The following is an excellent excerpt from the book “THE DEATH OF MONEY: The Coming Collapse of the International Monetary System” by James Rickards from the “Introduction” on page 6 and I quote: ”Financial War – Are we prepared to fight a financial war? The conduct of financial war is distinct from normal economic competition among nations because it involves intentional malicious acts rather than solely competitive ones. Financial war entails the use of derivatives and the penetration of exchanges to cause havoc, incite panic, and ultimately disable an enemy’s economy. Financial war goes well beyond industrial espionage, which has existed at least since the early 1800s, when an American, Francis Cabot Lowell, memorized the design for the English power loom and recreated one in the United States.
The modern financial war arsenal includes covert hedge funds and cyberattacks that can compromise order-entry systems to mimic a flood of sell orders on stocks like Apple, Google, and IBM. Efficient-market theorists who are skeptical of such tactics fail to fathom the irrational underbelly of markets in full flight. Financial war is not about wealth maximization but victory.
Risks of financial war in the age of dollar hegemony are novel because the United States has never had to coexist in a world where market participants did not depend on it for their national security. Even at the height of dollar flight in 1978, Germany, Japan, and the oil exporters were expected to prop up the dollar because they were utterly dependent on the United States to protect them against Soviet threats. Today powerful nations such as Russia, China, and Iran do not rely on the United States for their national security, and they may even see some benefit in an economically wounded America. Capital markets have moved decisively into the realm of strategic affairs, and Wall Street analysts and Washington policy makers, who most need to understand the implications, are only dimly aware of this new world.
Inflation – Critics from Richard Cantrillon in the early eighteenth century to V.I. Lenin and John Maynard Keynes in the twentieth have been unanimous in their view that inflation is the stealth destroyer of savings, capital, and economic growth.
Inflation often begins imperceptibly and gains a foothold before it is recognized. This lag in comprehension, important to central banks, is called money illusion, a phrase that refers to a perception that real wealth is being created, so that Keynesian “animal spirits” are aroused. Only later is it discovered that bankers and astute investors captured the wealth, and everyday citizens are left with devalued savings, pensions, and life insurance.
The 1960s and the 1970s are a good case study in money illusion. From 1961 through 1965, annual U.S. inflation averaged 1.24 percent. In 1965 President Lyndon Johnson began a massive bout of spending and incurred budget deficits with his “guns and butter” policy of an expanded war in Vietnam and Great Society benefits. The Federal Reserve accommodated this spending, and that accommodation continued through President Nixon’s 1972 reelection. Inflation was gradual at first; it climbed to 2.9 percent in 1966 and 3.1 percent in 1967. Then it spun out of control, reaching 5.7 percent in 1970, finally peaking at 13.5 percent in 1980. It was not until 1986 that inflation returned to the 1.9 percent level more typical of the early 1960s.
Two lessons from the 1960s and 1970s are highly pertinent today. The first is that inflation can gain substantial momentum before the general public notices it. It was not until 1974, nine years into an inflationary cycle, that inflation became a potent political issue and prominent public policy concern. This lag in momentum and perception is the essence of money illusion.
More recently, since 2008 the Federal Reserve has printed over $3 trillion of new money, but without stoking much inflation in the United States. Still, the Fed has set an inflation target of at least 2.5 percent, possibly higher, and will not relent in printing money until that target is achieved. The Fed sees inflation as a way to dilute the real value of U.S. debt and avoid the specter of deflation.
Therein lies a major risk. History and behavioral psychology both provide reason to believe that once the inflation goal is achieved and expectations are altered, a feedback loop will emerge in which higher inflation leads to higher inflation expectations, to even higher inflation, and so on. The Fed will not be able to arrest this feedback loop because its dynamic is a function not of monetary policy but of human nature.
As the inflation feedback loop gains energy, a repetition of the late 1970s will be in prospect. Skyrocketing gold prices and a crashing dollar, two sides of the same coin, will happen quickly. The difference between the next episode of runaway inflation and the last is that Russia, China, and the IMF will stand ready with gold and SDRs [Special Drawing Rights], not dollars, to provide new reserve assets. When the dollar next falls from the high wire, there will be no net.
Deflation – There has been no episode of persistent deflation in the United States since the period from 1927 to 1933; as a result, Americans have practically no living memory of deflation. The United States would have experienced severe deflation from 2009 to 2013 but for massive money printing by the Federal Reserve. The U.S. economy’s prevailing deflationary drift has not disappeared. It has only been papered over.
Deflation is the Federal Reserve’s worst nightmare for many reasons. Real gains from deflation cannot easily be taxed. If a school administrator earns $100,000 per year, prices are constant, and she receives a 5 percent raise, her real pretax standard of living has increased $5,000, but the government taxes the increase, leaving less for the individual. But if her earnings are held constant, and prices drop 5 percent, she has the same $5,000 increase in her standard of living, but the government cannot tax the gain because it comes in the form of lower prices rather than higher wages.
Deflation increases the real value of government debt, making it harder to repay. If deflation is not reversed, there will be an outright default on the national debt, rather than the less traumatic outcome of default-by-inflation. Deflation slows nominal GDP growth, while nominal debt rises every year due to budget deficits. This tends to increase the debt-to-GDP ratio, placing the United States on the same path as Greece and making a sovereign debt crisis more likely.
Deflation also increases the real value of private debt, creating a wave of defaults and bankruptcies. These losses then fall on the banks, causing a banking crisis. Since the primary mandate of the Federal Reserve is to prop up the banking system, deflation must be avoided because it induces bad debts that threaten bank solvency.
Finally, deflation feeds on itself and is nearly impossible for the Fed to reverse. The Federal Reserve is confident about its ability to control inflation, although the lessons of the1970s show that extreme measures may be required. The Fed has no illusion about the difficulty of ending deflation. When cash becomes more valuable by the day, deflation’s defining feature, people and businesses hoard it and do not spend or invest. This hoarding crushes aggregate demand and causes GDP to plunge. This is why the Fed has printed over $3 trillion of new money since 2008—to bar deflation from starting in the first place. The most likely path of Federal Reserve policy in the years ahead is the continuation of massive money printing to fend off deflation. The operative assumption at the Fed is that any inflationary consequences can be dealt with in due course.
In continuing to print money to subdue deflation, the Fed may reach the political limits of printing, perhaps when its balance sheet passes $5 trillion, or when it is rendered insolvent on a mark-to-market basis. At that point, the Fed governors may choose to take their chances with deflation. In this dance-with-the-Devil scenario, the Fed would rely on fiscal policy to keep aggregate demand afloat. Or deflation may prevail despite money printing. This can occur when the fed throws money from helicopters, but citizens leave it on the ground because picking it up entails debt. In either scenario, the United States would suddenly be back to 1930 facing outright deflation.
In such a circumstance, the only way to break deflation is for the United States to declare by executive order that gold’s price is, say, $7,000 per ounce, possibly higher. The Federal Reserve could make this price stick by conducting open-market operations on behalf of the treasury using the gold in Fort Knox. The Fed would be a gold buyer at $6,900 per ounce and a seller at $7,100 per ounce in order to maintain a $7,000-per-ounce price. The purpose would not be to enrich gold holders but to reset general price levels.
Such moves may seem unlikely, but they would be effective. Since nothing moves in isolation, this kind of dollar devaluation against gold would quickly be reflected in higher dollar prices for everything else. The world of $7,000 gold is also the world of $400-per-barrel oil and $100-per-ounce silver. Deflation’s back can be broken when the dollar is devalued against gold, as occurred in 1933 when the United States revalued gold from $20.67 per ounce to $35.00 per ounce, a 41 percent dollar devaluation. If the United States faces severe deflation again, the antidote of dollar devaluation against gold will be the same, because there is no other solution when printing money fails.
Market Collapse – The prospect of a market collapse is a function of systemic risk independent of fundamental economic policy. The risk of market collapse is amplified by regulatory incompetence and banker greed. Complexity theory is the proper framework for analyzing this risk.
The starting place in this analysis is the recognition that capital markets exhibit all four of complex systems’ defining qualities: diversity of agents, connectedness, interdependence, and adaptive behavior. Concluding that capital markets are complex systems has profound implications for regulation and risk management. The first implication is that the proper measurement of risk is the gross notional value of derivatives, not the net amount. The gross size of all bank derivatives positions now exceeds $650 trillion, more than nine times global GDP.
A second implication is that the greatest catastrophe that can occur in a complex system is an exponential, nonlinear function of systemic scale. This means that as the system doubles or triples in scale, the risk of catastrophe is increasing by factors of 10 or 100. This is also why stress tests based on historic episodes such as 9/11 or 2008 are of no value, since unprecedented systemic scale presents unprecedented systemic risk.
The solutions to this systemic risk overhang are surprisingly straight-forward. The immediate tasks would be to break up large banks and ban most derivatives. Large banks are not necessary to global finance. When large financing is required, a lead bank can organize a syndicate, as was routinely done in the past for massive infrastructure projects such as the Alaska pipeline, the original fleets of supertankers, and the first Boeing 747s. The benefit of breaking up banks would not be that bank failures would be eliminated, but that bank failure would no longer be a threat. The costs of failure would become containable and would not be permitted to metastasize so as to threaten the system. The case for banning most derivatives is even more straightforward. Derivatives serve practically no purpose except to enrich bankers through opaque pricing and to deceive investors through off-the -balance-sheet accounting.
Whatever the merits of these strategies, the prospects for dissolving large banks or banning derivatives are nil. This is because regulators use obsolete models or rely on the bankers; own models, leaving them unable to perceive systemic risk. Congress will not act because the members, by and large, are in thrall to bank political contributions.
Banking and derivatives risk will continue to grow, and the next collapse will be of unprecedented scope because the system scale is unprecedented. Since Federal Reserve resources were barely able to prevent complete collapse in 2008, it should be expected that an even larger collapse will overwhelm the Fed’s balance sheet. Since the Red has printed over $3 trillion in a time of relative calm, it will not be politically feasible to respond in the future by printing another $3 trillion. The task of reliquefying the world will fall to the IMF, because the IMF will have the only clean balance sheet left among official institutions. The IMF will rise to the occasion with a towering issuance of SDRs, and this monetary operation will effectively end the dollar’s role as the leading reserve currency.
A Deluge of Dangers – These threats to the dollar are ubiquitous. The endogenous threats are the Fed’s money printing and the specter of galloping inflation. The exogenous threats include the accumulation of gold by Russia and China (about which more in chapter 9) that presages a shift to a new reserve asset.
There are numerous ancillary threats. If inflation does not emerge, it will be because of unstoppable deflation, and the Fed’s response will be a radical reflation of gold. Russia and China are hardly alone in their desire to break free from the dollar standard. Iran and India may lead a move to an Asian reserve currency, and Gulf Cooperation Council members may choose to price oil exports in a new regional currency issued by a central bank based in the Persian Gulf. Geopolitical threats to the dollar may not be confined to economic competition but may turn malicious and take the form of financial war. Finally, the global financial system may simply collapse on its own without a frontal assault due to its internal complexities and spillover effects.
For now, the dollar and the international monetary system are synonymous. If the dollar collapses, the international monetary system will collapse as well; it cannot be otherwise. Everyday citizens, savers, and pensioners will be the main victims in the chaos that follows a collapse, although such a collapse does not mean the end of trade, finance, or banking. The major financial players, whether they be nations, banks, or multilateral institutions, will muddle through, while finance ministers, central bankers, and heads of state meet nonstop to patch together new rules of the game. If social unrest emerges before financial elites restore the system, nations are prepared with militarized police, armies, drones, surveillance, and executive orders to suppress discontent.
The future international monetary system will not be based on dollars because China, Russia, oil-producing countries, and other emerging nations will collectively insist on an end to U.S. monetary hegemony and the creation of a new monetary standard. Whether the new monetary standard will be based on gold, SDRs, or a network of regional reserve currencies remains to be seen. Still, the choices are few, and close study of the leading possibilities can give investors an edge and a reasonable prospect for preserving wealth in this new world.
The system has spun out of control; the altered state of the economic world, with new players, shifting allegiances, political ineptitude, and technological change has left investors confused. In The Death of Money you will glimpse the dollar’s final days and the resultant collapse of the international monetary system, as well as take a prospective look at a new system that will rise from the ashes of the old.”
(THE FOLLOWING IS ABOUT THE AUTHOR AND I QUOTE:
“JAMES RICKARDS is the author of the national bestseller Currency Wars, which has been translated into eight languages and won raves from the likes of the Financial Times, Bloomberg, and Politico. He is a portfolio manager at West Shore Group and an adviser on international economics and financial threats to the Department of Defense and the U.S. intelligence community. He served as facilitator of the first-ever financial war games conducted by the pentagon. He lives in Connecticut. Follow @JamesGRickards.
THE AUTHOR, JAMES RICKARDS, DESCRIBES JUST EXACTLY WHAT’S HAPPENING NOW OVER IN GRECE. I THINK HE’S RIGHT WHEN HE SAYS TO BAN DERIVATIVES. IF YOU ARE GOING TO GET THIS UNDER CONTROL, YOU ARE GOING TO HAVE TO BAN THE GROWING, UNREGULATED,TOXIC DERIVATIVES, WHICH WOULD BE THE CORRECT WAY TO GET THE PROBLEM UNDER CONTROL, CONSIDERING THERE ARE UNREGULATED METHODS THAT THE BIG INVESTMENT BANKS ARE USING WITH HEDGE FUNDS AND THE RIDICULOUS USE OF HIGH LEVERAGE RATIOS. ALSO, THESE COUNTRIES CAN’T KEEP GOING IN DEBT AT THE RATE THEY ARE GOING. I BELIEVE THE VALUE OF THE DOLLAR MUST BE PROTECTED. I DON’T BELIEVE, THOUGH, THAT THE NEW YORK STOCK EXCHANGE CAN DO THAT USING EXCLUSIVELY THE UNREGULATED, TOXIC DERIVATIVE MARKET. IT HAS TO BE THE CHICAGO MERCANTILE, WHERE THEY USE ALL OF THE COMMODITIES AND DERIVATIVES WHICH ARE USELESS. YOU ARE GOING TO HAVE TO BROADEN THE RANGE OF VALUABLE COMMODITIES SUCH AS GOLD, SILVER, LAND OR EVEN THE FOOD THEY ARE PRODUCING, IF YOU’RE GOING TO GET THE DOLLAR BACK AND THE RESPECT OF THE WORLD.
LaVern Isely, Progressive, Overtaxed, Independent Middle Class Taxpayer and Public Citizen and AARP Members