In last week’s update, Blame the Fed for the Global Economic Slowdown, Not the Tariffs, I wrote about how the Federal Reserve’s monetary tightening caused the current global economic slowdown by reducing the amount of U.S. Dollars available for global trade. As the world’s reserve currency, global trade is conducted in dollars, and by removing dollars from the global economy the Fed is leading the world into the next recession. The amount of dollars available for global trade is referred to as World Dollar Liquidity and it is up to the Fed to ensure there are enough dollars in the global economy to facilitate trade.
When there is an insufficient amount of dollars for global trade, the global economy is forced to contract until it reaches equilibrium with the number of dollars available. In a debt-based global economy, World Dollar Liquidity needs to continuously grow so the global economy can expand to ensure there is enough money to pay on all the dollar-denominated debts.
When the Fed began their monetary tightening cycle they believed that the global economy would be able to create enough dollars on its own without the support of the Fed. To keep the global economy running, World Dollar Liquidity needs to grow by approximately twenty-four percent per year. In 2016, World Dollar Liquidity contracted which nearly led to a global recession.
Fortunately for the global economy, China dumped a large amount of U.S. Dollar reserves into the global economy in 2016, which is no longer has. Even though World Dollar Liquidity grew, it contracted again in 2018 where it has remained in contraction since. A great deal of hope has been placed on a U.S.-China trade deal, but a trade deal will not rescue the global economy from the Fed.
Tariffs raise the price of goods and services, leaving consumers with less discretionary money to spend. Even if the tariffs were removed, there is not enough new spending that can occur to jump start World Dollar Liquidity along with the global economy. Removing the tariffs would help since foreign countries recycle their excess dollars accumulated through trade into U.S. Treasury bonds, which would increase World Dollar Liquidity.
Another source of the global economic slowdown is the Tax Cuts and Jobs Act of 2017, which lowered the tax rate of U.S. corporations to encourage the repatriation of their offshore dollars. By bringing dollars home, the tax cut has reduced World Dollar Liquidity. To help reignite the global economy by increasing World Dollar Liquidity, Congress would need to raise the corporate tax rate to encourage U.S. corporations to keep their profits offshore.
Removing tariffs and repealing the corporate tax cut would not be enough to turn the global economy around. The problem began with the Fed tightening monetary policy and the problem will not go away until the Fed resumes easing monetary policy. When the Fed does start a full-blown monetary easing cycle, it will cause a massive global recession.
As strange as it sounds, in order to fix World Dollar Liquidity and reignite the global economy, the Fed will first cause a global recession. Should the Fed continue to delay starting an easing cycle, which they appear to have already started, the global economy will continue to contract until it enters a recession. Either way, the global economy is on a path to a recession.
The Fed admits there are monetary lags, which is how long it takes the real economy to feel the effects of changes to monetary policy. Despite admitting the lags exist, the Fed does not appear to put any effort into determining how long those lags are. Based on the research and opinions of multiple experts, the monetary lag is approximately eighteen months.
Based on an eighteen-month lag, the real economy is still feeling the effects of when the Fed was engaged in $30 billion per month of Quantitative Tightening and it has more tightening to come over the next twelve months. When the Fed tightens monetary policy, long-term interest rates, and demand fall due to fewer dollars in the global economy. When the Fed starts to ease, they buy U.S. Treasury securities to lower the Federal Funds Rate before restarting Quantitative Easing, which is an outright purchase of U.S. Treasury and Mortgage-Backed Securities.
The Fed forces the economy into a recession by easing while the economy is feeling the effects of the prior tightening cycle. When the Fed starts buying large amounts of U.S. Treasury and agency securities, they drive interest rates even lower. In a debt-based economy, lower interest rates mean financial conditions are tightening. By further tightening financial conditions during a period of tight financial conditions, the Fed shoves the broad economy into a recession. Once the Fed does that, the only solution is to increase the amount of easing until it overcomes the tightening from the prior cycle.
Unfortunately, most investors are mispositioned for the Fed to push the economy into a recession since they are conditioned to believe that a new easing cycle leads to higher stock prices. Instead of rising, stock prices enter a Bear market as investors dump stocks to chase bonds which enter a new Bull market courtesy of the Fed buying large amounts of Treasury securities.
While the Fed does not want to admit we are in a new easing cycle, the New York Fed has begun overnight repurchasing (repo) operations to provide dollar liquidity. Repo operations are typically overnight loans but can be upwards of sixty-five days in length. The New York Fed currently has a daily cap of $75 billion for their repo operations where twenty-four approved banks can bid and if won, post collateral in the form U.S. Treasury and Agency securities for the overnight loan.
It is important to understand this is not Quantitative Easing. Quantitative Easing is when the Fed purchases U.S. Treasury and Agency securities to hold for an undetermined amount of time. A repo operation is a short-term collateralized loan that must be repaid. When the New York Fed begins conducting repo operations, it is not a sign of a healthy global economy, as repo operations are the last line of defense against a recession. When repo operations are unable to provide enough dollar liquidity, the global economy will contract.
The reason a reduction or contraction World Dollar Liquidity leads to a recession is that it creates a shortage of dollars in a monetary system that is already short dollars. There is not enough currency in our financial system to pay every debt since every dollar lent into existence needs to be paid back with interest that does not exist in the global financial system. When there is a large amount of debt in the financial system and there is a shortage of dollars due to the Fed tightening monetary policy, it leads to the delinquency and default on debts. When enough debts cannot be paid, the financial system collapses.
The Great Financial Crisis was born out of a reduction in World Dollar Liquidity. To keep the mortgage bubble inflating, the global financial system needed an increasing amount of dollars. When there were not enough dollars to support the mortgage bubble, it burst. Even though the Fed attempted to bail out the banks, it was too late. The monetary lags of the Fed’s tightening cycle meant the Fed’s liquidity injections were ineffective to stop the tidal wave of debt defaults.
The contraction in World Dollar Liquidity that began in 2016 is the largest contraction in dollar liquidity in history. This contraction is occurring at a time when there is a record amount of dollar-denominated debt in the global economy. It is also during a time when most of this debt is unproductive, meaning new debt is not creating economic growth, as much of the current debt was used to cover up the bad debts from the Great Financial Crisis.
It is the contraction of World Dollar Liquidity that is causing the global economy to slow and contract until it is at parity with the number of dollars in the global monetary system. Due to the extreme amount of debt, this contraction, without monetary intervention, will lead to a global recession. Should the Fed attempt to rescue the global economy by further easing monetary policy, they will start a global recession due to the effects of easing during a period where the real economy is still feeling the lags from the prior tightening cycle.
By understanding World Dollar Liquidity and the monetary lags, it is easy to see how the next recession will be the worst in our lifetime since the Fed will not be able to stop the debt deflation when the bubble finally bursts.
The Fed Wasted a Monetary Bullet (09/23/19 – 15 min)
A Quick Look at the Price Charts (09/25/19 – 16 min)
Weekly Economic Update 9/27/19 (09/27/19 – 25 min)