in September 2019, but definitely had transpired by March 2020. We are definitely in it now and it may last a while before we get to Phase Three.

When macro economists say that QE isn’t really money printing, they are generally correct despite what Peter Schiff thinks. The money created through QE is mostly locked up within the rails of the banking system and hardly ever makes it out into the dollars and cents retail economy in the amounts printed. Where this money shows up though is in the investment baking space. In my opinion, it’s no coincidence that the emergence of QE coincides with the explosion of useless “snapchat, but for dogs” tech startups that seemed to be able to raised hundreds of millions of dollars in series A investing rounds. Where the “inflation” of this money creation showed up was in cheap money for investment purposes. As Preston Pysh constantly points out, the money multiplier is fucked up.

That’s why we’ve seen stock appreciation through aggressive buy-backs rather than through reinvestment of profits within firms. It makes more financial sense for a firm to raise capital through cheap debt, buy back their stock shares (thereby making the shares more scarce and raising their nominal value) than it does for them to generate a profit on sales and re-invest in the business or distribute as dividends. Investors prefer this model as long term capital gains in the United States are taxed at a lower rate than dividends are. It’s just a matter of incentives rather than evil intent.

And these low interest rates? They’re necessary for the continued pumping of air into the water wings keeping all of us afloat over the Marianas Trench. And we haven’t even gotten into the monetising of the debt by the Fed and the Treasury through the manipulation of U.S. government bonds. It’s complicated stuff, which is why I am trying to paint broad pictures.

Enter the repo madness that transpired in September 2019. I don’t want to get into too much detail because I am both a lay person who only believes they have a partial understanding of what happened and why and because it is confusing and complicated. Essentially, here’s what occurred.

Banks have to settle balances with each other. All of the economic activity that happens on a massive scale means that balances in some accounts go up and some accounts go down. This happens within banks (a spreadsheet entry adjustment, basically) and between banks (think an actual physical transfer of a pallet of dollars from one bank to another for simplicity). Intrabank just requires an adjustment of the accounting as the total number of dollars the bank has under management hasn’t changed. Interbank on the other hand is a little more complicated.

In order to settle money, banks need to have the liquidity to make these transactions (i.e., if you owe $2,000 on your next credit card bill, but only have $1,500 in the bank, you do not have enough liquid assets to settle the transaction that needs to take place). Basically, the system that is used to settle these interbank transactions each day involves the banks lending cash to one another overnight to cover any liquidity differences needed to make these payments. If Bank A has $10 of cash and owes $5 of payments to Bank C, they can lend $5 to Bank B so that Bank B can make $5 of payment to Bank D. Bank A takes $5 of US short term treasuries as collateral (which they can earn some interest on) for the overnight loan as security. At the end of the term, Bank B pays back Bank A the $5 they borrowed and they receive their treasuries back. This isn’t a super accurate model, but it should give the average person an idea of how this stuff works.

Suppose then that Bank A suddenly believes that Bank B is at risk of defaulting (i.e. not paying them back on time). Bank A would demand a lot more interest on the loan to account for the extra risk. That’s what started to happen in late 2019, some bank(s) (and we don’t know which one(s) because this information is not public) didn’t trust other banks to have the money to pay them back the next day. The overnight interest rate spiked as a result of this.

The Fed stepped in and created a temporary overnight lending facility to provide the liquidity needed to keep the system flowing at the “normal” overnight rates. More and more banks utilised this facility as time went on and the amount of cash the Fed was injecting increased.

Long story short, around September 2019, the banks all started to not trust each other’s creditworthiness. Normally, this isn’t a great sign. To bring this back to our water wings analogy, think of it like this. As the Fed raised rates and began to unwind their balance sheet (which, in theory, was the right thing to do to bring the economy back to an equilibrium of normality), the air began to escape from the flotation devices. In my opinion, this is the source of the repo problems in 2019 — it was our hapless person beginning to dip their head below the waters of the Pacific.

So it was that the Fed abandoned their policy of removing air from the water wings to help teach the person to swim again, instead opting to blow air back in. And unfortunately, for a variety of reasons, the amount and quality of the air deteriorates the more this strategy is used, and thus even more air is needed.

And then Covid-19 hit.

The Fed stepped in ten-fold beyond the relief they brought in 2008. The Fed immediately pledged extraordinary amounts of liquidity (i.e. more cash reserves and providing exit liquidity to the treasury market, and even to some corporate debt and asset markets). Money was printed on a scale never before seen in modern finance. Congress passed relief on a scale that would, even just a few years ago, not have been believed was politically possible. A total collapse of the system was averted. However…

Money printing in the absence of productive activities is not real growth. It’s just money printing. And money printing into the general economy causes inflation. Here’s essentially what’s happening — Congress and the Fed have been providing liquidity and cash to people. People are being paid for work that isn’t being done (i.e. a collapse in productivity) while the Fed is making sure that when the cigar smoking monopoly men need to sell their junk bonds and US Treasuries, that there is buyer at a “normal” market price, i.e. preserving the value of the bonds. Further, in order for the government to actually spend the money that’s been legislated to be spent, the Treasury Department has to issue new US Treasuries into the market (i.e. debt), a market in which people are not willing to purchase these things. So the Fed buys them with printed money and puts them on their balance sheet (i.e. directly monetising the debt).

It’s slightly more complicated than I’ve laid it out above, but again, I am trying to paint a general picture so that people can follow along. The long and short of it is that this activity described above is basically replacing the lost productivity of the market. Where we would be seeing businesses close and banks collapse absent any of this activity, we are now seeing the US government pull the productive capacity of the future into the present by directly monetising the debt. The Federal debt to GDP ratio for the United States crossed 130% in this time, and remains above this level as of the time of writing (i.e. the Federal government owes 1.3 times the entire productive capacity of the entire United States over a calendar year denominated in US Dollars).

So we have this engine of massive money printing keeping the economy afloat now. Real, honest to god money printing, not just QE accounting tricks. And it is having exactly the effect traditional economics tells us it will have.

Your signal in all the noise is that the US stock market (we’ll say the S&P 500 for simplicity) has been on an upward tear since the Fed stepped in during March 2020 to provide liquidity. The debasement of your currency, the US Dollar, began in earnest.

The signs are everywhere. Raw materials prices are up and continue to climb. Food prices are up. Fuel and energy prices are up. Wages are finally up. Shipping costs are up. Everything is up. Companies are having to raise their prices in order to maintain margin as they are being squeezed both by rising wages and the rising prices of their suppliers.

This is a result of the money printing, make no mistake. We have way too much historical data on how this phenomenon occurs to say otherwise, and the MMTers of the world who try and argue this point have laughably little real evidence to suggest there is no link (never mind the tacit admission by the MMT school that inflation is real by their need to use taxes to remove money from circulation).

And so we now have a vicious cycle. The interest payments on the debt continue to grow. The government needs to keep printing more money to keep the economy from collapsing. This leads to more inflation, which leads to more economic hardship, which necessitates more printing. Historically, the 130% debt to GDP ratio has been an event horizon on the edge of a hyperinflation black hole that only one nation has escaped: Japan. There are many theories on why Japan has not succumbed to this (yet), but in my opinion, it’s likely to do with the fact the United States Dollar exists.

We find ourselves in an environment where, in my humble opinion, the nominal gains of the stock market are just that, nominal. If you get creative and use a different denominator than USD to measure growth (such as BTC or a metric related to M2 money supply growth), it’s been a disaster. And this is where the Peter Schiffs and the other “Mother of All Bubbles” people just don’t get it. They are correct when they asses that the market is overvalued — if you look at it through the models and paradigms of the unit of account being reliable. In reality, the stock market will continue to go up in nominal terms from here on out. Any dip is going to be backstopped by the Fed and people will continue to use it as a way to hedge against wider inflation. Nominal gains are here to stay and good luck to those who are in cash or short in nominal terms.

This can only go on for a time. I’m not sure how long, it could be a year or two, it could be a decade or two, but the math is clear (as Greg Foss likes to say). The inevitable is coming. We have three options — phenomenal economic growth the likes of which the world has never seen, hyperinflation to reset the debt to GDP ratio, or just straight up debt default (in which the United States simply does not pay what it owes).

Let’s explore the horror of Phase Three.

Phase Three — Annihilation

Let’s be honest, phenomenal economic growth that increases tax receipts to pay down the debt isn’t possible. Austerity to decrease government spending is not possible. The math is clear, we will not escape the event horizon by “normal” means.

This leaves two options, and neither are good. In fact, putting on my hat as a historian, these two options are terrifying. I won’t mince words, people need to steel themselves for what may come to pass. Liberalism and prosperity are aberrations in the long 150,000 year history of our species. No one is entitled to a comfortable existence and no amount of individual positive thinking and proactive political campaigning and action would have saved the average Polish citizen born in 1910 from a lifetime of war, despair, and dystopian misery. I don’t want to be defeatist and negative (a doomer if you will) — but at the same time, I think harsh times are ahead.

So let’s dive in to what may come to pass as we transition from debasement to annihilation of the US Dollar.

I want to rule out a straight up default of the debt. There is no conceivable reality where those at the levers of power will allow for a default. The United States will pay what it owes,. This article would be really short if this is indeed the future we find ourselves in. It would simply state: “good luck, and god speed” because that is a world of unimaginable suffering.

No, what is going to happen is that the United States government is going to inflate the debt away by bringing the debt to GDP ratio back down to manageable levels. Whether this is done traditionally or in line with MMT principles is yet to be seen, but I sincerely believe this world is coming.

Here’s why you need to prepare. Any cash you have is going to be made slowly (and maybe even suddenly) worthless. Your assets are going to have envious eyes cast upon them by those who are not fortunate enough to be able to purchase them. The leaders they elect are going to be stuck between the math of what’s happening and their need to “do something” to placate the people experiencing the negative sides of inflation. Make no mistake, this is a fate they will neither deserve nor should be condemned to, but the vast majority of people do not understand how these things work at a basic level — they will elect people who will see you (the Bitcoiner) as a prime target for retribution.

Given the growing popularity of MMT, it is entirely possible it will become the major economic theory of state affairs in the near future. If this system were to be put into practice it would require very punitive taxation and financial surveillance. I think given the proposals we see circling around these days for account activity and balance reporting, unrealised capital gains taxation, etc. that we are very likely to see some of these come to pass. Will MMT and these measures be enough to hold inflation at bay? I do not think so, but that is just my personal opinion.

No, what’s likely to happen is a combination of terrible inflation and the enactment of tyrannical and oppressive laws to combat all of the resulting social problems from this cycle playing out. One need only look at history to see some of the terrible conclusions from these types of cycles. Either decades of tyranny, war, or oppression.

Which leads to the death of the US Dollar. As faith in it crumbles internationally, the main geopolitical export of the United States, their currency and defense capabilities, will have much less demand.

As I’m sure most of us know, Bitcoin allows for an escape and I sincerely hope it becomes seen as a viable option for those in power to oversee a managed destruction of current iteration of the US Dollar. That we will see Bitcoin take some sort of central role in a new system that allows everyone to carefully and safely transition. I am skeptical the odds are in our favour, but it is certainly possible (and preferable).

So, at the end of the day, the most likely best case scenario to happen is that the United States will pay what it owes with dollars that are significantly worth less than when the obligations were made. Bond holders, whoever they may be at this point, will be some of the biggest losers. And so we’ll return to a more “normal” debt to GDP ratio via inflation as $20 trillion+ suddenly doesn’t look like that big of a mountain anymore. Average salaries might creep well north of six figures. Houses will costs millions of dollars across the country and be considered “affordable.”

There also exists the possibility that, like a flywheel with incredible amounts of momentum, we will see the US Dollar go from high inflation into uncontrollable hyperinflation. It will all depend on the global public’s confidence in the US Dollar. If we see more and more people, companies, and nations move away from the US Dollar and USD debt, we will probably see waning systemic confidence in the dollar and the United States. It’s a scary world for anyone who has significant wealth, especially in cash, in any jurisdiction in that present orbit. Time will tell, but one thing is clear — we’re headed for the annihilation of the present fiat system and a new “US Dollar”. Are you ready?