This week's theme is the global financial system. It's been around for 40+ years in its current guise. That is, since 1971 when Nixon reneged on the US government's promises to pay its debt in gold (or gold equivalent dollars).

However, abandoning gold didn't send the greenback down the toilet. That's because oil soon replaced gold as the 'foundation' of the US dollars' strength. We wrote about it in last month's issue of Sound Money. Sound Investments.

In 1973 US Secretary of State Henry Kissinger made a deal with Saudi Arabia. If the Saudis priced their oil in US dollars and agreed to buy US Treasuries with the proceeds from the oil sales, the US would protect the House of Saud's interests in the region. The Saudis would pay for this military protection (and the infrastructure required to modernise its economy) with the interest from its rapidly increasing stash of Treasury bonds.

Thus the petrodollar came into existence. And the recycling of dollars for oil back into the US economy provided vital support for the US dollar and by extension for the global financial system.

Saudi support sorted out the problem of the US' oil/energy deficit. In the 80s and 90s, Japanese support sorted out the problem of the US' consumer goods deficit. Following the Saudis, Japan recycled its huge trade surpluses back into the US via the purchase of Treasury bonds. And it has done so pretty much ever since.

But there's a looming problem. Abenomics. That's the term for the audacious efforts of Japanese PM Shinzo Abe in trying to engineer inflation in Japan's structurally deformed economy. His strategy makes the US Fed look prudent. Apparently it will pull Japan out of its multi-decade deflationary slump and Japan will once again be prosperous.

So how's it going?

It depends how you look at it. Yesterday, Japan announced a record trade deficit for September of US$9.5 billion, the 15th consecutive monthly deficit. In the first half of the Japanese fiscal year (which starts in April), the deficit came in at US$51 billion, also a record.

The yen has weakened significantly against the US dollar over the past year, but it still managed to run a trade surplus with the US of US$5.4 billion for the month. However it's deficit with China nearly doubled to US$6.3 billion.

What does all this mean and how does it fit in with the health or otherwise of the global financial system?

Well, Japan was a major supporter of the system by buying US Treasuries with the proceeds of its trade surpluses. But it's no longer producing these surpluses. Thanks to a weaker yen and increased energy importing needs after the Fukushima nuclear accident, Japan is now producing regular deficits.

More importantly, its legendary current account surplus is shrinking. (The current account is basically the trade balance plus net income from foreign investments.) In August, Japan's current account surplus was just US$1.64 billion.

In other words, its trade deficit is beginning to consume the income it receives from its vast holdings of foreign assets (including US Treasury bonds). If the trade deficit continues to grow, Japan may have to sell some of its foreign assets to fund it...or issue more debt, which may be difficult given its debt load is already the largest in the world.

The point is that if Japan continues down the path of Abenomics it will no longer be able to fund the US government - as it has basically done for decades. That's another nail in the coffin for the US dollar-based financial system.

That will leave the Fed and China as the main buyers of US debt. We'll get a sense of whether China is still buying with the delayed release of Treasury International Capital (TIC) data tomorrow. But it's quite clear that while they are still supporting the system, they are also making moves to abandon it at some point in the future.

They are importing record amounts of gold...and they are establishing bilateral swap lines with many of the world's central banks in order to bypass the US dollar when conducting trade. They don't want the yuan to replace the US dollar as the world's reserve currency; the Chinese economy doesn't have the depth or strength to fulfil that function. They simply want to build the infrastructure to allow the yuan to become a global trade based currency, while cutting out the US dollar middleman.

Right now, most global trade is settled in US dollars. Trading between two nations usually involves buying and selling the US dollar to facilitate the trade. This is what China is trying to get around. By removing the US dollar from trade transactions, it removes an important leg of support (via foreign exchange trade) for the dollar.

But China has to tread carefully. Its economy is a basket case, courtesy of maintaining the yuan-dollar peg for years at an artificially low rate. This fixing of exchange rates, along with crazy over-zealous central planning, created a huge asset and property price bubble along the lines of Japan in the 1980s.

Then the central planners did more planning to correct the problems caused by previous planning. The latest debacle is the revelation that China's vast affordable housing plan is not really working out, because those who it targets cannot afford it. See here for the sorry story...

So China finds itself helplessly bound up in the current US dollar system. It knows it must get out but cannot do so without causing major global volatility. This goes against the whole vibe of the Chinese leadership, which is stability.

This is why we suspect that China is rapidly accumulating physical gold, and encouraging its citizens to do likewise. They know the West has commoditised the 'price' of gold by throwing thousands of tonnes of paper supply at it. They also know that gold is a wealth reserve asset, not a commodity, and that it will trade as a wealth reserve asset when the current incarnation of the financial system morphs into something else.

For China, gold is a way of preserving some of their savings and hedging against their nearly US$1.3 trillion in US Treasuries. How much more they are willing to absorb is impossible to tell. But they can't be happy with the news that US debt soared by US$328 billion in one day following the resolution of the debt crisis.

Of course the US didn't just spend it all at once. It's been operating under 'extraordinary measures' for a while now, and the one-day increase represents a catch-up to normalise its debt needs. US debt now stands at $17.075 trillion and there is no limit on how much it can spend between now and February 7 when the next debt debate rolls around.

The point we're getting at with all this is that the financial system is in the process of major change. The structures that have held it together for decades are changing and changing fast - in a relative sense.

Right now we're getting a melt-up in asset prices as capital shifts from government debt to the private sector. This is leading to general complacency and the interpretation that 'things are getting better'. In the absence of strong fundamentals, confidence is levitating assets prices around the world.

But confidence is fleeting. Confidence doesn't provide the investor with attractive prices. Instead, it distorts judgment and makes you think that a Semper Augustus is more than just a tulip. So you pay anything for it, secure in the knowledge that someone will come along at some point and pay even more to take it off your hands.

Where does Australia fit into all this? Tomorrow we'll take a look at that very question...

Regards,

Greg Canavan+
for The Daily Reckoning Australia