THE DEATH OF FIAT / MACLEOD FINANCE

The death of fiat

Fiat will die considerably quicker than anyone thinks. It is oil which will kill them off this time, starting with Japan’s yen.

ALASDAIR MACLEOD

All fiat currencies end either by going back onto a metallic exchange standard or they simply die. 

The reason they die is loss of their users’ faith in their value, which always comes about through abuse. 

From Roman times to the current day, the abuse was by metallic debasement. 

Coins are now no more than tokens. 

The more topical abuse today is in the management of the currency by central banks, coupled with excess government spending over revenues.

In modern accounting, it is the accumulation of government debt which finally breaks a currency. 

We can begin to see this today in all G7 nations, whose currencies are the US dollar, the Canadian dollar, the euro, yen, and pound. 

The most critical debt situation is in Japan’s yen where the government’s debt is 240% of GDP, of which about half is owned by the Bank of Japan through quantitative easing.

When the issuer of a currency buys in its government’s debt obligations it amounts to naked currency debasement.

The reasons for Japan’s debts need not detain us, other than to say they are still increasing. 

The question arises as to whether it can continue to be financed. 

Underlying this question is a mathematical certainty: If the economy grows faster than the debt, the level of debt to GDP declines. 

If it does not, then debt to GDP increases. 

Japan’s debt to GDP has declined from about 260% because of this changing relationship, despite the increase in debt.

Japan now faces an unexpected problem as a result of the Middle East oil crisis. 

90% of her oil and LNG supplies come from the region, and so far the US has replaced them from her own strategic reserves. 

These reserves are now running dry, which is why oil prices are beginning to increase again. 

The chart below is of WTI over the last week:

The indications are that Hormuz and the Bab el-Mandab straits will remain closed indeterminately. 

When they eventually reopen, it will take considerable time for flows to return to normal for technical and logistic reasons. 

And now that the US cannot suppress prices by releasing strategic reserves to make up for Middle Eastern supply disruptions, the oil price will almost certainly move significantly higher.

Consequently, Japan’s business activities will face higher input prices, which are bound to impact both GDP and consumer prices. 

The last time this happened to Japan was in the mid-seventies. 

In his paper titled “Great Inflation and Central Bank Independence in Japan”, Professor Ito of the University of Tokyo wrote in his abstract,

“Japan suffered a very high inflation rate in 1973-74. 

The CPI inflation rate rose to near 30% in 1974, the highest rate in the postwar Japanese history after the chaotic hyperinflation following the end of the Second World War. 

Traditionally, the oil crisis is blamed for the 1973-74 high inflation. 

However, due to monetary policy mistakes in 1972-73, the inflation rate had already exceeded 10% before the onset of the oil crisis in October 1973.”

Elsewhere in his paper, Professor Ito reported wholesale price inflation at nearly 35% by spring 1974. 

Repeat: wholesale price inflation 35% and consumer price inflation 30%.

At the time, Japan’s debt to GDP was only 20%. 

Two points arise. 

Wholesale prices will rise considerably with today’s oil crisis, and how much they are passed on to consumers will depend on the second point, the Bank of Japan’s interest rate policy.

There can be little doubt that in 1972—73 when deposit rates had fallen from 6.25% to 4.25% interest rates were too low. 

As the OPEC crisis unfolded, the BOJ raised the discount rate to 9% in February 1974 where they stayed for the rest of the year. 

But that was still considerably less than the inflationary impact of the OPEC crisis.

Today, we commence with the Bank of Japan’s (BOJ) interest rate suppressed at 1%, with rumours that they might increase it to a paltry 1.5%. 

Clearly, this is far too low in the context of Japan’s mounting energy crisis. 

Markets are already sensing this with the 10-year JGB yield having risen to 2.85% from 1.55% in the last 12 months. 

But if the BOJ raises rates to discount the potential inflationary impact, it will crash the economy, raising the debt to GDP metric potentially to over 300%.

Alternatively, if it continues to supress interest rates as it did in 1973. 

The currency then crashes and consumer price inflation soars to similar levels as in 1974 or even more. 

The best guess is that with political anathma to higher interest rates, the BOJ will continue to suppress rates at the expense of the currency.

Commentary that Japan’s mounting crisis will disrupt the carry trade, upon which the US Treasury is increasingly dependent for its financing seems wide of the mark. 

As Japan’s problems become more apparent in the coming weeks, the carry trade will profit less perhaps from interest rate differentials but considerably more from a weakening yen.

Therefore, the immediate problem appears to be Japan. 

But the other G7 members face debt traps of their own and however it all plays out, bond yields will soar popping financial bubbles everywhere.

Get out of credit. 

While it has any value it won’t be too late!