ALSO BY JAMES RICKARDS
Currency Wars
The Death of Money
The New Case for Gold
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Copyright © 2016 by James Rickards
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To the memory of John H. Makin,
economist, mentor, and friend. We need him now more than ever.
When he had opened the third seal, I heard the third living creature cry out, “Come forward.” And I beheld a black horse, and its rider held a scale in his hand. I heard a voice in the midst of the four living creatures. It said, “A measure of wheat costs a day’s pay, and three measures of barley cost a day’s pay. But do not damage the oil and the wine.”
Revelation 6:5–6
CONTENTS
Also by James Rickard
Title Page
Copyright
Dedication
Epigraph
Introduction
Chapter 1
This Is the End
Chapter 2
One Money, One World, One Order
Chapter 3
Desert City of the Mind
Chapter 4
Foreshock: 1998
Chapter 5
Foreshock: 2008
Chapter 6
Earthquake: 2018
Chapter 7
Bonfire of the Elites
Chapter 8
Capitalism, Fascism, and Democracy
Chapter 9
Behold a Black Horse
Conclusion
Acknowledgments
Notes
Selected Sources
Index
INTRODUCTION
FELIX SOMARY WAS PERHAPS THE GREATEST ECONOMIST OF THE TWENTIETH CENTURY. He is certainly among the least known.
Somary was born in 1881 in a German-speaking part of what was then the Austro-Hungarian Empire. He studied law and economics at the University of Vienna. There he was a classmate of Joseph Schumpeter’s and took his Ph.D. with Carl Menger, the father of Austrian economics.
During the First World War Somary served as a central banker in occupied Belgium, but for most of his career he was a private banker to wealthy individuals and institutions. He moved to Zurich in the 1930s where he lived and worked until his death in 1956. Somary spent most of the Second World War in Washington, D.C., where he served as a Swiss envoy on financial affairs and provided advice on finance to the War Department.
Somary was widely considered the world’s greatest expert on currencies. He was frequently called upon by central banks to advise on monetary policy. Unfortunately for those banks, his sound advice was mostly ignored for political reasons.
He was called the Raven of Zurich for his uncanny ability to foresee financial catastrophes when others were complacent. Ravens in Greek mythology are associated with Apollo, god of prophecy. In the Old Testament book of Kings, ravens are commanded by God to minister to the prophet Elijah. Somary was perhaps the greatest economic prophet since antiquity. The English-language translation of Somary’s memoir is titled The Raven of Zurich.
Somary not only foresaw the First World War, the Great Depression, and the Second World War before others, but he accurately warned about the deflationary and inflationary consequences of those cataclysms. He lived through the demise of the classical gold standard, the currency chaos of the interwar period, and the new Bretton Woods system. He died in 1956 before the Bretton Woods era came to an end.
Somary’s success at forecasting extreme events was based on analytic methods similar to ones used in this book. He did not use the same names we use today; complexity theory and behavioral economics were still far in the future when he was engaged with markets. Still, his methods are visible from his writings.
A vivid example is a chapter in his memoir called “The Sanjak Railway,” which describes an episode that occurred in 1908 involving Somary’s efforts to syndicate a commercial loan. The loan proceeds were to build a railroad from Bosnia to the Greek port city of Salonika, today’s Thessaloniki. The railroad itself was an insignificant project. Somary was engaged by backers in Vienna to report on its financial feasibility.
The proposed route crossed an Ottoman province called the Sanjak of Novi Bazar. This route necessitated an application from Vienna to the Sublime Porte for permission.
What happened next shocked Vienna. Foreign ministries from Moscow to Paris protested vehemently. As Somary writes, “The Russian-French alliance had reacted to Austria-Hungary’s application for a rail concession with a storm of protest unparalleled in intensity—and had in turn made a political countermove by proposing a railway from the Danube to the Adriatic.”
This railroad incident took place before the Balkan Wars of 1912–13, and six years before the outbreak of the First World War. Yet, based on the French-Russian reaction alone, Somary correctly inferred that world war was inevitable. His analysis was that if an insignificant matter excited geopolitical tensions to the boiling point, then larger matters, which inevitably occur, must lead to war.
This inference is a perfect example of Bayesian statistics. Somary, in effect, started with a hypothesis about the probability of world war, which in the absence of any information is weighted fifty-fifty. As incidents like the sanjak railway emerge, they are added to the numerator and denominator of the mathematical form of Bayes’ theorem, increasing the odds of war. Contemporary intelligence analysts call these events “indications and warnings.” At some point, the strength of the hypothesis makes war seems inevitable. Bayes’ theorem allows an analyst to reach that conclusion ahead of the crowd.
The sanjak railway episode echoes rivalries in our own day about natural gas pipelines from the Caspian Sea to Europe, some of which may traverse old Ottoman sanjaks. The players—Turkey, Russia, and Germany—are the same. Where is our new Somary? Who is the new raven?
Somary also used the historical-cultural method favored by Joseph Schumpeter. In 1913, Somary was asked by the seven great powers of the day to reorganize the Chinese monetary system. He declined the role because he
felt a more pressing monetary crisis was coming in Europe. A decade ahead of a powerful deflation that held the world in its grip from 1924 to 1939, he wrote:
Europeans found the Chinese amusing for their rejection of paper money and their practice of weighing metallic currency on scales. People presumed that the Chinese were five generations behind us—in reality they were a generation ahead of Europe. Under the Mongol emperors they had experienced a boom in which paper billions were issued to finance military conquests and vast public works, only to go through the bitter deflationary consequences—and the impression of all this had lasted through many subsequent centuries.
Somary also showed his mastery of behavioral psychology in analyzing an incident from July 1914, in which King George V of England assured the kaiser’s brother, who was the king’s cousin, that war between England and Germany was impossible:
Doubtless the King too had spoken in good faith to his cousin, but I was uncertain how much insight the King could have into the situation. I had seen six years before how little informed more capable rulers had been; the information available to insiders, and precisely the most highly placed among them, is all too often misleading. I relied more the on the judgment of The Times than of the King. On behalf of those friends whose assets I was managing, I converted bank deposits and securities into gold and invested in Switzerland and Norway. A few days later the war broke out.
Today, the king’s mistaken views would be described by behavioral psychologists as cognitive dissonance or confirmation bias. Somary did not use those terms, yet understood that elites live in bubbles beside other elites. They are often the last to know a crisis is imminent.
Somary’s memoir was published in German in 1960; the English-language translation only appeared in 1986. Both editions are long out of print; only a few copies are available from specialty booksellers.
One year after the English edition was published, on October 19, 1987, the Dow Jones Industrial Average dropped over 20 percent in a single day, ushering in the modern age of financial complexity and market fragility. One is inclined to believe that had Somary lived longer he would have seen the 1987 crash coming, and more besides.
Using Somary’s methods—etiology, psychology, complexity, and history—this book picks up the thread of financial folly where the Raven of Zurich left off.
Is economics science? Yes, and there the problems begin. Economics is a science, yet most economists are not scientists. Economists act like politicians, priests, or propagandists. They ignore evidence that does not fit their paradigms. Economists want scientific prestige without the rigor. Today’s weak world growth can be traced to this imposture.
Science involves both knowledge and method. Sound method is the way to acquire knowledge. This is done through induction, basically a hunch, or deduction, an inference drawn from data. Either an inductive or deductive approach is used to form a hypothesis: a rigorous guess. The hypothesis is tested by experimentation and observation, which lead to data. The hypothesis either is confirmed by data, in which case the hypothesis becomes more widely accepted, or is invalidated by data, in which case the hypothesis is rejected and replaced by new hypotheses. When a hypothesis survives extensive testing and observation, it may become theory, a conditional form of truth.
Scientific method applies readily to economics. The familiar distinction between hard sciences such as physics and soft sciences such as economics is spurious. Academics today categorize specific branches of science as best suited to explain particular parts of the universe. Astronomy is a sound way to understand galaxies. Biology is a fruitful way to understand cancer. Economics is an excellent way to understand resource allocation and wealth creation. Astronomy, biology, and economics are branches of science applied to distinct areas of knowledge. All are science, and amenable to scientific method.
Still, most academic economists are not scientists; they are dogmatists. They cling to an old version of their science, are not open to new views, and discard data that contradict dogma. This decrepit landscape would be academic but for the fact that economists control powerful positions in central banks and finance ministries. Their use of outdated theory is not merely academic; it destroys the wealth of nations.
This topic bears discussion before the next financial crisis because so much is at stake. The United States’ economy has grown, albeit sluggishly, for more than seven years since the last crisis as of this writing. That’s a historically long expansion. The time since 2008 roughly tracks the tempo of panics in 1987, 1994, 1998, and 2008. Seven years between crises is not a fixed span. A new crash in the near term is not set in stone. Still, no one should be surprised if it happens.
With a financial system so vulnerable, and policymakers so unprepared, extreme policy measures will be needed when catastrophe strikes. This book is a plea to reimagine the statistical properties of risk, apply new theories, and turn back from the brink before it’s too late.
Scientists understand that all theories are contingent; a better explanation than the prevailing view eventually emerges. Newton is not considered wrong because Einstein offered a better explanation of space and celestial motion. Einstein advanced the state of knowledge. Unfortunately economists have shown little willingness to advance the state of their own art. The Austrians, Neo-Keynesians, and monetarists all have their flags firmly planted in the ground. Research consists of endless variations of the same few themes. The intellectual stagnation has lasted seventy years. Ostensible innovation is really imitation of ideas limned by Keynes, Fisher, Hayek, and Schumpeter before the Second World War. These originals were transformative, but the postwar variations are limited, obsolete, and if used doctrinally, dangerous.
The Austrian understanding of the superiority of free markets over central planning is sound. Still, the Austrian school needs updating using new science and twenty-first-century technology. Christopher Columbus was the greatest dead-reckoning navigator ever. Yet no one disputes he would use GPS today. If Friedrich Hayek were alive, he would use new instruments, network theory, and cellular automata to refine his insights. His followers should do no less.
Neo-Keynesian models are the reigning creed. Interestingly, they have little to do with John Maynard Keynes. He was above all a pragmatist; those who follow in his name are anything but. Keynes advocated for gold in 1914, counseled for a higher gold price in 1925, opposed gold in 1931, and offered a modified gold standard in 1944. Keynes had pragmatic reasons for each position.
Churchill once sent a cable to Keynes that read, “Am coming around to your point of view.” Keynes replied, “Sorry to hear it. Have started to change my mind.” It would be refreshing if today’s economists were half so open-minded.
Keynes’s insight was that a temporary lack of private aggregate demand can be replaced with government spending until “animal spirits” are revived. Spending works best when a government is not heavily indebted, and when a surplus is available to finance the spending. Today economists such as Paul Krugman and Joseph Stiglitz, using invalid equilibrium models (the economy is not an equilibrium system), propose more deficit spending by deeply indebted countries for indefinite periods to stimulate demand, as if someone with four televisions buying a fifth is the way forward. This is folly.
Monetarists are no better. Milton Friedman’s insight was that maximum real growth with price stability is achieved by slow, steady growth in the money supply. Friedman wanted money supply to rise to meet potential growth—a variation of the Irish toast, “May the road rise to meet your feet.”
Friedman’s adopted formulation, MV = PQ (originally from Fisher and his predecessors), says that money (M) times velocity (V) equals nominal GDP (consisting of real GDP [Q], adjusted for changes in the price level [P]).
Friedman assumed velocity is constant and ideally there should be no inflation or deflation (an implied P = 1). Once maximum real growth is estimated (averaging about 3.5 percent per year in a mat
ure economy), the money supply can be smoothly increased to achieve that growth without inflation. While useful for thought experiments, Friedman’s theory is useless in practice. In the real world, velocity is not constant, real growth is constrained by structural (i.e., nonmonetary) impediments, and money supply is ill defined. Apart from that, Mrs. Lincoln, how was the play?
Prevailing theory does even more damage when weighing the statistical properties of risk.
The extended balance sheet of too-big-to-fail banks today is approximately one quadrillion dollars, or one thousand trillion dollars poised on a thin sliver of capital. How is the risk embedded in this leverage being managed? The prevailing theory is called value at risk, or VaR. This theory assumes that risk in long and short positions is netted, the degree distribution of price movements is normal, extreme events are exceedingly rare, and derivatives can be properly priced using a “risk-free” rate. In fact, when AIG was on the brink of default in 2008, no counterparty cared about its net position; AIG was about to default on the gross position to each counterparty. Data show that the time series of price moves is distributed along a power curve, not a normal curve. Extreme events are not rare at all; they happen every seven years or so. And the United States, issuer of benchmark “risk-free” bonds, recently suffered a credit downgrade that implied at least a small risk of default. In brief, all four of the assumptions behind VaR are false.
If Neo-Keynesians, monetarists, and VaR practitioners have obsolete tools, why do they cling tenaciously to their models? To answer that question, ask another. Why did medieval believers in a geocentric solar system not question their system when data showed inconsistent planetary motion? Why did they write new equations to explain so-called anomalies instead of scrapping the system? The answers lie in psychology.
Belief systems are comforting. They offer certainty in an uncertain world. For humans, certainty has value even if it is false. Falsity may have long-run consequences, yet comfort helps you make it through the day.
The Road to Ruin Page 1
