While the Chinese devaluation was not as large in percentage terms as the 20 percent Swiss franc revaluation, the shock must be viewed in the context of China’s significance to the global economy. China and the United States are the world’s two largest national economies with a combined $30 trillion in GDP comprising 40 percent of global GDP. The United States is China’s largest trading partner. China is the second-largest trading partner to the United States after Canada. One cannot overstate the importance of the U.S.-China exchange rate to world trade and global capital flows. An unexpected 3 percent move in the world’s most important exchange rate relationship is an earthquake.
Effects of China’s shock devaluation were immediate and severe. The Dow Jones Industrial Average fell over 11 percent from 17,615.18 on August 10 just before the devaluation to 15,666.44 on August 25 when the yuan reached an interim low. This U.S. stock market correction wiped out more than $2.5 trillion in shareholder wealth. China’s Shanghai Stock Exchange Composite Index had already fallen from a post-2007 high of 5,166.35 on June 12, 2015, in anticipation of devaluation. The index took another plunge from 3,928.41 on August 10 to 2,927.28 on August 26. The collapse was 43 percent from the June high, and 25 percent from the date of the shock devaluation. Lost investor wealth on China’s stock exchanges exceeded $3 trillion from June to August 2015. In addition to $5.5 trillion in investor losses from U.S. and Chinese stock markets, China suffered more than $1 trillion in capital outflows from January 2015 to August 2016, mostly related to fears of currency devaluation. China’s investors and debtors were in full flight to either acquire dollar assets or pay off dollar loans before the dollar grew even stronger.
Then came a fourth foreshock, even stronger than those before. On June 23, 2016, the United Kingdom voted to leave the European Union in a referendum. The popular name for British exit was “Brexit.” Parties on either side of the debate chose the words “Leave” and “Remain” to reflect their respective positions on relations with the EU. Immediately prior to the vote, markets priced in a victory for Remain, sending pounds sterling to $1.50.
The reason the market was so certain Remain would win is a fascinating case study in the misapprehension of behavioral science. Polls leading up to the vote showed the race was too close to call. However, betting markets run by Ladbrokes and Betfair showed a 70 percent probability that Remain would win. A certain type of foreign exchange market participant, the young London City banker who makes markets for his firm and clients, considered betting odds a distillation of the “wisdom of crowds” and priced sterling to reflect that ostensible wisdom.
The wisdom of crowds concept was popularized in a 2004 book by that title written by James Surowiecki. The book included an overview of published behavioral research on the subject. The classic example involved guessing the number of jellybeans in a large jar. In a typical experiment, an average of mere guesses by a large number of everyday observers proved more accurate than the estimate of a single expert who might try to calculate the jar’s volume divided by the estimated volume of one jellybean with allowance for the irregular space between beans. In the crowd’s estimate, extreme guesses (“one” or “a million”) cancel out and the average of the remaining guesses is quite close to the actual number. Hence, the wisdom of crowds. Based on a naïve understanding of this science, the City bankers decided the everyman nature of betting markets produces a better forecast than the “expert” pollsters.
Flaws in the London bankers’ logic are legion. Accuracy of betting odds in predicting an election is only as good as the correlation of views between the betting pool and the voting pool. That correlation is low. Bettors self-select for those with money to lose, and those for whom betting is an acceptable pastime. Bettors pay real money to bet and are prepared to lose. Voters do not pay to vote.
One little-noticed quirk in the betting data was that the number of Leave bets was more than four times the number of Remain bets. But Remain bets were for far larger amounts. Some hotshot City bankers bet £10,000 on Remain, while a typical punt on Leave might be a fiver. Bookies are not forecasters; their job is not to lose money. When the bookies gave Remain short odds, they were not predicting the election, they were balancing the weight of money on both sides of the bet. Money is irrelevant at the ballot box; voting is free. No doubt, rich City bettors were acting out their own cognitive biases (and skewing results) because final polls showed that London was heavily for Remain while England as a whole was for Leave.
Within hours of polls closing at 10:00 p.m. GMT on June 23, a major win for Leave was apparent. The result was near panic. The pound plunged from $1.50 to $1.32 within hours, a 12 percent decline that took sterling to its lowest level in more than thirty years. Other markets also gyrated wildly. The dollar price of gold soared from $1,255 per ounce immediately before Brexit to $1,315 at the close on June 24, a gain of 4.8 percent in one day. The intraday volatility was even greater. By July 8, gold was $1,366 per ounce for a total post-Brexit two-week bounce of 8.8 percent.
One-day gains and losses of 3 percent to 20 percent, the kind discussed here, are not unusual in stocks. A well-known company’s shares can drop 95 percent in a single day if the company files for bankruptcy. But our examples are not equity shocks. These are money shocks, or in the Treasury note example, shocks in the world’s safest bond.
Swiss francs, euros, pounds sterling, and the U.S. dollar are all major reserve currencies. The yuan is less freely convertible, but is still the fifth most actively traded currency in the world and, as of October 1, 2016, one of five component currencies of the SDR. The U.S. Treasury ten-year note is the safest intermediate term security in the world and the benchmark for every sovereign bond market in the world. Gold is a major international reserve asset; over 70 percent of U.S. reserves are in gold. Collectively Treasuries, gold, and major reserve currencies are the bedrock of the entire international monetary system. They should be stable. They are not.
A reprise shows that since late 2014:
Treasury ten-year note yields moved from 2.02 percent to 1.86 percent in six minutes. (October 15, 2014)
The euro fell 20 percent against the Swiss franc in twenty minutes. (January 15, 2015)
The yuan instantaneously fell 2 percent against the U.S. dollar. (August 10, 2015)
Sterling fell 12 percent against the U.S. dollar in two hours. (June 23, 2016)
Gold rose 4.8 percent against the U.S. dollar, and 19 percent against sterling in two hours. (June 23, 2016)
Where major currencies, bonds, and gold are involved, moves of this magnitude formerly took years. Now they take minutes or hours.
This type of volatility may be new to currency and bond traders. It is quite familiar to complexity theorists, who recognize the volatility as the kind of turbulence that can spontaneously arise in a formerly stable system just before that system spins out of control. Such instability is also familiar to seismologists tracking foreshocks on the fault lines in anticipation of the next major catastrophic earthquake. In the language of chaos theorists, the system is going wobbly.
A critic of applied complexity in capital markets could shrug at this litany of shocks. None of them meant the end of the world. Markets bounced back from every one. Treasury note yields rose as fast as they fell in 2014. The all-important euro-dollar cross rate was relatively undisturbed by the Swiss franc revaluation in 2015. The Federal Reserve mitigated the worst effects of the August 2015 yuan devaluation by delaying its planned September 2015 “liftoff” in rates until December. The Bank of England boosted sterling after Brexit by cutting interest rates on August 4, 2016. For every foreshock, central banks stood ready to truncate dynamic processes and restore a semblance of stability.
Still, it is a semblance, not real. Unreleased energy from one foreshock is stored for the next even as the tempo and magnitude of the foreshocks themselves increase. What is unarguable is that we are watching liquidity disappear in the
world’s most liquid markets. A Geiger counter is clicking madly. Global capital markets are closing in on the supercritical state from which there is no recovery.
The liquidity crises sketched above are not the only crisis catalysts. Natural disasters, cyberwarfare, and nuclear arms in the Middle East are all on the table. Complexity theory teaches that what counts is not the proximate cause of a collapse, but the density, interactions, and systemic scale that make collapse inevitable.
The greatest danger comes from what complexity theorists call linked complexity. This happens when one critical state system collapses, and that collapse cascades into another system causing it to go critical and collapse too.
There is no better example of linked complexity than the Fukushima disaster in northern Japan on March 11, 2011. The first critical state systems to snap were tectonic plates under the Pacific Ocean. The initial energy release was known as the Tōhoku earthquake, which measured 9.0 MW, the fourth most powerful earthquake recorded since 1900 when modern record keeping started. The earthquake triggered a tsunami in a second critical state system, causing waves more than one hundred feet high. The tsunami waves crashed into the Fukushima Daiichi nuclear power plant, a third critical state system, causing nuclear meltdowns in three reactors and the massive release of radioactive material. Next, news of the disaster hit the Tokyo Stock Exchange, the fourth critical state system in the chain. The Nikkei 225 Index plunged 8.25 percent, from 10,434.38 the day before the disaster to 8,605.15 on March 15, 2011, just four days after. Finally, the fifth critical system affected was the foreign exchange market. Japanese insurance companies began to sell dollars for yen in order to have enough yen liquidity to pay property and casualty claims. Initially the yen rallied from ¥81.89 to one dollar on March 11, to ¥80.59 to the dollar by March 18, a 1.6 percent move in one week—huge by currency market standards. Then came the policy truncation. Christine Lagarde, French finance minister at the time, coordinated a G7 currency intervention to weaken the yen. This was considered necessary to boost the Japanese economy after the devastation. The intervention worked. By April 8, the yen had sunk to ¥84.70 to one dollar, a 5 percent drop from the post-Fukushima high. Lagarde’s finesse was another example of policy putting a lid on the Pandora’s box of complex state system dynamics.
From tectonic plates, to tsunami, to reactor cores, to stock market, to foreign exchange, critical state systems cascaded into one another causing near-record catastrophes at each link in the chain. Interestingly two of the systems—tectonic plates and tsunamis—are natural, while three others—reactor cores, the stock market, and currency markets—are man-made. This illustrates how natural and synthetic complex systems interact seamlessly when agents are arrayed in the critical state.
Some combination of unforeseen emergence and linked complexity—not a black swan, but a black horse as depicted in the book of Revelation—is the most likely cause of capital markets collapse. A small default by a Malaysian borrower could cause a loss of confidence in a related Chinese enterprise, leading to capital flight from China, a rush into U.S. Treasuries, illiquidity in the Treasury market, a stronger U.S. dollar, and a tsunami of defaults in suddenly unpayable emerging markets dollar-denominated debt. In the midst of this, an advanced persistent threat squad of Kremlin-backed hackers (APT 29, code name: COZY BEAR) shuts down the New York Stock Exchange as a force multiplier to deter U.S. naval activity on the Baltic Sea. Within two days every market in the world has announced a twenty-first-century version of “HOUSE CLOSED.” The precursor of such tightly linked cascading crises is the onset of the First World War in late July 1914, foreseen by the Raven of Zurich, Felix Somary. This is how eras end.
Incoherence
The international monetary system is now in a time of dynamic uncertainty. This dynamic resembles the phase from 1971 to 1981 when extremes in inflation, interest rates, commodity prices, exchange rates, and geopolitical instability pushed markets to the edge of chaos until Henry Kissinger, Paul Volcker, Ronald Reagan, James Baker, and later Robert Rubin provided the leadership and enlisted the international cooperation needed to restabilize the former Bretton Woods gold-based system around a new dollar-based one. The task of restabilization today is no less daunting.
In 2015, I spoke privately with two of the world’s most powerful central bankers on this topic. On May 27, 2015, I spoke to Ben Bernanke, former chairman of the Federal Reserve Board, in Seoul, South Korea. Two weeks later, on June 11, I spoke to John Lipsky, former head of the IMF, in New York. (Curiously, Lipsky was the only American ever to head the IMF; he stepped in as acting head upon the unplanned resignation of Dominique Strauss-Kahn until the executive board had time to replace Strauss-Kahn with Christine Lagarde. By custom, the IMF head is never an American.) Without prompting or coordination, both central bankers used exactly the same word to describe the international monetary system today. The word was “incoherent.” They meant the monetary world has no anchor, no reference frame.
The June 23, 2016, post-Brexit shock is a good case study in the point Bernanke and Lipsky made. If pounds sterling moved from $1.50 to $1.32 in two hours, what really happened? Did the dollar go up, or did sterling go down? If the answer is that the dollar went up, then how did the dollar go down 4.8 percent against gold at the same time? If the answer is that the dollar went up and down depending on the unit of measurement (gold or sterling), then why privilege one form of measurement over another? Viewed this way, today’s money is lost in a valuation wilderness of mirrors. This is what Bernanke and Lipsky meant by incoherence. Implicit in this is a need for a new Bretton Woods–type agreement: a reform of the international monetary system and new rules of the game.
The predicate for a new system is to move gold to China. Under the old Bretton Woods system, Europe and Japan acquired eleven thousand tons of gold from the United States between 1950 and 1970. Market impact was never an issue because the price of gold was fixed at $35 per ounce. Today, to mitigate market impact the gold must be moved by stealth, using agents such as BIS and HSBC that intermediate consistent gold flows from London vaults, through Swiss refiners, finally to deep storage in Shanghai.
In November 2015, the IMF preannounced that China would be welcomed into the elite club of currencies that comprise the IMF’s special drawing right. This move was followed by an IMF study dated July 15, 2016, that called for the creation of a market-based SDR (“M-SDR”) to coexist with the official SDR (“O-SDR”). As if on cue, the World Bank and the China Development Bank planned an issue of private bonds denominated in SDRs, according to a Reuters report on August 1, 2016. Other SDR bond issues were expected soon thereafter from the China-based Asian Infrastructure Investment Bank and Chinese banking giant ICBC. Finally, on October 1, 2016, the yuan formally entered the SDR basket with a 10.92 percent weight, greater than the shares accorded yen or sterling.
The transfer of gold to China, inclusion of the Chinese yuan in the SDR, and preparation for a deep, liquid market in SDRs are the makings of a new Bretton Woods, yet lacking in the transparency and accountability of the original Bretton Woods. The new system is a grand bargain, worked out in secret, conducted by stealth, and understood fully by a relative handful of global elites.
The final phase of this grand bargain is inflation to wipe out the real cost of global sovereign debt. If central banks could not cause inflation despite their best efforts, the IMF would create inflation for them with massive issuance of SDRs to be spent on global infrastructure and global welfare. The infrastructure needs, intermediated by the World Bank, would be targeted at so-called climate change, another elite hobby horse.
Now the postcrisis global elite plan is seen in full:
Capture the banking system, 2009–10
Redistribute gold to China, 2009–16
Redenominate the SDR, 2015–16
Print and distribute SDRs, 2017–18
Destroy debt by inflation, 2018–25
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p; Ice-nine and shock doctrine are handmaidens to this plan. A new global financial crisis arising before inflation took hold would be highly deflationary and contrary to elite goals. Ice-nine stops the crisis in its tracks, blocking asset liquidations to give the inflation plan time to work. The shock doctrine is held in reserve to pursue wish-list agendas such as climate change, and the war on cash in the midst of a crisis.
If all went well, neither would be needed, and debt elimination would proceed as planned. As always, the winners would be governments and banks. The losers would be investors, except those elites who were in on the plan or could catch glimpses and prepare accordingly.
Complexity theory makes a mockery of plans. The most likely path is the one no one sees. A systemic crisis could erupt at any time. Monetary elites will move quickly to ice-nine solutions. Still, civil society will revolt. Citizens will not accept their $300 per day from the ATMs alongside vague promises to reopen exchanges and unfreeze accounts “as soon as conditions permit.” They will riot. They may burn down banks, loot supermarkets, and destroy critical infrastructure, all in an effort to secure transitory wealth. After ice-nine and money riots come neofascism, martial law, mass arrests, and government-controlled media. This is the endgame.
Palazzo Colonna
In the heart of Rome, at the foot of the Quirinal Hill, is Palazzo Colonna, a private palace owned by one family for thirty-one generations over nine hundred years. The family legacy began in the eleventh century with Pietro Colonna, who lived in the town of Colonna, south of Rome. Family members established residence on the current palazzo site around AD 1200. The palazzo took many shapes over the centuries. It evolved from a rudimentary residence to a fortress to the palace seen today. Principal construction spanned five centuries. The façades, interior apartments, and galleries date to the late Renaissance period with seventeenth- and eighteenth-century Baroque additions.
The Road to Ruin Page 30
