Parallels

History is a gallery of pictures in which there are few originals and many copies. - Alexis de Tocqueville

Parallels in history are not only fascinating but also of significant importance. They illustrate how specific patterns, trends, and events can repeat themselves across different times and places. This allows us to draw valuable lessons from past experiences and better prepare ourselves for similar challenges in the present.

The concept that history often reveals recurring patterns has had a profound influence, as seen in Ray Dalio's theory on economic cycles. According to Dalio, some cycles repeat over centuries, a notion he substantiates with numerous historical examples where he highlights the commonalities.

Dalio is not alone in this perspective. Regardless of which phase of the economic cycle we find ourselves in, economists, analysts, and even traders seek historical parallels to current events, hoping to gain insights into future developments.

I came across a new trend on the social media platform TikTok just last week. In this trend, women ask their partners how often they think about the Roman Empire or when they last thought about it. The hashtag #RomanEmpire has now garnered more than 800 million views, and according to most responses, it seems that men think about the Roman Empire at least three to four times a week, as the American Time Magazine reported.

While it's clear that ancient civilization significantly influenced the Western world, the author ponders why this topic remains so prevalent. Beyond the references presented in the article within popular culture, it might also be due to the apparent economic parallels between the ancient high culture and current world events.

In my October 2021 article titled A Roman Fate?, I delved into the parallels between the Roman Empire and the European Union. Just as Rome was the center of the ancient empire, Brussels is increasingly becoming the hub of European politics.

The Roman Empire prospered through free trade, the protection of property rights, and favorable conditions for entrepreneurs, which allowed for the financing of social programs. In the end, an expanding state, higher taxes for redistribution, financial mismanagement, and monetary expansion played a significant role in the downfall of the Roman Empire.

There are many parallels here with the EU, which, as the European Economic Community, initially relied on the fundamental freedoms of the free movement of people, goods, services, and capital. Over time, however, much like ancient Rome, nation-states ceded more authority, leading to a growing EU bureaucracy.

Simultaneously, parallels can also be drawn regarding monetary and fiscal policies, so I warned that the same fate could ultimately befall the EU. In the article, I also referenced the already-rising energy prices, some of which were partially self-inflicted. I cautioned that price regulations would yield the same results as in the time of Diocletian in Rome.

Although I appealed for the EU to refocus on its fundamental freedoms, the EU has moved in the direction I had feared at that time. Almost daily, discussions revolve around gaining more powers and implementing stricter regulations.

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Today, however, the focus is on the United States and the US dollar. Historical parallels can also be found here, but these pertain to the United States. Several months ago, I examined the development of the Fed Funds Rate and the situation of the US budget as a percentage of the Gross Domestic Product (GDP).

Since 1970, it has been the case that higher US interest rates have resulted in a lower US deficit (as a percentage of GDP). This is an attempt to avoid additional costs due to rising interest expenses. Simultaneously, rising interest rates often occur due to increasing inflation, which, with unchanged government spending, leads to a reduced deficit. However, government spending has increased more rapidly than nominal GDP in the current interest rate hike cycle.

The United States only experienced a budget surplus during the late 1990s. This was due to the economic boom, increased tax revenues from the technology sector thanks to the Dot-Com bubble, tax hikes implemented under Clinton's administration, and fiscal discipline measures such as a reduction in defense spending.

Despite the ongoing positive economic developments in the United States, the Biden administration, often with support from Republicans, has taken a different path. In contrast to the Federal Reserve's monetary policy, the administration has pursued an expansive approach with multi-billion-dollar programs to bolster industry, electric vehicle production and semiconductors, and infrastructure projects.

The administration's (Keynesian) hope that increased spending would reduce the deficit through higher tax revenues has not materialized. The government's actions are unnecessary because unemployment is currently at a historic low, and weekly unemployment claims indicate a robust job market.

The White House forecasts that the budget deficit will remain around 6% annually until 2028. However, these projections rely on a positive economic outlook and do not account for a recession. As we know, a recession has a nonlinear impact on the job market, meaning unemployment can spike rapidly. In such a scenario, it is logical to assume that government spending will expand significantly again.

With the Federal Reserve raising interest rates from zero to over 5 %, the interest burden on US government debt has increased. Since late 2020, this burden has nearly doubled. Recently, the US has increased short-term borrowing, which will further drive up interest costs should the Fed maintain interest rates near current levels in the long term.

However, this is not the only issue facing the US government. Currently, tax revenues are declining, resulting in the United States increasingly accumulating new debt if it wishes to maintain or increase government spending. In 2022, 46% of government expenditures were allocated to fund entitlement programs such as Social Security, Medicare, Medicaid, unemployment benefits, and welfare programs. Since it's unlikely that these will be reduced, they will be financed even more through debt, further driving up the interest burden.

According to the Financial Report from the US Government Accountability Office in February 2023, it is projected that the United States' national debt, compared to its Gross Domestic Product, will increase to 566% by 2097. It concludes that the predicted continuous rise in the debt-to-GDP ratio suggests that the current policy is not sustainable.

This implies that the USA needs to reduce its debt-to-GDP ratio. In principle, there are two ways to achieve this: higher taxes or lower expenditures, with the latter being the preferable route. The problem, however, is that neither higher taxes nor lower expenditures are desired or easily enforceable. Nevertheless, there's a third option: the inflation tax.

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Inflation has been on the rise in recent months. Whether it has reached its bottom or is just a temporary reversal remains uncertain. The question is whether oil and food prices, which are primarily responsible for the increase, will maintain or continue to rise. If oil prices remain at $90, by the end of the year, they would be 12% higher than a year ago.

Rising energy prices affect the entire production cycle and thus impact the overall price development of products within a value chain. Increasing energy prices also push prices in other product categories, especially in energy-intensive sectors.

The high energy prices strongly resemble the 1970s, when energy prices and an expanded money supply drove inflation higher. This may be why many analysts and economists are drawing parallels with the 1970s. However, inflation in the 1970s was primarily characterized by solid credit growth due to the Baby Boomer generation rather than exorbitant increases in government spending. The government debt-to-GDP ratio was below 40% then, whereas it is over 120% today.

The last time the debt-to-GDP ratio was as high as now was after World War II ended. It surged from 42% to 106% within five years. This might be why it is essential to compare the current inflationary regime not with the 1970s but with the 1940s.

If this were the case, it would also question the thesis that bonds would be a good medium-term investment in the event of a hard landing. The recent increase in long-term interest rates is, after all, less a result of decoupled long-term inflation expectations and much more a higher term premium due to uncertainty.

As previously mentioned, inflation arises from an expansion of the money supply. This can stem from an increase in private-sector credit or a rising fiscal impulse. With a higher debt-to-GDP ratio, private and institutional investors will demand a higher premium, meaning higher interest rates. Since US government bonds are considered risk-free interest, they serve as a benchmark for all other interest rates.

Consequently, rising interest rates for government bonds lead to higher interest rates for all future loans and existing variable-rate financing. In a situation like the 1970s, where inflation resulted from an expansion of the money supply through lending, higher interest rates normalize inflation by inducing a deflationary effect (reduced borrowing).

However, if the inflation shock is fiscally driven, fueled by passive debt monetization by the central bank through purchases on the secondary market, the increased government spending due to rising interest rates can offset this effect. Simultaneously, by tapping into the Strategic Petroleum Reserve, the Biden administration effectively executed a commodity subsidy program, as it artificially lowered oil prices. As mentioned earlier, this consequently alleviates prices for energy-intensive products. Just two weeks ago, Biden spokesperson John Kirby even said that Biden is considering using the SPR again to push oil prices down.

A look at the rolling budget and the CPI in the United States reveals that the fiscal impulse of the COVID-19 pandemic, driven by an expansion of the money supply, resembles the situation in the 1940s. During that era, increased spending due to the war generated an inflationary wave, while the government budget remained stable in the 1970s.

Usually, interest rate hikes should also bring down the stock market because rising interest rates make bonds more attractive than stocks. However, the stock market seems unfazed by the interest rate hikes, at least when considering the major indices. Beneath the surface, though, the first signs of trouble are already emerging.

Interest rate hikes following a fiscal-induced inflation shock also benefit those with fixed financing. For instance, Individuals with fixed-rate mortgages won't necessarily sell their homes, as they would face higher interest rates when buying a new (larger) house. But with robust wage growth, their debt burden decreases. The same goes for large corporations that have financed themselves in the capital markets with long-term fixed-rate bonds.

Conversely, companies that financed themselves through short-term fixed-rate bonds or variable-rate bonds suffer more quickly from rising interest rates. A prime example is the Russell 3000, which represents American small and medium-sized enterprises (SMEs) and has been moving sideways since 2022, unlike the major indices. This means that small and medium-sized businesses feel the effects of interest rate hikes more rapidly than others.

What's the likely scenario if falling bond prices, due to persistently high interest rates, start to drag down stock prices and the real economy stalls? Probably higher government spending. Yet, this worsens the debt-to-GDP ratio and might increase long-term interest rates because inflation expectations and term premiums (compensation for holding long-term bonds) increase.

Ultimately, this could lead to a failed bond auction where the Fed must purchase bonds at the offered interest rate. That would mark the beginning of fiscal dominance, as described in a paper by the St. Louis Fed. In that paper, the author also explores ways to reduce the resulting inflation triggered by significantly higher unremunerated reserve requirements, in his example, from 16 % to 8 %.

However, this would require market participants to anticipate the point at which this would occur; otherwise, they would incur real losses on their bond holdings. Unlike after World War II, this would affect many foreign investors. In 1950, foreign investors held less than 5% of US Treasury bonds; today, they hold just under 50%.

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Thus, debt monetization through yield curve control would significantly affect the dollar's value. Does this mean it spells the end of the dollar? Some commentators had argued that the August BRICS conference would herald the dollar's demise. However, this notion can be dismissed following the BRICS countries' conference in August, which ended (as expected) without an announcement of a common currency. Instead, the meeting made it clear that the members are pretty divided on what such a currency should look like.

Furthermore, it's not states that engage in trade but rather businesses and individuals. They agree on a currency in which to conduct their trade. Since the dollar is the world's reserve currency, it is chosen because it can be exchanged for goods and services anywhere in the world. If BRICS nations wish to create an alternative, they must select one that market participants view as superior and can agree upon. In my opinion, they are still far from achieving that.

All other currencies lack the global acceptance and trust to replace the dollar. Originally conceived as an alternative to the dollar, the euro is not a viable substitute due to the issues within its member countries. Seemingly, Frankfurt and Brussels have also recognized this, as they now align more geopolitically with the USA. Therefore, the euro cannot be an alternative for the rest of the world.

If the scenario outlined for the US dollar materialized, I would go so far as to say that other Western fiat currencies would lose value against the dollar. It would be the first global financial crisis that simultaneously encompasses all Western economic regions, making me doubt that these currency zones would act differently from the USA.

Such a scenario would favor limited assets, notably precious metals (potentially including Bitcoin), land, energy, and agricultural commodities. In the 1940s, commodity price fluctuations were minimal because the dollar was tied to gold, and productivity gains tended to lower commodity prices. Productivity gains are now less likely, especially considering that production in many countries can be expected to decline due to stricter regulations.

We are not the same as I hope to show
There is a better way if we just let go
We are not, we are not the same
We are not, we are not the same

And in the parallels, we struggle to upkeep,
There’s a better way for us to be, for us to be set free
As I Lay Dying – Parallels

I wish you a splendid weekend!

Fabian Wintersberger

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(All posts are my personal opinion only and do not represent those of people, institutions, or organizations that the owner may or may not be associated with in a professional or personal capacity and are no investment advice. I may change my view the next day if the facts change.)