‘It is not speed that kills, it is the sudden stop’
This quote from a paper on currency crises by economist Rudiger Dornbusch came to mind last week as the price of silver having climbed over 100% in a month, collapsed by 30% in an afternoon. The sudden stop in silver is emblematic of many of the problems with financial markets, but also strikes a chord with some of the deeper changes materialising within the world economy, such as the rising quantum of debt, and recent attacks on Jerome Powell.
As we noted in ‘Grasshopper’, silver used to be a money, though the propensity of some users to mix it with inferior metal lead Sir Thomas Gresham to coin Gresham’s law that ‘bad money drives out the good’. In bulk form, silver and more so gold, was good enough to be a money, and to back up the paper money system until 1971 when the gold standard came to an end (one could present dollars to a bank and demand gold in return).
Without the backing of gold, the reasons people held and used paper (fiat money) were determined largely by important intangible factors – such as the rule of law, policy credibility, quality of institutions, as well as the economic usage of that paper – did central banks hold it as a reserve currency, is it widely traded and are financial institutions happy to use it? On most of these criteria, investors, businesses and central banks avoid China’s renminbi, but for the same reasons have been very happy to use the dollar, and to a lesser extent the euro. But, that might be changing.
First of all, as globalization crumbles, there is a rise in distrust, notably in the dollar. There are two facets to this.
In my notes, I have mentioned the work of Barry Eichengreen a number of times. He is the academic authority on currencies and in a paper entitled “Mars or Mercury? The Geopolitics of International Currency Choice” written with two economists at the ECB, he finds that military and geopolitical alliances are a significant factor in explaining currency strength. The rationale is that a country that is geopolitically well placed is engaged with and trusted by its allies through trade and finance.
Unsurprisingly one of the main implications of the “Mars or Mercury?” paper is that in a scenario where the United States withdraws from the world and becomes more isolationist, its strategic allies no longer become enthusiastic buyers of US financial assets and long-term interest rates in the United States could rise by up to 1 percent (there would be fewer buyers of American government debt), according to the paper. As such the many geopolitical events at the start of the year may now have triggered a move away from US assets.
A related move is that the institutions behind the dollar are also under attack, and from outside at least, look less sure. The mid-term elections and the way in which they are held, will be instructive.
The nomination of Kevin Warsh as the next head of the Federal Reserve is another important development. My instinct, unlike other economists is to put less store on his family background, and suspicions that he might not be independent, simply because any political bias or even more general lack of judgement, will be quickly punished by markets. I agree with stances he has taken in recent years, notably against the ongoing deployment of quantitative easing. The really interesting element of the Warsh Fed will be the partnership he forms with Scott Bessent, and I suspect that this ‘accord’ will focus on creating the means by which the financial sector (notably banks) becomes the driving engine of the economy.
There are other factors at work. China has been aggressively courting its emerging market trading partners to use the renminbi, and this is beginning to show up in currency flows (the renminbi has jumped from 2% to 4% of international trade driven transactions in the last two years, according to a research paper from the Fed). The big shift however is central banks, who for a variety of reasons, mostly geopolitical, have a newfound penchant to hold gold as a reserve, rather than Treasuries.
In this regard, buying by central banks has been the new development in the gold market in recent years, this has been surpassed by the side-effects of the financialisaton of gold and silver. To state it simply, the existence of exchange traded funds (with liquid options markets on these ETFs) has allowed retail investors, and institutions, to speculate on the price of gold. In the old days one had to buy it in barloads, and in Zurich at least, take the No. 13 tram to visit the gold, as we described in a note, Marmite .
The lashings of financial products that have been built around gold and silver have to a large extent transformed them from stores of value, into Frankenstein like speculative assets. The 30% collapse in the price of silver last week had many causes, but most of them can be traced to financial engineering. As such, this is a warning that, in a world with more US PE funds than McDonalds in the US and with more ETF’s than stocks, financialisaton can ultimately be highly damaging.
Another angle on this is bitcoin, a techno-financial response to the growing lack of trust in economies. Some commentators have described it as digital gold, but it looks to have failed the test of being a money and is most certainty not a safe asset. I regard it as a risk asset, in a small, narrow pantheon with art, penny stocks and racehorses. Indeed, its utility as an instrument to transfer money is also diminishing, in a world where stablecoins are more prevalent, and where fintech is getting better (and cheaper) at facilitating transactions. It might be next for a stress test.
Have a great week ahead, Mike
The Levelling 