The Investment Scientist

For the final article of this macroeconomics series, I want to write about something that is much more relevant to your financial wellbeing, whether you are a wage earner or business owner. That is, what would happen if the dollar loses its status as the predominant reserve currency?

The Quantity Theory of Money states:

M/P = kY where

M is the total money supply, P is the gross price level, and kY can be interpreted as the demand for money.

If the dollar loses its “gold” status, central banks around the world will need much fewer dollars and the demand kY for the dollar will drop. To balance this out, either the gross price level P will increase, or the total money supply M will have to be reduced. To put it in layman’s terms, we will get hyper inflation and hyper interest rates, the latter to reduce the money supply.

Let’s look at a historical precedence. See the chart below

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“Why are so many countries lending to the US for negative real interest?” Professor Sussman opened the floor for debate at our Oxford macroeconomics class. In totality, foreign countries own $6.2T of US debt. The chart below shows the countries that lend to the US.

In the previous three articles, I wrote about The Gold StandardThe Fiat Money andThe National Saving Shortage respectively. I hope I explained that the trade deficit is recycling of foreign savings for US private investments. And as long as we are paying negative real interest on our national debt, It’s not a problem, but a win to be able to keep borrowing. What I did not explain is why foreign countries would lend to us at negative real interest, and this is exactly what the professor asked in class and what I hope to explain with this article.

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In macroeconomics, there is the balance of payments (BOP) identity …

Imports – Exports = Investments – Savings

This formula is called an identity, not a theory, because it is as true as 1+1=2. The identity basically says if a country imports more than it exports, that is, having a trade deficit, it is because the country does not have enough savings for its investments. (The chart below shows the saving rate of the US in the last few years.) The intuition is this. Foreign countries only have two ways to spend the money they earned from exporting to us, they can either buy our products, or they can lend the money to us. If we have a national saving shortage, we need them to lend us the money, not buy our products. This creates a trade deficit.

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On August 15th, 1971, President Nixon announced that the US would no longer redeem US dollars for gold, thus formally ending the gold standard. During the gold standard, the dollar bill was a certificate of deposit of gold which was redeemable to the bearer on demand. Post-gold standard, the dollar bill is pure paper money, what the academics call fiat money. Read my previous article The Gold Standard.

One immediate consequence was that the government could now issue money at will. And indeed, since 1975, the US has increased the money supply tenfold. As you can see from the chart below, the money printing accelerated in 2009, after the Great Recession. With this level of money printing, we actually need a lot of cheap imports to keep inflation at bay or else there would be too much money chasing too few goods.

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The Trade Deficit: Who Is The Winner?

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The June module at Oxford was all about macro-economics. The course was taught by a world-renowned economist, Professor Oren Sussman. There was so much I learned in the class that I can’t wait to share with my clients and readers.

The first topic I’d like to discuss is the Gold Standard. This will help us understand President Trump’s trade policy.

The gold-standard dollar
Below is a 100 dollar bill issued in 1888. Printed on the right side are the words “Gold Certificate.” From top to bottom, it reads “This certifies that there have been deposited in the Treasury of the United States One Hundred Dollars in Gold Coin.” Right below it is the italic “repayable to the bearer on demand.”

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This is actually a response to a client who asked to know what I do regularly that might benefit him. There are many things I could suggest, but I’d like to highlight just three.

Follow academic research

Those of you who have followed me for a while know that I am disdainful of financial news. I liken it to highway noise and I think that listening to it won’t get you anywhere. I am, however, an avid reader of peer-reviewed journals like the Journal of Finance, Review of Financial Studies, etc. These journals contain the best and most rigorous research on the subjects of finance and investment. That’s why I can confidently tell my clients, whatever I do with their money, that I can back up my actions with rigorous peer-reviewed research from the best minds of the world.

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The trade deal between the US and China fell through a few weeks ago. Since then, I’ve read at least three versions of what happened, ranging from Trump applying maximum pressure, to Xi reneging, to Xi wanting to do the deal but not being able to get the politburo to go along. Wall Street is hoping Trump and Xi, who will be meeting at the G20 a month from now, can magically salvage the deal. Based on what I’ve read in Chinese media, I am a lot less hopeful.

Bloomberg recently published a study of the economic impact of tariff escalation (see chart below.) As you know, I generally don’t react to the news, but this is looking like a structural change to the world economy that may warrant a reduction in risk exposure. If you are worried, feel free to schedule a time with me to talk about it: http://calendly.com/mzhuang/15min.

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.

Twitter: @mzhuang

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