The Coming Global Currency Collapse

What happens when any Central Bank decides to inflate the supply of money in the economy? This is a relevant question in the present circumstance wherein various artificial refinancing operations are underway by a number of central banks. The Fed, ECB, BOJ are all on walking on a similar path in an attempt to kick start their economies. The US is the worlds largest economy with $15.69 trillion GDP. If the Economy of European Union is considered as one single bloc, then with a GDP of over $16.56 Trillion it would surpass the US economy by more than $ 850 Billion. Japan in spite of a decade long dismal economic performance is still the third largest economy of the world. Hence, when their Central banks embark upon such a monetary adventure, it becomes imperative to understand their short term and long term consequences on the broader global economy. So let us try and answer a basic question. Simple economics tells us that any money printing out of thin air, not representative of real output or actual ground fundamentals leads to Inflation. What happens when there is inflation? The Value of currency or the real value of money drops. This may be accompanied by a number of other problems. The bank interest rates would rise leading to lower spending by the public. This may eventually turn out to be a drag on the broader economy leading to lower growth rates. Even in terms of foreign trade, a country may end up running higher Current account deficits as the artificial money supply would not necessarily reflect higher economic output for exports. So the aim of all the current monetary easing is to spur growth. But this aim is being pursued by means which have a proven track record of derailing growth. So why are these central banks walking this path? Let us try and understand this for further. What is so special about the USD? The US Dollar is the Worlds Reserve Currency. So what does that really mean? In simple words it is the currency that many central banks keep as foreign reserves. In foreign exchange market USD is traded and used more than any other international currency. Till date USD accounts for more than 60% of all allocated reserves globally.

What advantage does US derive out of this? Well, for US, it becomes possible to borrow at lower rates as there will always be demand for USD as a forex reserve globally. Major part of current economic woes of America stem from this reserve currency status. The Subprime mortgage crisis caused an economic tsunami in 2008-09, but many economists believe that a greater threat to its economy stems from debt. The Current US debt is a little over $16.1 trillion in comparison to its GDP of $15.69 trillion. In an endeavor to understand this further, it become imperative to rewind and understand the currency market history better: In 1944, the Breton Woods system fixed the exchange rates based on USD. The Greenback was redeemable for gold at a fixed price of $35 per ounce. The US then held half of global Gold reserves equaling roughly 574 million ounces. As other nations led by Japan and Germany recovered in the post war era, their share of global output increased vis--vis US. By 1971, the US was running a Balance of Payment Deficit and had lost nearly half of its reserves. The exchange value of Gold vis--vis dollar was still the same. The US share of global economic output dropped from 35 to 27% in this period. The scenario reached such an extent that the USD to Gold exchange value was not reflective of the actual market reality. It became preferable for Central banks to exchange dollar for gold than to buy it in the open market. This led to the possibility of US having a potential run on its remaining gold reserves. On 13 Aug 1971, President Nixon abandoned the Breton wood system and suspended convertibility of USD into Gold. He made the USD a free float currency i.e. its value would be determined only on the basis of its demand and supply in the international currency market. Thus the USD was continued to be held in large amounts as preferred forex reserve by many central banks and the greenback continues to maintain its reserve currency status till date. This is one of the prime reasons quoted in support of Quantitative easing. So how much artificial money has been printed till date and to what extent can the current adventure shield the economy? Let us look at the monetary expansion carried out by Fed since 2008: QE1: Launched in Nov 2008, The US Fed bought $600 billion in MBS in less than 6 months . QE2: Launched in Nov 2010, Fed started buying $600 billion of Treasury Securities till second quarter of 2011. QE3: Fed begins purchase of $40 billion of MBS (QE3 includes $45 billion from operation Twist) totaling to $ 85 billion.

So from a conservative estimate so far more than $1.5 trillion of artificial money has been pumped into the economy, roughly equaling 10 percent of US GDP as on date. If we assume this to continue for another year, some $540 billion of excess liquidity would be added to this figure which could increase the percentage of artificial money to between 12.5 to 13% of GDP. If we look at the inflation during this period, it has been hovering around the 2% mark since Nov 2008. The mean inflation being since that period is 1.63% and the highest was 2.31% on April 2012. The Fed plans to continue with the Quantitative easing program as long as the inflation stays below 2.5% and the unemployment falls to 6.5% level. Let us also compare another measure. The Average US GDP growth since Q3 2008 has been 0.64 percent. The average inflation on the other hand is 1.63%. Let us do a relative comparison with India to objectively understand the graveness of the situation. The Average GDP growth since 2010 march has been 6.83% in comparison with inflation of 8.75% for the same period. The effective ratio of Inflation to growth has been 0.78.

In case of US, the same ratio is a meager 0.39, about half of India. When we consider the 13 percent odd artificial money, the inflation levels over a period of time could reach 15-16% levels, which could well be categorized a hyperinflation. What is more important to note is the Inflation to growth ratio then. The QE has inflation and unemployment target, but not a clear growth target. Moreover the QE has not shown any direct correlation with growth figures or unemployment data till date. The latest US jobs data indicated a meager 88,000 job additions as against an anticipated 2,00,000. So what happens with all this artificial money and how does it flow into the economy? The initial recipients of the Feds artificially printed money are the primary dealers. The primary dealers use this money to buy bonds which are ultimately purchased by the Fed. This leaves more liquidity at the hands of banks for them to lend to the public at large. Another advantage for the Fed is that, with initiatives like the Operation Twist, the Fed is able to sell shorter maturity bonds and simultaneously purchases longer maturity bonds, thereby increasing their overall repayment period. Now, what happens with this excess money at the hands of public? Excess money does not necessarily correlate to greater output. In the short run things may look rosy, but in the long run, unless effective output corresponds to the greater money supply (which is highly unlikely), hyperinflation is bound to set in. This may lead to even more painful recession or depression.

Some economists argue that QE would be monitored with other parameters like inflation. Also they quote that upon exceeding a set target the monetary easing would be stopped. It is also imperative to note that most of this artificial money ends up in stock markets than in real economy. Hence, a realistic assessment of its impact on the real economy hard to gauge. Also in a scenario where the existence of artificial money will be close to 13% of Gross Domestic product, the adverse consequences are bound to come in some or the other form. Either as Unemployment or Growth deceleration or as Inflation. One of the most recent cases of hyper Inflation and Depression was Zimbabwe. The country experienced inflation rates of 500%. They eventually abandoned their currency and till date have no declared currency. Often the currencies of other neighboring countries are used. The Irony of the current situation is that its not some Third world underdeveloped nation that is embarking on this adventure. But the list this time includes some of the most advanced economies like the US, UK, Japan and EU. Only time will tell if the tested economic principle would lead to the decline of their economies (and the global economy at large) or if they manage to survive this forthcoming tsunami and force economists to rewrite the basic principles of economics.