“What we may be witnessing is not just the end of the Cold War, or the passing of a particular period of post-war history, but the end of history as such… That is, the end point of mankind’s ideological evolution and the universalization of Western liberal democracy as the final form of human government.” -Francis Fukuyama
I’d like to pause our discussion on building an all-weather portfolio today in favor of a big-picture idea.
It’s an idea that’s been rattling around in the back of my head… and I’ve made some investment decisions based on it. But I’ve never fleshed the idea out on paper before.
So please forgive me if the idea isn’t completely formed yet. Sometimes you just have to start writing with what you have and then the rest will come to you…
The quote from Mr. Fukuyama above comes from an essay he wrote in 1989. He titled it The End of History?.
Fukuyama’s essay suggested that the collapse of the Soviet Union marked the end of history. With the communists defeated, Fukuyama said that humanity’s ideological evolution was complete. Thus, the Western liberal democracy as it then existed would last forever.
At the time Fukuyama’s suggestion made a fair amount of sense. It had become clear for the world to see that market-based economies are superior to socialist ones.
After all, it was “morning in America”. The economy was humming. The labor market was strong. And household incomes were on the rise.
Meanwhile, technological developments were powering forward.
American households were getting personal computers for the first time in history. And a gentleman named Steve Jobs was putting the finishing touches on the Macintosh Classic to accelerate this trend.
Jobs took the Classic to market in 1990. It became the first computer available for less than $1,000. That made personal computing affordable for a wider range of households than ever before.
So it certainly looked like Fukuyama’s idea had merit. What system could possibly be better than the one driving so much innovation and prosperity?
Fast forward to today and the global financial system is fracturing right before our eyes.
Geopolitical tensions are as high as they’ve been since the Cold War. And as we discussed yesterday, most of the world’s liberal democracies are now drowning in debt.
But now that interest rates have normalized, that debt is quickly becoming unmanageable. The annual interest expense is starting to crowd out other spending… which will force countries to make a difficult choice. Budget cuts and austerity? Or accelerated inflation?
That got me thinking… how did we get to this point?
Obviously the global financial system is incredibly complex—far too complex for anybody to understand all the nuances and the moving pieces in real time. So I don’t pretend to have a complete answer here. But a big piece of the puzzle revolves around our choice of global reserve assets…
Gold was the developed world’s primary reserve asset for centuries prior to 1971.
We can trace this all the way back to 1717. That’s when Sir Isaac Newton fixed the gold content of the pound sterling – creating a variation of the gold standard that would persist for the next 200 years.
The world abandoned the gold standard during World War I. But even then the new monetary system used gold as the underlying reserve asset.
That changed in 1971 when President Nixon closed the gold window. From that point forward the US dollar became the world’s reserve currency.
And this created a dynamic by which US Treasury bonds became the de facto reserve asset. That’s because economic actors didn’t want to hold their reserves in government currency. Instead, they parked their dollars in Treasury bonds to generate a yield.
So we swapped out gold for US government debt as the world’s reserve asset. That’s the core issue.
Today all major countries, central banks, and corporations hold US Treasury bonds on their balance sheets. Some international trade deals are secured using US Treasury bonds as collateral as well.
We can see how this created a perverse incentive for the US government to go deeper and deeper into debt by selling Treasury bonds to the world.
And then the government had to do something with the proceeds it received from selling those bonds… so it began spending money on every kind of program imaginable. That’s how the US government came to be such a massive behemoth.
Of course, other national governments didn’t sit idly by. They employed the same model of selling bonds to finance increased government spending. It became something of an arms race. In some cases quite literally.
It all stems from our choice of global reserve asset. There are many other nuances at play here… but if we want to point to a single thing, that’s it.
Gold as a reserve asset encourages fiscal responsibility. Government debt as a reserve asset incentivizes irresponsible government spending for its own sake.
The problem is, a system of perpetually growing debt isn’t sustainable. And we’re rapidly approaching the end of the road.
That said, I can see a clear path towards salvaging the current system. It’s just a matter of shoring up broken balance sheets. Here’s one possible path…
There’s a reason why all major central banks still own gold today – even though it hasn’t been part of the financial system for over fifty years now. And it’s the same reason why central banks bought record amounts of gold in 2022 and 2023.
Perhaps ironically, the central banks could use gold to save themselves and the current banking system.
The US government still owns 8,133 metric tons of gold. That’s worth about $612 billion with gold trading around $2,340 an ounce as I write.
At the same time, the Federal Reserve’s (the Fed’s) balance sheet now stands at $7.4 trillion. The bulk of that consists of US Treasury bond holdings.
This puts the ratio of gold to Treasury bonds on the Fed’s balance sheet at 1-to-12 in dollar terms. To my way of thinking, this means the Fed is leveraged 12X when it comes to its real underlying collateral.
Now let’s suppose that gold is allowed to rise to, say, $10,000 an ounce. That would make those 8,133 metric tons worth $2.6 trillion.
Suddenly the Fed’s balance sheet would only be levered up by about 2.8X. That’s far more sustainable.
And at that point it would open the doors to addressing the US national debt and its unfunded liabilities in some creative ways. That’s assuming the Fed maintains normalized interest rates and Congress agrees to cut government spending.
Based on my analysis, I’m very confident that the Fed will hold firm on interest rates. I’m not at all confident that Congress will cut spending… but that’s what would have to happen to salvage the current system.
With that in mind, I’ve noticed something curious.
There’s been chatter out there about the US dollar collapsing and the US government going bust for years now.
That chatter projects current trends out to their logical conclusion… but it ignores the fact that these trends could change. And they need to change if the people empowered by the current banking system want to stay in power.
And notice how it’s always the US dollar in the crosshairs. I can’t recall coming across any doom and gloom commentary about the Euro or the European Union (EU) being at risk. But the fact is that the Euro and the EU are in a far more precarious situation.
If we’re staring down a global debt crisis in the Western world – the US is in the best position by far. Because of its massive gold hoard.
In a crisis, confidence is the name of the game. And gold equals confidence.
I think that’s why gold has been on a tear this year.
The gold market is sniffing out the fact that we may see a debt crisis thanks to normalized interest rates. That’s why gold is hitting all-time highs even as rates have risen.
And there’s one more angle to this story that may seem counter-intuitive…
If I’m right that gold could be used to salvage the current financial system… and if I’m right that saving the current system is the Fed’s true goal – I could make a case that this is also bullish for US stocks looking forward. Because it’s all about global capital. Capital is going to flow to where it’s treated best.
In the short-term I still think the US stock market is overextended and due for a correction. I also think a recession is inevitable. Fourteen years of zero-bound interest rates fueled a lot of malinvestment, and that malinvestment needs to be liquidated.
These are the things that the financial news screeches and squawks over. They tell us corrections, recessions, and government budget cuts are bad. But in my mind’s eye, they sure look like the path forward to me.
I’m still trying to piece this all together into a true thesis that I can clearly articulate. I don’t think I’m there yet. There are still some pieces rattling around in the back of my head trying to find their way out.
But I do know that the investment themes we’ve been discussing this week stand to do very well thanks to this complicated economic dynamic. We’ll finish that discussion next week.
-Joe Withrow
P.S. Everything we’re seeing play out on the macro stage is converging to create what I’m calling The New Rules of Money. For a deeper dive on how this all impacts finance and investing – and how we should get ahead of it – just go right here.