It’s time for a big financial system reset


The writer is founder and CEO of Longview Economics

On average, international monetary systems last around 35 to 40 years before the tensions they create become too great and a new system is needed.

Before World War I, major economies existed on a hard gold standard. During the wars, most economies reverted to a “semi-hard” gold standard. At the end of World War II, a new international system was devised – the Bretton Woods Order – with the dollar tied to gold and other key currencies tied to the dollar.

When this collapsed in the early 1970s, the world moved to a fiat system where the dollar was not backed by a commodity and therefore was not pegged. This system has now reached the end of its usefulness.

An understanding of the drivers of the 30-year debt supercycle illustrates the fatigue of the system. These include the endless liquidity that has been created by commercial and central banks as part of this anchorless international monetary system. This process has been aided and encouraged by global regulators and central banks who have largely ignored monetary targets and money supply growth.

The massive growth in mortgage debt in most of the world’s major economies is a key example. Rather than a shortage of housing supply, as is often postulated as the main reason for high house prices, it is the abundant and rapid growth in mortgage debt that has been the main driver in recent decades. .

It is also, of course, one of the factors that are at the heart of current inequalities and the generational divide. Solving it should contribute significantly to healing divisions in Western societies.

With a new US administration and the end of the Covid battle in sight with the vaccination rollout underway, now is the time for the major economies of the west (and ideally the world) to sit down and design a new international monetary order.

In this framework, there should be generalized debt cancellation, in particular public debt held by central banks. We estimate that at around $ 25 billion in public debt in major regions of the world economy.

Whether the debt cancellation extends beyond that should be at the heart of negotiations among policymakers over how to build the new system – ideally, it should be a form of jubilee. debt.

The implications for bond yields after debt cancellation need to be fully reflected and debated. A normalization of returns as liquidity levels normalize is likely.

Strong ownership of public debt in this environment by parts of the financial system such as banks and insurers could inflict significant losses. In this case, the recapitalization of parts of the financial system should be included as part of the establishment of the new international monetary order. Likewise, the impact on pension assets must also be considered and prepared.

Second, policymakers should negotiate some form of anchor – whether it’s tying currencies to each other, tying them to a central electronic money, or perhaps electronic special drawing rights, the international reserve asset created by the IMF.

As pointed out above, one of the main drivers of inequality in recent decades has been the ability of central and commercial banks to create endless amounts of liquidity and new debt.

This created somewhat speculative economies, too dependent on cheap money (be it mortgage debt or otherwise) which then funded serial asset price bubbles. While asset price bubbles have been a pervasive feature throughout history, their size and frequency have increased in recent decades.

As the Fed reported in its 2018 survey, every major asset class over the 20 years from 1997 to 2018 grew on average at an annual rate faster than nominal GDP. In the long run, it is neither healthy nor sustainable.

With a liquidity anchor in place, the global economy will then move closer to a cleaner capitalist model where financial markets will return to their primary role of price discovery and capital allocation based on perceived fundamentals (rather than liquidity levels).

Growth should then become less dependent on debt creation and more dependent on productivity gains, global trade and innovation. In this environment, income inequality is expected to decline as the gains in productivity growth become more widely shared.

The main reason why many Western economies are now excessively dependent on consumption, debt and house prices is the establishment of the national and international monetary and financial architecture. A big reset therefore offers the opportunity to restore (some semblance of) economic equity in Western and other economies.

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Don F. Davis

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