Blame the Fed for the Global Economic Slowdown, Not the Tariffs

Excluding the U.S. stock market, the global economy is rapidly slowing down. Most people believe it has to do with the trade war, but the global slowdown started long before the tariffs started as every economic expansion and contraction begins with the Federal Reserve easing or tightening monetary policy. While investors remain optimistic that this is nothing more than a slowdown, by understanding how global trade works, it becomes obvious that another massive recession is unavoidable.

Global trade is conducted in U.S. Dollars which flow around the globe in what I refer to as the dollar superhighway. Since nearly every currency is pegged to the dollar, it is the Fed’s role to make sure there are enough dollars available to conduct trade. With the world operates on a debt-based monetary system, the Fed needs to continuously pump an increasing amount of dollars into the global economy. When there is an insufficient amount of dollars for world trade, trade slows and asset prices fall.

The concept of the dollar superhighway is expressed by World Dollar Liquidity or the number of dollars available for global trade. World Dollar Liquidity is the sum of the Monetary Base, or the total amount of currency in circulation and the currency held in reserves by commercial banks, plus the amount of foreign debt held by foreign and international investors. By understanding World Dollar Liquidity, it becomes obvious how the Fed set the world up for a global recession.

When the Fed began tightening monetary policy by raising the Federal Funds Rate and by selling off the bonds on their balance sheet, or Quantitative Tightening, the Fed reduced the Monetary Base. As the Fed increased the rate of its monetary tightening, the Monetary Base began to contract on a year-over-year basis. World Dollar Liquidity shows that the Fed’s tightening removed dollars from the global economy, which caused the slowdown in the global economy as the world was starved for dollars.

To offset the decline in the Monetary Base, foreign investors, which are mostly foreign central banks, need to buy enough U.S. Treasury bonds to match the amount of currency the Fed destroys. While the Fed was busy destroying currency to counteract inflationary fears, foreign central banks stopped buying U.S. Treasury bonds. As a result, World Dollar Liquidity contracted which caused the global economy to slow.

Prior to 1971, when the world was on the gold standard, trade was conducted in gold and debts were settled in gold. Gold, which was stored inside central bank vaults throughout the world, would move from one country’s storage area to another country’s storage area as needed. Since fiat currencies were printed against the quantity of a gold a country had, the more gold in a country’s storage area, the more currency they could print.

When one country accumulated more gold, inflation would become a problem. For those countries with less gold, deflation would take over. Consumers in the inflationary country would purchase goods and services from those countries with cheaper products, which would send gold from one country to the other. Gold allowed the global monetary system to self-regulate.

Once the dollar became the world’s reserve currency, the global monetary system changed. Instead of settling trade and debts in gold, they were now settled in dollars. In a debt-based global monetary system, there is a demand for an increasing amount of dollars to cover the increasing quantity of debts. After all, a debt-based economy expands as its debts expand, so the world found itself needing an increasing amount of debt and dollars to expand the global economy.

As the world’s reserve currency, it is the role of the United States government to perpetually run a deficit to create an increasing amount of dollars for global trade. While we need to run deficits, the world would prefer we run reasonable deficits and use those deficits for productive purposes that lead to increased trade.

The U.S. Treasury spends currency into the global economy, but primarily into the domestic economy. U.S. consumers spend some of their currency on foreign-produced goods and services, which sends dollars overseas. When those dollars end up in the hands of foreign producers, they exchange their excess dollars with their local bank, who in turn exchanges its excess dollars with their central bank, for local currency.

As the quantity of dollars builds in the accounts of the foreign central bank, they purchase U.S. debt, in the form of U.S. Treasury bonds, to lower their quantity of dollars. Foreign central banks make this exchange of dollars for debt to tamper the inflationary effects of holding too many dollars. Once a foreign central bank purchases U.S. Treasury bonds, the cycle completes and restarts.

Foreign central banks get dollars from trade, so they do not have an infinite amount of dollars available to offset the Fed’s monetary tightening. When the Fed tightened monetary policy and World Dollar Liquidity began to shrink, it makes sense why foreign central banks stopped purchasing U.S. Treasury bonds. The foreign central banks were hoarding dollars in hopes to facilitate local dollar demand for trade and for payment against dollar-denominated debts.

Foreign central banks started hoarding dollars right after the Tax Cuts and Jobs Act of 2017 was passed, due to its effect on World Dollar Liquidity. Even though the U.S. corporate tax rate was above average, after deductions their tax rate was about average. In addition to cutting the corporate tax rate, corporations were expected to repatriate large quantities of offshore dollars to reinvest in the domestic economy. While most of the repatriated currency when to corporate share buybacks and dividends, it made World Dollar Liquidity worse.

Prior to corporate tax cut passing, U.S. corporations held large quantities of dollars in offshore bank accounts in the form of cash and U.S. Treasuries. This money was used to help facilitate trade, as foreign banks need a supply of dollars to lend. As the currency came back to the United States, it led to a decrease in global trade and forced foreign central banks to hold onto dollars.

In a similar fashion, the trade war has led to a reduction in global trade. When World Dollar Liquidity falls or contracts, American consumers need to increase their demand for foreign-produced goods and services to keep the global system flush with dollars. Usually, foreign-produced goods and services fall in price as World Dollar Liquidity decreases, but the tariffs have temporarily kept import prices elevated. The real issue is not the increase in prices, even though it reduces consumption, it is how tariffs shortcut the global trade system.

Normally dollars flow back to foreign-owned producers when foreign good and services are sold in the United States, but the tariff goes directly to the U.S. government. Tariffs are nothing more than an import tax that is paid by consumers on foreign-produced imports, but the tax does not lead to an increase in World Dollar Liquidity since it shortcuts the global trade cycle. The tariff tax, which is paid in dollars, is paid directly to the U.S. government rather than being used to purchase U.S. Treasury bonds to increase World Dollar Liquidity.

While the corporate tax cut and trade war are contributing to the global slowdown, the real culprit is the Federal Reserve who causes a global slowdown every time they tighten monetary policy and subsequently reduce World Dollar Liquidity. When World Dollar Liquidity falls or contracts, global asset prices need to fall, which is why recessions are prevalent following every Fed tightening cycle.

By understanding World Dollar Liquidity and the Federal Reserve’s role as the central bank of the world, it makes sense why the Fed needs to perpetually ease to create enough dollar liquidity to expand the global economy by facilitating global trade. When World Dollar Liquidity stalls out, as it has now, global asset prices need to collapse to the level of liquidity or the global trade system has to be restarted.

For those who own stocks, a restart of the global trade system is not favorable to holding risk assets. For those who own bonds, this is a rare opportunity to earn a handsome return on a low-risk asset, as interest rates collapse, and bond prices rally when the Fed attempts to restore World Dollar Liquidity. Next week, or in a future update, I will share with you exactly what must be done to restore World Dollar Liquidity and how it has always led to a U.S. recession, except once. And the next time the Fed restarts World Dollar Liquidity, it will lead to a recession.

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Weekly Economic Update 9/20/19 (09/20/19 – 30 min)