Entropy and the Dollar
Asked to make a presentation on the increasing shift in the commercial and geopolitical world toward de-dollarization, I reviewed (yet again) a recent study by the U.S. Defence Department, ‘At Our Own Peril: DoD Risk Assessment in a Post-Primacy World’.
The bottom line was regionally predictable, a call to increase the defence budget, and further increase military spending from conventional and nuclear through to cyberwarfare. The reasoning, albeit somewhat at the fringes of the study stated that the U.S. framework of international order that was established post World War II is both ‘fraying’ and ‘collapsing.’
That caught my attention, as it is one of the support pillars of the U.S. Dollar. The study published by the U.S. Army War College’s Strategic Studies Institute is to evaluate the DOD’s approach going forward in assessing risk and policy. Of necessity, it closely tracks with the current economic trends and perceptions prevalent in Washington.
Apparently, the study finds that the nation’s power is in decline because the world has entered a new phase of transformation, where the U.S. led international order is unravelling, and in fact, the authority of traditional governments everywhere is increasingly unstable.
The report further finds ‘global events will happen faster than the Defence Department is currently equipped to handle,’ and that the U.S. ‘can no longer count on the unassailable position of dominance, supremacy, or pre-eminence it enjoyed for the 20-plus years after the fall of the Soviet Union.’
In conclusion, the study claims that not only the U.S. is seeing a decline, ‘All states and traditional political authority structures are under increasing pressure from endogenous and exogenous forces. The fracturing of the post-Cold War global system is accompanied by the internal fraying in the political, social, and economic fabric of practically all states.’
This expected void will likely over time be filled by various multilateral regional alliances and powers. International governance as never before is using currencies and trade as weaponized extensions of foreign policy. Governance is changing before our eyes in real time from a system anchored in predictable, relatively constant positions to a system that is more erratic, unsettled, and mostly devoid of traditional behavioural norms. Diplomacy as a tool of government is quickly losing the dignity once ascribed to affairs of state. In geopolitical terms, we have moved from an age of order to an age of increasing political and financial entropy.
In reviewing current affairs, I do not see heightened threats coming from some self-immolating global Armageddon; rather I see increasingly strident schisms and conflicts over geopolitical, monetary, trade, and societal issues and influence. The majority of these schisms historically were comfortably located far from the immediate territorial borders of the U.S. No longer is this true, the current trade and tariffs dust-up with Mexico, Canada and several nations in Latin America are a case in point.Rudyard Kipling perhaps best summed up the old geopolitical order, when he coined a brilliant term for it, which caught at once the athletic, masculine, goal-oriented and sentimental components comprising the ‘Great Game’. It is now a quaint memory of a distant time. Compared with today’s complexities it is akin to a classic game on a chessboard, contrasting with a three-dimensional game of chess now being played out on a virtual digital board.
The second law of thermodynamics, the entropy law, states that in closed systems, randomness, disorder, and chaos tend to prevail over the long term. Centres do not hold; all systems disintegrate. A nation is a system; disintegration is its fate. As Clausius demonstrated in 1865, entropy grows out of all proportion to the energy expended in producing it. His famous example is the cue ball: shot into a racked set of billiards, it transfers the energy of the cue into the formation of the balls; and while the energy of the system is in this way transformed and briefly increased, the entropy is amplified far more, as demonstrated by the balls careening madly across the surface of the table. This example takes place on two dimensions. Imagine this concept as applied in three dimensions: the complications are immeasurable.
The second law of thermodynamics states that entropy must always increase with time, which, loosely speaking means that things always become more disordered as time increases. Since heat is random motion, ordered energy eventually turns to heat. Molecules never align their motion; a bag of balls spilled over a playing field never roll back together and pile themselves in a nice neat heap.
The other aspect of entropy is the strangely curious tendency within chaos to gravitate towards homogeneity. Keeping heterogeneous things that are in contact from becoming homogenous takes energy and effort. We see global systems become more alike as they come into contact. In the geopolitical and trade context this can be observed as loss of multilateralism, loss of cultural diversity, loss of political diversity, loss of economic or trade diversity, and loss of the unique protections that come with diversity.
There is not much to be done about it either – as we increasingly accept homogenous globalization, as our culture becomes a single closed system, rising entropy is inevitable. We have seen this repeated throughout history, from history’s age of empires (China, Egypt, Greece, Rome, Mongol, Holy Roman, Ottoman, Spanish, Dutch, French, British, etc.) and into our last century with the Greater East Asian Co-Prosperity Sphere, Axis, Soviet Union, the Warsaw pact, and today’s US.
We are seeing political entropy ongoing within the dissonant nations comprising the EU, and we see the stresses worldwide economically and politically under the umbrella of political, financial and military alliances with the U.S. from Asia, Africa, Europe and Latin America. Perhaps because the fallout from entropy has only recently played out its recent hand in Russia and China, they are less exposed yet certainly are not immune over time.
The political clashes of the 20thcentury were largely focused on the perceived battle, simply stated between individualism vs; collectivism, the haves vs; the have nots, the informed vs; the oblivious. This has a 21stcentury sequel today as heterogeneity vs homogeneity within a never before experienced globally accessible and interactive digital information field.
There is a constant in this world, and that is ‘size matters’ in the affairs of state. A nation can grow massive muscles, get pumped up to huge proportions, become solidly in thrall to financial steroids, become a global champion world eater, yet at the end of the day should the massive infusions slow down or stop the ripped body eventually deflates, not fair, but that is life.
In the 1960s, French politician Valéry d’Estaing complained that the United States and its exporters enjoyed an ‘exorbitant privilege’ due to the dollar’s status as the world’s reserve currency. He had a point. Because the dollar was, and is, the world’s currency, the U.S. can borrow more cheaply than it could otherwise due to lower interest rates. U.S. banks and companies can conveniently do cross-border business using their own currency, and when there is geopolitical tension in the world, central banks and investors buy U.S. Treasuries, keeping the dollar high and the United States insulated from the conflict. A government that borrows in a foreign currency can go bankrupt, but not when it borrows from abroad in its own currency.
So, is the U.S.D slipping away from its ‘exorbitant privilege’? While those attending the Bretton Woods conference in 1944 envisioned the U.S.D enjoying these advantages in perpetuity, the reality is the greenback has been in decline for some time. Since the Federal Reserve was created in 1913, the dollar has lost more than 95% of its value. Over a hundred years ago, a buck was worth a buck; in 2018, its value has been estimated at less than 5 cents, it’s worth eroded by inflation.
Then there is the U.S. sovereign debt, currently sitting at over $21 trillion and growing daily. In 2011 Standard & Poor’s, a ratings agency, downgraded U.S. sovereign debt from AAA to a far lower A. The U.S. produces just 22% of world output, but according to the Bank for International Settlements accounts for over 80% of cross-border invoicing, reserves, settlements, liquidity and funding.
The quantitative easing program that saw the Fed’s assets skyrocket from $900 billion to $4.5 trillion between 2009 and 2015 (through the buying up of Treasuries, paid for by printing money), made it inexpensive for the U.S. government to continue to borrow and spend—with rates close to zero.
However, what that did was show other countries that no longer was the United States following a sound fiscal policy; all they were doing was printing money. Countries started to diversify their foreign exchange reserves and reduce their dependence on the dollar. According to the IMF, U.S.D foreign exchange reserves have dropped from 72% of the world’s forex in 2001 to less than 62% today and is continuing to shrink.
Russia sold off 84% of its U.S. debt holdings between March and May of this year, leaving just $14.9 billion in its U.S. reserve account, which since then has been reduced further. That compares to $102 billion in December 2017. The sell-off corresponded with more U.S. financial sanctions imposed on Russia.
The dumping of U.S. Treasuries by Russia was easily shrugged off by U.S. Treasury officials and politicians, who know that Russia only held about one-tenth of the T-bills owned by China, which has the most of any country, $1.2 trillion. The question then is what would happen if China, like Russia started selling U.S. Treasuries and how would that affect the U.S. dollar? The follow on effect is how then would the U.S. finance its $21.476 trillion debt if the anti-T-bill movement spread further among sovereign nations and the market for them slowed or even in some cases stopped?
It therefore is no wonder that the search for alternatives to the U.S. dollar is so active. One very clear new example is the growing crypto-currency world, fintech and the blockchain. While still in relative infancy and viewed with some disdain by financial traditionalists, nonetheless the concept and mechanisms are making steady inroads into the financial fabric of the world, and are at early stages of regulatory acceptance by several sovereign states.
Today the value of all cryptocurrencies if viewed in dollar terms is comparatively small with a total market capitalization of just over $587 billion. This real potential financial mechanism is consolidating, shaking off the ‘wheat from the chaff’, and continuing with some notable volatility to expand. This, albeit with grudging acceptance by global financial market players and regulators alike.
As in Clausius’ example earlier, the principles of entropy are slowly becoming quite apparent even on the pool table of the greenback. The farther the dollar moves away from a medium of exchange to a political instrument of policy projection, the greater is the energy exerted by other nations in their effort to determine, establish and grow their own sovereign heterogeneity. Change happens, and the great question before us to try to determine is the trajectory and timing of these changes