Inflation in the U.S. is the worst it’s been in 40 years. The view from beyond our borders, however, has largely been even bleaker — so bad that the American economy is now viewed as an enviable bastion of strength amid a collapsing global system. Last week, that reality became more apparent after new U.K. prime minister Liz Truss unveiled a budget proposal that, during normal times, would have been unremarkably conservative — but instead triggered a deep sell-off in the British pound, nearly triggered a Lehman Brothers–like domino effect, and compelled the International Monetary Fund to regard the United Kingdom like a struggling third-world economy.
To get a better understanding of what’s happening at a structural level, I spoke with Brent Johnson, the CEO of the financial-advisory firm Santiago Capital, who laid out the problems in the global economy years ago with his “Dollar Milkshake Theory.” The core of his thesis has been that the U.S. financial system’s strengths — especially the value of the dollar against other currencies — can end up hurting the rest of the world and may end up, eventually, making things even worse domestically. (In another commonly used metaphor for this idea, the dollar gets so strong that it becomes a financial wrecking ball, smashing overseas economies large and small.) Over recent weeks and months, the greenback has strengthened enormously against all the world’s other major currencies, from the pound and the euro to the Japanese yen and Chinese yuan — creating an increasing amount of chaos in financial markets, with Great Britain at the top of the list. Johnson, who thinks in real time about financial news on Twitter under @santiagocap, walked us through the logic that led him to predict these events and what he sees happening next.
Why is the dollar getting stronger — and why should people care?
As Americans, we are trained to think in one currency — that being the dollar. And the reason is because, with the United States being the global leader, the global hegemon, we have the global reserve currency. So not only do we use the dollar for our local day-to-day business and purchases, but the dollar is also used throughout the world. So people outside the United States have grown up thinking in two different currencies. They understand things in their local currencies, but then they also conduct business and financings in dollar terms.
The reason the dollar has been getting stronger is because it is the best of a bad bunch. For more than a decade, but especially since the pandemic, all countries have been using the same basic policies to manage their economies: a mix of fiscal stimulus and low interest rates to encourage growth. Under those conditions, the relative value of a currency comes down to the level of demand. And since the dollar is the global reserve currency, there’s just simply a lot more demand for dollars around the world than there is for euros or yen or pounds. Like it or not, whether you think it’s appropriate or not, whether you think it’s sustainable or not, the fact is there’s an incredible amount of demand for dollars right now. There’s just no alternative for settling debts around the world.
You called this scenario of the dollar rising in value while other currencies decline the “Dollar Milkshake.” Why a milkshake, of all things?
In There Will Be Blood, there’s a scene in the movie where this oil baron is negotiating with one of his neighbors. The neighbor is trying to convince the oil baron to buy his land in order to get the oil that’s underneath it. And Daniel Day-Lewis, who is the oil baron, says, “I don’t need to buy your land. All I have to do is stick a straw down into the ground. I drink your milkshake.” When I saw that, I said, “Oh my God, that’s a perfect way to describe what I believe will play out with currencies in the global economy.”
What I think has happened since the great financial crisis was essentially that, in order to bail out the world, governments and central banks around the world just flooded the market with new money. I think of that as the mixing of the milkshake. In a world where capital can flow around the globe, it’s not so important who prints the money; it’s more important who captures the money — in the same way that Day-Lewis’s character is saying that what really counts is not who owns the land above the oil but who is most able to suck it out of the ground. Everybody’s printing money, everybody’s mixing the milkshake, but the United States is the only one that has a straw. So we get to drink the milkshake.
When you talk about strong international demand for dollars, you’re talking about, for instance, the global-market oil being priced in dollars?
Correct. When other countries trade internationally, commodities are generally priced in dollars. So when a company in Japan buys soybeans from Brazil, it’s typically invoiced in dollars. Not only that but countries all over the world borrow in dollars because there’s a greater demand for dollars on a global basis. Overall, there’s an incredible amount of dollar-denominated debt outside the United States. This all works fine as long as the dollar stays at a relatively benign level. But as the dollar gets stronger, it becomes even harder for these other countries and these other international entities to pay back that dollar debt. Think of it like this: Let’s say you live in the U.K. and you’re denominated in pounds and you take out $100 in debt denominated in dollars, and at the end of the year, you have to pay it back. Well, if the pound loses 10 percent versus the dollar over that time period, now you’re effectively having to pay $110 back rather than paying $100 back, right?
As that dynamic worsens, there starts to be a rise in global defaults. Once these defaults start to happen, it can have a knock-on effect, which creates more defaults and more financial volatility and more contagion. And now with global growth slowing, they are all hitting the wall — they just don’t have the cash to make those dollar-denominated payments that just keep rising in their local currencies.
Can you talk us through a real-world example?
Let’s use Europe as an example. Europe is in this energy crisis because of supply-chain issues, the war with Russia, all of these reasons. Europe is now having a tough time getting energy. The energy they can get is increasing in price. So that in itself would be bad. But then consider that the dollar has risen close to 20 percent versus the euro over the past year — and remember, energy markets are priced in dollars. So not only has energy gotten more expensive overall, but for Europeans there’s a 20 percent kicker on top of it.
Now with everything getting more expensive, it is getting harder and harder to pay the bill. So what they’re doing is they’re printing more of their own currency to buy dollars and meet those payments. But when they print more of their own currency, that just makes it lose even more value versus the dollar. (Keep in mind the Federal Reserve is pursuing a very tight policy with the dollar right now.) That in turn creates even more demand for dollars. So credit is extended even more.
The problem is once there is no more credit available, then the system can’t grow anymore. Once the system cannot grow, that’s when you start to get these defaults.
Let’s talk about the U.K.’s budget cuts. The pound reached a record low against the dollar. At the same time, the U.K. bond markets started plunging. In response, the Bank of England announced that they were going to buy bonds. But they are also expected to raise interest rates in November. When I first heard about this, I thought I wasn’t understanding this correctly because those are two seemingly contradictory directions — buying bonds is loosening monetary policy, and raising rates is tightening. What’s happening in London?
They’ve had to resort to yield curve control. That’s a fancy term for saying they need to step into the bond market and manipulate interest rates on U.K. debt lower. They print more money, then they go in, and to keep government bond yields from rising (which happens when the value of a bond falls), they buy those bonds. But again, by doing this, they’re putting that money that they printed into the market, and that makes the dollar even stronger against the pound.
In the end, a government and central bank can’t save both the currency and the bond market. Ultimately, they’re going to have to choose one or the other. The big political consideration is that when inflation is high, that’s when the citizenry gets very upset. Throughout history, people typically don’t revolt when their standard of living is increasing, and they do revolt when it’s declining. So from a political perspective, these governments are having a hard time dealing with inflation because the population is upset about it. But governments almost always will choose to sacrifice the currency rather than sacrifice the bond market.
It’s hard to be an optimist right now.
It really is. I don’t know if you’ve watched Game of Thrones or not, but there was an episode where all this crazy stuff is going on, and this one guy keeps moving up and moving up and moving up in stature. At one point he says, “Chaos is a ladder.” My clients have kind of hired me to get them through this. They haven’t hired me to be a financial-justice warrior or to be a moral authority on anything. They’ve hired me to figure out what’s going to happen and position their portfolios in a way that we kind of get through the craziness and profit from it.
In very simple terms, I think it’s going to get much worse. I don’t think this is all going to play out over the next two or three months. It’s going to take at least two or three years, maybe more than that.
If the dollar has already risen so much, why does the U.S. keep raising interest rates — which just drives the dollar higher?
The U.S. needs a tighter monetary policy for domestic reasons — to try to combat inflation here. The Fed thinks a tighter policy on dollars will help tamp down inflation domestically. But it also exacerbates the overseas situation. This power over the global currency allows the U.S. to use the dollar as a kind of weapon, putting other countries in a more vulnerable position. The U.S. can offer to kind of bail them out — but there’s going to be strings attached. “We’re going to need your help versus China” and so on.
Other countries know that the U.S. can use the dollar as a weapon. They know that, by having to use the dollar for international trading and borrowing, they’re not really sovereign. There have been many attempts by other countries over the last few years to get away from the dollar. That’s what Russia is trying to do now and China’s trying to do now, and there are some successes being made on the margins. It’s very possible the dollar loses its global reserve status at some point — but it will happen because of strength rather than because of weakness. And whatever that transition to a new system looks like, it will probably be violent, both economically and militarily.
That doesn’t make me feel better.
No, it doesn’t. But see, here’s the thing. These big macro moves, they always take longer to play out than you think that they’re going to. These government bonds and currencies are the bread and butter of governments — and governments are the most powerful entities in the world. They don’t just want to sit by and watch their kingdoms crumble to the ground. And I think what’s happened the last couple of weeks has kind of shocked them into action.
In my opinion, this is just getting started. I think we’re gonna get into a sovereign-debt crisis. There’s no good decisions; there’s just less bad ones. So while we may have a couple of weeks or even a couple of months of calm after the last two weeks, I think it’s just getting started.
I cannot find any point in any literature where a country only had to intervene in the currency or a bond market once in order to solve its problem. It typically goes on for a long time, and they have to do increasing levels of manipulation or interference or however you want to define it. So to me, this was just like the first move. There’s a lot more to go.
Europe went through a major debt crisis about ten years ago. So do you think that this will be worse than last time?
I do think it will be worse than last time. You know, the last time, then–European Central Bank chief Mario Draghi very famously said the ECB would do “whatever it takes” and “believe me, it will be enough.” It’s one of the greatest calls, or one of the greatest bluffs, in the history of money. He scared the crap out of the markets, and the markets backed down.
But I don’t see how it’s all going to work out this time.
We’ve been talking a lot about the realm of markets and economies here, but these kinds of major changes in economies tend to have electoral consequences as well. We were talking before about East versus West, things like that, but there’s also a dynamic of democracies or liberal economies versus more centrally controlled ones. Have you given any thought to the political repercussions?
For 30 years, the world was moving toward globalization, working more cooperatively together. But in the last two to three years, the world has stopped working together — it’s more fractured now. Russia is trying to define itself as a serious global power. China’s trying to ascend to become the dominant global power. The U.S. is trying to hold on to its place as the dominant global power. They’re all facing, to a certain extent, popular uprisings, or populist policies are gaining traction. This is the great game, right? This is competition on a global scale — East versus West, capitalism versus communism.
The U.S. wants to enforce its will. Russia wants to enforce its will. China wants to become the global superpower. We’re getting to the point where it’s going to get decided. I don’t think that will be next week, but over the next ten years, it’s probably going to play out. I happen to believe that the U.S. is going to do better in this “game of thrones” than many people who think that the U.S. is doomed to fail. But I don’t think it’s going to be easy for anybody.
This interview has been edited and condensed for clarity.
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