Currency Wars, Trade and the Consuming Crisis of Capitalism   (September 6, 2011)

To understand why the euro is failing and the Swiss Franc peg is a sand castle that will dissolve in a rising tide, we must start with a historical context and the crisis of global Capitalism.

The recent 40th anniversary of President Nixon withdrawing the U.S. from the gold standard triggered an avalanche of commentary mourning this introduction of the "fiat" (unbacked) dollar. But as most financial commentators have a conventional-economics perspective, they missed the key point: Nixon had no choice.

To really make sense of the past 40 years, and the current crisis of advanced global Capitalism, we must turn to everyone's favorite misunderstood economic framework, Marxism. I recently addressed several aspects of Marx's view of the inevitability of advanced Capitalism's crises in Marx, Labor's Dwindling Share of the Economy and the Crisis of Advanced Capitalism (August 31, 2011).

Here's the thing about conventional economics: it cannot make sense of our current interlocking crises because it lacks the tools and perspective to do so. Conventional economics has failed on a grand scale. Not only has its policies failed, its account of what's really going on fails to explain the underlying dynamics because it is fundamentally self-referential, parochial, mechanistic, blind to broader forces of history and soaked in the quasi-religious hubris that reductionist equations and quant models can not only explicate reality, they can predict human behavior.

The catastrophic failure of its policies result not from poor policy choices but from a tragically inadequate intellectual foundation. Hubris, indeed.

As I note in Chapter One of my new book An Unconventional Guide to Investing in Troubled Times, Like a creature born in the morning that has only seen daylight, conventional economics has never experienced night and so it has no conception of darkness.

The Marxist perspective has its own limitations, for example its weak purchase on the role of Peak Oil and resource depletion in the coming crises, but because Marxism is grounded in a historical and philosophic understanding rather than a reductionist, mechanistic, econometric one, it offers us the only comprehensive account of what's really going on with paper money, gold, trade and the crises of advanced Capitalism.

To understand the role of paper money, credit and gold in trade, we need to understand the role of trade in advanced global Capitalism. If we don't understand this, then we cannot possibly understand the current interlocking crises.

As I described in the entry noted above, Marx foresaw that mechanization/automation and the dominance of finance capital would lead to labor's share of the national income shrinking while industrial capital's factories produced ever greater quantities of goods at prices pushed down by labor-saving machinery and software (i.e. invested capital). (Marx also laid out the inevitable progression of capital to monopoly and cartel Capitalism, but that's another entry.)

This "crisis of overproduction" has several consequences. As less labor is needed for production, then the "army of surplus labor" (the unemployed) grows while wages stagnate or decline for everyone below the professional/technical Caste. As the labor component of goods and services declines, workers no longer have enough income to buy the rising output. At that point the economy collapses as demand declines to the point that nobody can make money even as production keeps ramping ever higher.

The solution is trade: dump the surplus production (the production beyond what the domestic market of workers can buy) overseas. The ideal setup is of course Global Empire, where the home economy strips away productive capacity in its colonies and essentially forces its colonial populations to buy its surplus manufactured goods in exchange for raw materials.

This "solution" to advanced Capitalism's ongoing "crisis of overproduction" is brilliantly described in the book Sweetness and Power: The Place of Sugar in Modern History.

The second very important thing to understand is what Mish has tirelessly explained on his blog Mish's Global Economic Analysis: everybody can't have a trade surplus, as that is a mathematical impossibility. Somebody has to run a trade deficit, i.e. import others' surplus production.

With a historical perspective rather than a superficial econometric one, we can trace out the larger forces that have been at work for the past 60 years:

1. The end of World War II ushered in the end of colonialism. France lost Vietnam in 1953, and clung bitterly to Algeria into the early 1960s. Great Britain relinquished the "Jewel in the Crown," its vast market for its own goods, India, and Africa shed the shackles of colonial Empire. This meant the cozy Imperial arrangement for dumping surplus production for a fat profit in one's colonies ended.

2. Fortunately for global Capitalism, the Allies had conveniently destroyed most of Germany and Japan's industrial base, and so there was a postwar boom as the U.S. created credit and lent dollars to Western Europe to fund its reconstruction and oversee Japan's rebuilding.

Behind the scenes, global Capitalism began making other arrangements to replace the iron-fisted colonial scheme with new mechanisms for extracting raw materials from former colonies and selling surplus goods overseas. Unfriendly regimes were replaced with pliable, corrupt dictators, etc.

3. This boom created a demand for labor, and as a result labor's share of the national income rose: with labor in scarcity, wages rose, and this enabled a "consumer society" that was mutually beneficial to both labor and capital: workers got a more affluent lifestyle and capital earned ever-higher profits. This fed a "virtuous cycle" in which higher revenues and profits led to higher wages and an expanding workforce, which was then enabled to buy more goods and services, which drove profits higher, and so on.

4. Globalization at this stage was limited to the flow of capital and goods: trade was in the classic model where one nation's advantages in production of one good was traded for another country's comparative advantages in another good. American capital flowed around the world, constructing a new kind of global Empire that wound together diplomacy, finance, trade and military might.

Here's the thing about this globalization: once the postwar Cold War reshuffling in Europe, China and Pakistan/India was complete, people mostly stayed in the nation of their birth. Labor was in scarcity in advanced and rising economies because labor was not yet flowing across borders as freely as capital, and that capital was mostly invested in facilitating trade, not in manufacturing goods overseas for domestic markets.

5. As the "leader of the free world," the U.S. had powerful geopolitical and economic reasons to fund the rebuilding of Japan and Germany as bulwarks against global Communism, and to do so on the "export model": the U.S. would open its domestic markets to German and Japanese manufacturers to ensure their stability and growth. Japan and Germany were the "frontline" linchpins in Asia and and Europe against the (at the time) formidable forces of totalitarian Communism.

As a result of these dynamics, the U.S. accepted the role of importer of surplus production from our allies and client states. That was the Grand Bargain: to corral the Communist enemies in the East, America would become the importer of the entire free world's surplus production.

6. But as Marx foresaw, eventually domestic "organic demand" for goods was sated, and automation's relentless shedding of jobs overtook the postwar expansion of employment. By the peak of the postwar boom in 1966, everybody in the advanced countries already had everything: a telephone or two, a TV, a car, a moped, a washing machine, etc.

7. The "solution" was to manufacture demand with sophisticated and increasingly pervasive marketing, and to create a "consumer credit economy" which enabled labor to leverage its income via credit cards to buy more stuff.

8. By the late 1960s, the Grand Bargain was untenable. The rest of the world had increased production to such a degree that America's trade deficit was now structural and growing. Simply put, if the U.S. had to pay for its imports with gold fixed at $35/ounce, it would soon run out of gold and the Grand Bargain would implode, endangering the entire geopolitical stability of the free world.

Recall that in the early 1970s, the Soviet Union was still a powerhouse of space technology, a vast military power and a ubiquitous global player. It was a formidable and dangerous opponent to American domination and the free world.

As a result, Nixon had no choice but to jettison paying trade debt in $35/ounce gold. With huge structural deficits required to soak up the surplus production of the free world, the gold would soon be gone and so would the U.S. market for allies' goods. That had the potential to destabilize the entire security of the free world and global Capitalism, so Plan B was the only conventional choice left: a "fiat" unbacked currency, the dollar.

9. Cheap oil, an unquestioned foundation of postwar prosperity, also went away in the early 1970s. The Arab exporting nations awoke to their geopolitical significance, and the rise of OPEC upended the advanced Capitalist nations' semi-colonial reliance on cheap oil from the Gulf states.

10. The end of the "organic growth" phase of the postwar boom and cheap oil led to stagflation in the 1970s. As the "importer of last resort," the domestic U.S. economy began facing intense competition from our allies, who still held the great advantage of undervalued currencies.

11. The U.S. and Saudi Arabia reached a new mutually beneficial stalemate understanding about oil. Nixon had ferried A-4 Skyhawks across the Atlantic to Israel in the crisis phase of the 1973 Yom Kippur War, enabling Israel to reassert the crucial air superiority that it had lost to the Soviet-supplied Arab combatants. Saudi Arabia punished this "save" with an oil embargo that triggered panic and rationing in the U.S.

But Saudi Arabia learned something important in this exercise of geopolitical leverage: Saudi surpluses had already reached the point that its investment income from capital invested in the West matched or exceeded it oil revenues. Choking the West via oil embargoes also snuffed out its investment income.

12. Nixon realized the West was at that time potentially vulnerable to the Soviet Empire for the reasons outlined above. His "outside the box" solution was to peel China away from the Soviet sphere of influence and create a "second front" for the Soviets to deal with, while freeing the U.S. from any live threats to its Asian alliances, which had been frayed by the Vietnam War. Tired of its erstwhile Soviet "ally," China had its own reasons to welcome detente.

13. The high inflation of the 1970s had effectively written down domestic debt, and so the vast expansion of credit/debt in the Reagan years created a fertile ground for consumption. The solution to the Grand Bargain of the U.S. as "importer of last resort" was simply massive quantities of credit: we would buy the Free World's surplus production with credit and printed dollars.

14. Fast-foward to the present. The "importer of last resort based on credit" scheme is unraveling, as the U.S. allowed its own production capacity to be hollowed out and replaced by ever-higher and more burdensome credit-based consumption. The "virtuous cycle" has ended and now credit creation to fund consumption is a self-destructive force.

The rest of the world is delighted to dump its surplus production and resources into the U.S.-- the U.S. is literally the only nation with a globally meaningful trade deficit--but the "grease" of that Grand Bargain--printed fiat dollars--is now causing complaints as its value weakens under the flood of credit issued by the U.S. to maintain its vast consumption.

Alas, you can't have it both ways, and that is a key dynamic in the Crisis of Advanced Capitalism: if you want to dump your surplus production on America, then you have to accept its paper money in exchange. If you decline that deal, and cease producing a surplus, your domestic economy will implode and your political stability will unravel.

Given the choice, the rest of the world accepts the dollars while complaining that it had a better deal in the good old days. Meanwhile, the U.S. consumer, hollowed out by intolerable debt loads, a declining asset base (the family home) and a domestic economy based on ever-expanding credit, is unable to continue the decades-long buying spree without massive transfers from the Central State, which must borrow $1.6 trillion every year to keep the whole creaky structure from collapsing.

China jumped on the export-model as its engine of growth and political stability, and it guaranteed that stability by pegging its currency to the U.S. dollar, making the renminbi a proxy of the dollar.

In the oil-exporting world, OPEC has lost its cartel powers as non-OPEC exporters gained market share and the cartel divided into those who benefit from investing in the West and those who benefit solely from higher oil prices.

If we put all these pieces together, we have a clearer understanding of the long-term historical forces at work: the global consumer society funded by credit is in its end-game, and is the "Central State as guarantor of private consumption" model in which governments borrow/print vast sums of fiat currency to distribute to their citizenry to prop up consumption.

Once exports go away, then domestic economies the world over implode. Ironically, perhaps, the one nation which doesn't depend on exporting its surplus production for its stability is the U.S.

This is one reason why the Swiss pegging their fiat franc to the Euro will fail to hold back the ceaseless tide eroding the Euro. You can play games with currency pegs for awhile, but ultimately the value and utility of a fiat currency is established by trade, energy and the geopolitical issues outlined above.

If we don't understand trade flows, surplus production, the surplus in labor and the resultant decline in its share of national income, credit and currencies in this Marxist-inspired historical perspective, we cannot make sense of the financial/political crises which are sweeping over the global economy. The end-game is at hand, and we need models that are up to the task of explaining the vast forces now in play.

Podcast/Interview alerts:

My friend Richard Metzger of the highly popular Dangerous Minds site invited me down to his studio in L.A. for a high-definition (and hopefully illuminating) discussion on THE END OF WORK: AN INTERVIEW WITH CHARLES HUGH SMITH (video). Thanks, Richard! As always, it was great fun and I learned a lot.

Zack Miller of was kind enough to interview me recently: check it out if you're interested in investing in troubled times, like now, f'rinstance: Investing In Troubled Times With Charles Hugh Smith. Thank you, Zack, for the chance to ramble on about my favorite topics.

If this recession strikes you as different from previous downturns, you might be interested in my new book An Unconventional Guide to Investing in Troubled Times, now available in Kindle ebook format. You can read the ebook on any computer, smart phone, iPad, etc. Click here for links to Kindle apps and Chapter One. The solution in one word: Localism.

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