Sanctions on Russia are Altering the Global Financial System
Let’s explore how this altered system might evolve.
Article Highlights:
U.S. and EU sanctions on Russia have frozen Russia’s dollar savings.
Russia has responded by pricing natural gas in rubles and linking the ruble to gold conversion, essentially pricing gas in terms of gold.
A message has been sent to all nations that their dollar reserves may not be safe if they engage in actions unacceptable to the U.S.
Most non-Western countries have not joined the sanctions because they are reliant upon Russian energy and food exports.
Nations will need to decide whether they want to continue participating in the U.S. dollar reserve system, or if they want to transition to a multi-polar currency system, which increasingly looks like it could end up gold-backed.
Impact of these changes points to higher U.S. inflation, rising gold price, devalued dollar, and increased reshoring of U.S. manufacturing.
NOTE: If you are unfamiliar with some of the concepts in this article, you can check out these Apples to Apples articles, which were created to sequentially provide a basic understanding of how the U.S. dollar system functions along with a brief history of its evolution:
The U.S. driven sanctions recently imposed on Russia have done more than just prevent Russia from using dollars to trade with other countries. These sanctions have blocked trade of important Russian-produced commodities, and of equal importance, have frozen externally-held dollar reserves of the Russian central bank. In essence, these sanctions have frozen a large part of Russia’s savings in foreign banks. This is a big deal.
There has been a flurry of discussion in the online financial community regarding the consequences of these sanctions. Of all the information I have encountered on this topic, the March 12 interview of macroeconomic analyst Luke Gromen (founder of Forest for the Trees) by Grant Williams provides one of the best analyses. Grant Williams, himself a renowned macroeconomic analyst, normally places his interviews behind a paywall, but the response to this interview was so overwhelming that he generously made it public. It created quite a stir online because of its predictions, a couple of which have already come to pass.
The interview’s first 30 minutes reviews in detail U.S. dollar history since the Bretton woods meetings. The remainder of the discussion spells out what may reasonably be expected to occur next.
Listen to Grant Williams - Luke Gromen Interview
Monetary history highlights shared in this interview of Luke Gromen:
Gromen points out two options proposed in the 1944 Bretton Wood’s talks:
Option 1: Proposal by noted economist John Maynard Keynes to implement the “Bancor” as a neutral reserve asset.
Keynes’ idea was that the Bancor would serve as a common global money used between nations to settle trade imbalances. Countries would buy Bancor from a centralized entity using their own national currency if they had a trade deficit, and pay that Bancor to the country to which they owed the deficit. The country having the trade surplus would then receive these Bancor that they could use to settle any trade deficit with a different country.
Option 2: Use the dollar as reserve currency pegged to gold at a price of $35 per ounce.
This option, promoted by the U.S., is the path that was taken, largely because of the strength of the U.S. economy and because the U.S. had 21,000 tons of gold to back up the proposal. America’s gold dwindled to 8,000 tons by 1971 due to developing trade deficits.With a shrinking gold supply, America could have devalued the dollar against gold, but the Nixon admin decided to stop paying the U.S. trade imbalances to other nations using gold, effectively ending the dollar’s gold backing.
Fed Chairman Paul Volcker, in the early 1970’s, raised interest rates to 21% with dual goals to curb inflation and to retain the dollar’s value in the global currency markets, thus ensuring global confidence in the dollar.
In the mid-2000 decade, oil price began to rise above the $15-$30 range it had been in for the nearly three decades following the Nixon-Saudi agreement that effectively tied the dollar to oil. This occurred just before the 2007 subprime mortgage crisis, so instead of the Fed contracting the money supply by raising interest rates in an attempt to lower the price of oil and tame inflation as Volcker did, the Fed printed large amounts of money to bail out the large banks. This printing devalued the dollar in the eyes of other countries, seeding doubts of U.S. intention to maintain the dollar as being ‘good-as-gold-for-oil’.
The Chinese soon balked at the U.S. money printing, arguing that a new system of trade was needed using other currencies or gold for oil, rather than dollars. The Chinese saw the U.S. Baby Boomers heading into retirement, and with that, great demand on the U.S. pension system. Since the U.S. pensions and social security were becoming increasingly underfunded, their expectation was that the U.S. government would print even more dollars to cover its pension requirements, further devaluing Chinese dollar savings.
By 2015, China and Russia begin conducting trade using their own currency, utilizing gold as an intermediary through the newly established Shanghai gold exchange. China has great need for the ability to print yuan for oil because they must import most of their oil. Europeans have the same problem – also needing to print Euros for oil purchases.
Russia too recognized pending dollar devaluation, so began selling dollar reserves, buying gold, and diversifying savings into other currencies, such as the Euro. In the process, Russia became a creditor nation with some of the lowest public debt of any major country.
Luke Gromen’s thoughts on the current situation and future events:
Oil importing companies holding U.S. dollar savings are benefited by paying for oil pegged to gold or by using their own currency, if the U.S. dollar is devaluing due to excess money printing.
The U.S. faces ‘Triffin’s dilemma” – holding reserve currency status promotes GDP growth through financialization, making society feel richer in the short to medium term (~1950’s through 2005), but due to exporting manufacturing and later printing excess money with large trade deficits, the country goes bankrupt.
Gold is the cleanest alternative because central banks/countries have been acquiring gold for well over a decade, anticipating current events.
The U.S. will choose to print ever larger amounts of money in the future to cover pension requirements.
As the U.S. printed money to address its Covid response, other countries/central banks, unlike previously, did not buy the U.S. debt because they were buying gold instead. This forced the Fed to buy the debt, placing its balance sheet significantly in the red.
For geological reasons, U.S. shale oil production cannot be increased enough to offset loss of Russian oil. This was recognized by Putin’s Russia, giving them a bargaining chip since removal of Russian oil would send the rest of the world into a deep recession.
U.S. true interest expenses equaled total tax receipts last year, which is a precarious financial position.
Sanctioning of Russia’s dollar bank reserves sent the message that Russia’s savings are no good. This tells all other countries that if they engage in actions perceived as unacceptable by the U.S., their reserves could also be frozen. In effect, this was the U.S. telling the rest of the world that they need to move to a gold-backed or Bancor system because the dollar can no longer be trusted for safe storage.
Sanctioning Russia makes the U.S. appear strong, but the resulting restructuring of the financial system ultimately devalues the dollar. Dollar devaluation triggers reshoring of U.S. factories. A strong dollar has been an impediment to bringing those factories back home.
Losers in the long-term scenario are the big U.S. banks. This is good for the U.S. overall because in the longer term, it can now rebuild its factories and infrastructure. The financial sector will shrink while the commodity, industrial/factory, and infrastructure sectors will benefit.
Movement from the dollar reserve platform benefits all countries eventually because it allows a level playing field. Unfortunately, it is being done through conflict. Governments may see conflict as beneficial because it takes public attention off the fact that people are getting poorer as asset values drop and commodity prices rise.
Russia will require other countries to pay in rubles for their oil, thus supporting the ruble. Next Russia will require oil to be purchased for gold, with Russia pegging the ruble to a specified amount of gold. Through this action, Russia could initiate the transition of the primary reserve asset from its current dollar arrangement to a new gold standard.
The Bank for International Settlements (BIS) had changed the bank gold holding requirements on Jan. 1, 2022, effectively initiating a movement away from the paper gold market, in an apparent shift to a physical gold market. (This is a bit beyond the scope for anyone unfamiliar with the gold market, but is something I hope to discuss in a future issue.) This would eventually eliminate the ability of banks to short the gold market, which they use to suppress the gold ‘paper/spot’ price. This is the reason gold at a coin dealer costs more (i.e., holds a premium) over the spot price.
All these changes are expected to increase the price of gold.
From 2000 to 2015, the U.S. dollar reserve system expanded from $2 trillion to $12 trillion. Since this required the U.S. making trillions more dollars available, this resulted in U.S. Treasury Bonds becoming by far the largest U.S. ‘export’. (It is hard for me to see Treasury Bonds – which are an IOU – as an export, but in our fiat dollar system, that perspective is valid.) This lowered the cost of funding the U.S. government while devaluing the currencies of other countries against the dollar, driving further U.S. de-industrialization.
From 2014 to 2020, global central banks slowed buying, and in some cases sold, U.S. Treasury bills. The Fed was left to buy these Treasury bills, expanding their negative balance sheet. This required the Fed to buy more Treasury debt in order to fund the U.S. government deficits, a process that accelerated during Covid spending. This combination will be highly inflationary for the U.S.
These combined events are already spurring American re-industrialization as evidenced by Intel recently announcing construction of semi-conductor factories in Texas, Ohio, and Arizona.
Financially, this is good news for the industrial sector, commodities, and precious metals, and also for the American worker because of wage inflation and job growth.
“The illegitimate freezing of some of the currency reserves of the Bank of Russia marks the end of the reliability of so-called first-class assets. In fact, the US and the EU have defaulted on their obligations to Russia. Now everybody knows that financial reserves can simply be stolen. And many countries in the immediate future may begin – I am sure this is what will happen – to convert their paper and digital assets into real reserves of raw materials, land, food, gold and other real assets which will only result in more shortages in these markets.”
Vladimir Putin, (March 16, 2022)
Gromen makes a lot of important points. Let’s explore some that stand out.
What to do with those Treasury Bills?
America’s largest ‘export’ is IOUs. You won’t see this showing up in standard trade data, but in dollar terms, his statement is correct. Those IOU Treasury Bills are held by other countries as savings (because we are using a debt-based money system where one country’s debt is another country’s asset).
If the dollar’s status as a savings vehicle diminishes, as reaction to Russian sanctions indicate it will, then all countries are likely to question the wisdom of holding dollars. Savers are known to take action when the value of their savings erode or are otherwise challenged.
Case in point – the recent freezing by the Canadian government of trucker bank accounts sent the message to regular Canadians that their money was not safe in the bank. As a result, Canadian banks experienced an immediate bank run. The banks halted withdrawals temporarily to stop the run.
Apparently, the bankers promptly took Justin Trudeau aside and gave him a talking to, because the very next day he cancelled the recently issued emergency order driving the trucker account freeze. The message had been sent, though, and the public understood that their money could no longer be ensured safe in the system. The same response will be true of nations in regard to their dollar savings.
"Europe froze $400+ billion in Russian fiat assets in response to Russia’s invasion of Ukraine, which is equivalent to over 20% of Russian GDP and over five years of Russian military spending; an utterly massive economic confiscation. The weaponization of FX reserves is historic "
- Lynn Alden lynalden.com
What are these nations to do with their dollar savings? Obviously, they will want to use them for trade; but if they continue to lose value, will they become a hot potato?
For the past couple decades, the Chinese have been using these dollar assets to build their Belt and Road Initiative, an infrastructure system modeled after and in the general path of the ancient Silk Road. They have also been buying farmland around the world, especially in Africa.
About ten years ago, a Swiss couple stayed at our bed and breakfast. The wife worked for a non-profit development organization that had done a lot of work in Africa. She told me that the Chinese had been buying up as much land as they could in Mozambique, an east African country just north of South Africa with large swaths of uncultivated, arable land. More recently, the Chinese have been buying farmland in the U.S., and their housing purchases are the reason Vancouver real estate prices have risen to astronomical levels.
If I were one of those countries, I would want to buy something tangible, and preferably from the country that issued the IOU. That doesn’t always happen though. Large-scale war can trigger denial of all repayments. Or vice-versa, denial of repayment could be a trigger for war.
A less dangerous option is to settle the debts with purchase of the new reserve currency. Historically, this would be with gold. Assuming the U.S. has the gold we are told it does (no audits have been made public for decades - although it should all still be in Fort Knox since James Bond foiled Goldfinger’s attempt to steal it😊), the price of gold could be allowed to rise to the level that the debts could be paid. The American problem with that approach is that for at least the past two decades, Eastern countries (China and Russia) have been stockpiling gold. The U.S., to my knowledge, has not.
Parallel to these events, the central bankers have made it clear they want to take a different approach and implement a global digital currency to replace all current currencies. This is a primary feature of the Great Reset they keep talking about. That is a topic for a later issue of Apples to Apples.
“We are witnessing the birth of Bretton Woods III – a new world (monetary) order centered around commodity-based currencies in the East that will likely weaken the Eurodollar system and also contribute to inflationary forces in the West. A crisis is unfolding. A crisis of commodities. Commodities are collateral, and collateral is money, and this crisis is about the rising allure of outside money over inside money. Bretton Woods II was built on inside money, and its foundations crumbled a week ago when the G7 seized Russia’s FX reserves…”
- Zoltan Pozsar, Credit Suisse Bank analyst (March 7, 2022)
Russia selling oil and gas for rubles or gold
Gromen predicted that since Russia was now banned from the U.S. dollar system, it would demand its oil and gas be paid in rubles or gold. It didn’t take long for Gromen’s prediction to come true, because by April 1, Russia announced it would only sell gas for rubles. Quoting Putin, “We are not operating a charity.” Furthermore, Russia set a ruble price for physical gold trade, thus tying the price of gas to gold. They set the ruble-gold price below the current dollar price to entice that trade. It appears the seeds of a new gold standard may have sprouted.
The EU countries are in a bind because they are highly dependent on Russian energy – not just for heating and transportation, but also for industry. Germany is particularly trapped as they do not have consequential domestic energy sources, plus has shut down its nuclear plants for political and environmental reasons.
Much of German industry requires Russian gas. I recently saw an article citing the head of BASF, one of Germany’s largest chemical companies, stating they could not continue operation without Russian natural gas.
To make matters worse for Germany, much of their gold (maybe most) is stored in London banks, and it looks like the U.K. will not want to release that gold until the EU meets some lingering U.K. Brexit demands.
The U.S./EU sanctions may be backfiring as many countries have not joined in. Actually, that list is long – all African, Middle Eastern and Latin American countries, plus more, for a total of 150 countries not abiding by the Russian sanctions. These countries recognize that they need Russian energy and food. It is also likely they are concerned about their own dollar reserves.
Reshoring of American factories
While all these events are very disruptive to the financial system, could easily lead to a highly inflationary period, and will likely be damaging to savers and those on pensions, it shows promise to rebuild America’s infrastructure and especially its manufacturing base.
According to The Reshoring Initiative, 5,264 cases of reshoring or prevention of offshoring have occurred over the past decade or so, and this process is accelerating due to supply chain disruptions. It will be further stimulated by a weaker dollar, which makes it more profitable to invest on American soil.
This is good news for the working class and younger generations. It is likely to be robotized where applicable, so I expect the need for technicians and engineers to grow to maintain and operate all those robots.
Reshoring and decentralization create a more resilient and thus stable society. I have concerns that this movement will be dampened by energy and raw material constraints, so will see how much of an impact arises from that.
“Since 1971, the global reserve status of the US dollar has been underpinned by oil, and the petrodollar era has only been possible due to both the world’s continued use of US dollars to trade oil and the USA’s ability to prevent any competitor to the US dollar.
But what we are seeing right now looks like the beginning of the end of that 50-year system and the birth of a new gold and commodity backed multi-lateral monetary system. The freezing of Russia’s foreign exchange reserves has been the trigger. The giant commodity strong countries of the world such as China and the oil exporting nations may feel that now is the time to move to a new more equitable monetary system. It’s not a surprise, they have been discussing it for years.
While it’s still too early to say how the US dollar will be affected, it will come out of this period weaker and less influential than before.”
- Ronan Manly, BullionStar.com
Here is a quick animation illustrating changes in reserve currencies over the past 120 years. It appears this animation may need changes in the not-so-distant future.
https://www.visualcapitalist.com/cp/how-reserve-currencies-evolved-over-120-years/
The interview with Luke Gromen is one of the most important I have heard yet this year. In essence, it describes the principles of game theory in action.
Game theory is the science of strategy. According to game theory, the actions and choices of all the participants affect the outcome of each. And it's assumed players within the game are rational and will strive to maximize their payoffs in the game.
That is exactly what is playing out, but between nations. Let’s hope it does not become irrational and lead to expanded war as seen in prior Fourth Turning periods. These events normally take years to play out, and it is impossible to predict how long these transitions will take, or if they will even happen. We can only look back to history for guidance.
As I see it, a common currency that equally serves all is fairer and supports a less contentious world. A common currency fosters education, innovation and wise use of resources for growth. The world’s easily accessed resources are dwindling. This creates further competition between nations.
A common, fair currency that suppresses fraud and corruption minimizes the tendency for distrust, and subsequent hostility, between nations.
The need for a means to facilitate trade can be provided without that means being controlled by other parties, as long as that means is equitable to all parties involved. The vehicle for trade does not need to be the store of value.
Historically, the monetary store of value has been interchangeable with the exchange mechanism such that the store of value is not subject to the problems associated with frequent changing of hands. This is how the gold-backed system has always worked when linked to paper currencies.
Whatever means of future exchange is chosen, it is important that it not be depreciated, as this erodes confidence in the system and in government, as well as robs those holding it. This occurs due to excess money printing, is unfair, unwise, and detrimental to all in the long run. Gold backing places a brake on currency overprinting.
Recently, there has arrived a new kid on the block that could serve this role as effectively as gold, and in some ways better. That kid is bitcoin – but that is a topic for a future newsletter.
To wrap things up, on the lighter side – after weeks of research, I finally determined the real reason Putin invaded Ukraine. 👇👇
Disclaimer: This newsletter is for educational purposes and is not to be taken as financial advice. Also, for full disclosure purposes, I must state that I hold gold as an investment/insurance policy.
I'm still reading this article. Do you read Mathew Crawford? I haven't read his (Inside Money and Outside Money) yet, but have just put it on my next list.