The bumpy road ahead for the world economy

Things have “gone downhill” since 1970 when the US oil supply first started to shrink (Figure 5). Suddenly, the US needed help from the financial system to work around the need to import more oil. One change (in August 1971) was making the dollar a fiat currency, rather than tied to a gold standard. This enabled greater use of debt in operating the economy.

Without the gold standard, the US dollar was able to become the world’s reserve currency. Instead of gold reserves, other countries began buying US Treasuries, which they considered to be a safe store of their money. The US dollar could also play a greater role in financing international transactions. A 2021 analysis by the Federal Reserve shows the dominance of the US dollar in many areas of trade.

This dominant role for the US dollar is now being questioned after the US froze the central bank assets of Russia, as part of the sanctions imposed in response to Russia’s invasion of Ukraine. Other countries are beginning to wonder if holding Treasuries is really a good idea, if the US can impose sanctions which make them unavailable. Countries are also figuring out that it is quite possible to arrange sales of commodities and other goods in currencies other than the US dollar.

Also, the US’s ability to win wars is not very clear. The US’s first big loss was the Vietnam War. After 20 years of fighting, that war ended in 1975, with communist forces seizing control of South Vietnam. The Afghanistan War did not go well either. After 20 years, the US abruptly pulled out. While the US claims the mission was accomplished, it is hard to see that the high cost was justified.

The Russia-Ukraine conflict does not appear to be going well for Ukraine and the allies supporting Ukraine. The US and NATO are having difficulty supplying as many armaments as quickly as President Zelensky would like. Ukraine seems to be using up its conventional weapons very rapidly. Neither the US nor other NATO countries can manufacture weapons very quickly, in part because supply lines from around the world are required. How helpful is the US’s hegemony, if the US can’t even easily win a “proxy war” in Ukraine?

There are sanctions, other than freezing assets, that are of concern to other countries. A recent list from a Chinese source lists the following types of hegemony that it considers to be problematic.

• Political hegemony – Throwing the US’s weight around
• Military hegemony – Wanton use of force
• Economic hegemony – Looting and exploitation
• Technological hegemony – Monopoly and suppression
• Cultural hegemony – Spreading false narratives

Quite a few countries in my Rest of the World grouping are clearly getting fed up with America’s hegemony. Increasingly, Middle Eastern countries that were previously at odds with each other are setting aside their differences. They are also becoming much more closely aligned with China. Countries in this group, as well as the BRICS group of countries, are already taking steps toward trading in currencies other than the US dollar.

[8] The path ahead looks very bumpy. The US is likely to be kicked out of its role as global hegemon. Rival countries may choose to attack the US with nuclear weapons, or the US may lash out with nuclear weapons as it sees its hegemony fail.

As I analyze the world economy’s future trajectory, I see the following situations falling into place:

(a) The world economy is being stressed by inadequate energy supplies. When prices rise, it tends to cause inflation. Some countries are experiencing a second kind of stress, as well. Their central banks have raised interest rates. This is a dangerous thing to do because it tends to cause falling asset prices in addition to slowing the economy.

I expect that countries that have recently raised interest rates will have many bank failures. Partly, this will come from the falling value of long-term bonds. In time, it will also come from failing real estate mortgages and other loans, since asset prices will tend to fall with higher interest rates. Governments will be tempted conduct massive bailouts. The countries that have recently raised interest rates include the US, the UK, Eurozone countries, Switzerland, Canada, Australia, and Brazil.

Countries that did not raise interest rates, which seem to include China, India, and Iran, will find their economies less affected by bank failures. Russia temporarily raised interest rates, and then lowered them again, so Russia would also seem to be less affected by bank failures.

Countries that raised rates will be tempted to do bailouts of banks and of “too big to fail businesses.” These bailouts will greatly increase the monetary supply, making countries that didn’t raise interest rates unwilling to trade with them. This dynamic will tend to increase the trend toward two separate trading areas–one including much of Eurasia and one including the US, Canada, Europe and perhaps South America.

(b) If we think about it, cutting back greatly on trans-Atlantic and trans-Pacific shipping would save a great deal of oil if there is not enough oil to go around. This will be another impetus for “Rest of the World” countries, especially those in the Asia-Pacific area, to cut back on shipping across the major oceans.

(c) With failing banks and a cutback in trade between regions, the US dollar will cease to be used as a reserve currency for a large part of the world. The US dollar might still be the reserve currency for some trades, particularly with other countries in the Americas.

(d) I expect that a block of countries will eventually coalesce, centered in Asia, that will mostly trade among themselves. China will probably be the leader of this block.

(e) The US and Europe will mostly be pushed off to the side, to trade among themselves and some geographically close neighbors. These areas may need to set up new financial systems using much less debt. These countries will not be able to produce advanced goods, such as computers, by themselves. They will not be able to build new solar electricity generation or new wind turbines because too much of the supply chain will be out of reach. While these countries have been looking at digital currencies, it is not clear that there will be a stable enough electricity supply to make such currencies possible.

(f) There will probably be war at the time of the division into the two (or perhaps more) trading areas. Nuclear weapons may be involved since there are many countries with nuclear weapons. The supply of conventional weapons available for warfare is depleted, with the ongoing war in Ukraine. According to a study done at Harvard, involving 16 cases in which a major rising power challenged an existing major power over the past 500 years, 12 cases ended in war. This analysis would suggest a 75% likelihood of war.

(g) I don’t know what the timing of all these things will be. Bank failures are just beginning. Let’s keep our fingers crossed that the world economy holds together a while longer.