The world's central banks have been on a collective and profligate printing spree for much of the past decade, doubling down after the financial crisis to stave off a worldwide depression.
Over the last five years alone, for example, the Federal Reserve and the European Central Bank have expanded their balance sheets by a combined $4 trillion, spawning the biggest and fastest growth in the respective money supplies on record.
Under normal circumstances, doing so this quickly and significantly would lead to massive inflation, akin to Germany's experience between the world wars. Yet nothing of the sort has happened. In fact, the bigger concern in the U.S. is deflation.
Where has all the money gone?
The answer to this question is, at once, nowhere and everywhere. It's nowhere because much of the newly created currency hasn't made its way into the economy at large, remaining in the proverbial vaults of the world's central banks. And it's everywhere because effectively none of it is in the vault from which it originated.
As you can see in the table below, the collective size of the world's largest currency reserves has exploded since the turn of the century, increasing by more than $5.5 trillion, or 954%. In other words, a good deal of the money that's been created in the U.S. and Europe has been squirreled away by central banks abroad. China alone has accumulated more than $3 trillion of it.
Increase in Reserves
% Increase in Reserves
Source: Federal Reserve Bank of St. Louis.
Moreover, besides the size of these reserves, a particularly interesting aspect of this phenomenon is how recent it is. To illustrate this point, I charted the reserves of these central banks for the last 30 years. And as you can see below, reserve balances really didn't start accumulating until the mid- to late 1990s. But once they did -- notably, after the Asian financial crisis demonstrated the prudence of doing so -- they haven't looked back.
Source: Federal Reserve Bank of St. Louis. Countries included: Australia, Brazil, Canada, China, India, Japan, Russia, Saudi Arabia, and South Korea.
What does all of this mean?
The honest answer is: I have no idea, as there is simply no recent precedent for this magnitude of global monetary expansion in peacetime. While I agree with the explanation that we're in the midst of a deflationary cycle related to deleveraging, that doesn't answer the question of what happens next. In other words, what happens if and when all of these reserves are eventually released into the economy at large?
Once the dust settles from the current crisis, which could take years or perhaps decades, my guess is that Western economies are looking at a highly inflationary future. Indeed, as far as we know, that's what happens when the money supply in circulation increases dramatically -- assuming, of course, that money velocity eventually recovers as well, and central banks aren’t able to fully drain all the excess liquidity. And related to this, I'd also venture a guess that the currencies of developed nations -- namely, the U.S., Europe, and Japan -- will depreciate markedly relative to currencies of the so-called emerging markets -- namely, China and India.
How should investors prepare?
If you haven't already done so, one way to prepare for this is to diversify a portion of your portfolio into emerging market equities -- and, by doing so, gain exposure to their explosive growth. My preference is to use exchange-traded funds like the Vanguard MSCI Emerging Markets ETF
A second option is to invest in ETFs that hold bonds denominated in emerging market currencies. Three that I discussed recently are Guggenheim Funds' Guggenheim Yuan Bond ETF
Finally, if you prefer to stay invested in American-based companies, then it also makes sense to explore ones that are themselves globally diversified. To learn the identity of three companies that we recommend in this regard, click on the following link to access our free report, "3 American Companies Set to Dominate the World."
Foolish contributing writer John Maxfield does not have a financial position in any of the companies mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.