THE DEATH OF MONEY
THE COMING COLLAPSE
OF THE INTERNATIONAL
MONETARY SYSTEM
JAMES RICKARDS
PORTFOLIO / PENGUIN
PORTFOLIO / PENGUIN
Published by the Penguin Group
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First published by Portfolio / Penguin, a member of Penguin Group (USA) LLC, 2014
Copyright © 2014 by James Rickards
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Write down, therefore, what you have seen, and what is happening, and what will happen afterwards.
Revelation 1:19
CONTENTS
TITLE PAGE
COPYRIGHT
DEDICATION
EPIGRAPH
INTRODUCTION
PART ONE
MONEY AND GEOPOLITICS
CHAPTER 1
Prophesy
CHAPTER 2
The War God’s Face
PART TWO
MONEY AND MARKETS
CHAPTER 3
The Ruin of Markets
CHAPTER 4
China’s New Financial Warlords
CHAPTER 5
The New German Reich
CHAPTER 6
BELLs, BRICS, and Beyond
PART THREE
MONEY AND WEALTH
CHAPTER 7
Debt, Deficits, and the Dollar
CHAPTER 8
Central Bank of the World
CHAPTER 9
Gold Redux
CHAPTER 10
Crossroads
CHAPTER 11
Maelstrom
CONCLUSION
AFTERWORD
ACKNOWLEDGMENTS
NOTES
SELECTED SOURCES
INDEX
INTRODUCTION
The Death of Money is about the demise of the dollar. By extension, it is also about the potential collapse of the international monetary system because, if confidence in the dollar is lost, no other currency stands ready to take its place as the world’s reserve currency. The dollar is the linchpin. If it fails, the entire system fails with it, since the dollar and the system are one and the same. As fearsome a prospect as this dual collapse may be, it looks increasingly inevitable for all the reasons one will find in the pages to come.
A journey to the past is in order first.
Few Americans in our time recall that the dollar nearly ceased to function as the world’s reserve currency in 1978. That year the Federal Reserve dollar index declined to a distressingly low level, and the U.S. Treasury was forced to issue government bonds denominated in Swiss francs. Foreign creditors no longer trusted the U.S. dollar as a store of value. The dollar was losing purchasing power, dropping by half from 1977 to 1981; U.S. inflation was over 50 percent during those five years. Starting in 1979, the International Monetary Fund (IMF) had little choice but to mobilize its resources to issue world money (special drawing rights, or SDRs). It flooded the market with 12.1 billion SDRs to provide liquidity as global confidence in the dollar declined.
We would do well to recall those dark days. The price of gold rose 500 percent from 1977 to 1980. What began as a managed dollar devaluation in 1971, with President Richard Nixon’s abandonment of gold convertibility, became a full-scale rout by the decade’s end. The dollar debacle even seeped into popular culture. The 1981 film Rollover, starring Jane Fonda, involved a secret plan by oil-producing nations to dump dollars and buy gold; it ended with a banking collapse, a financial panic, and global riots. That was fiction but indeed was powerful, perhaps prescient.
While the dollar panic reached a crescendo in the late 1970s, lost confidence was felt as early as August 1971, immediately after President Nixon’s abandonment of the gold-backed dollar. Author Janet Tavakoli describes what it was like to be an American abroad the day the dollar’s death throes became glaringly apparent:
Suddenly Americans traveling abroad found that restaurants, hotels, and merchants did not want to take the floating rate risk of their dollars. On Ferragosto [mid-August holiday], banks in Rome were closed, and Americans caught short of cash were in a bind.
The manager of the hotel asked departing guests: “Do you have gold? Because look what your American President has done.” He was serious about gold; he would accept it as payment. . . .
I immediately asked to pre-pay my hotel bill in lire. . . . The manager clapped his hands in delight. He and the rest of the staff treated me as if I were royalty. I wasn’t like those other Americans with their stupid dollars. For the rest of my stay, no merchant or restaurant wanted my business until I demonstrated I could pay in lire.
The subsequent efforts of Fed chairman Paul Volcker and the newly elected Ronald Reagan would save the dollar. Volcker raised interest rates to 19 percent in 1981 to snuff out inflation and make the dollar an attractive choice for foreign capital. Beginning in 1981, Reagan cut taxes and regulation, which restored business confidence and made the United States a magnet for foreign investment. By March 1985, the dollar index had rallied 50 percent from its October 1978 low, and gold prices had dropped 60 percent from their 1980 high. The U.S. inflation rate fell from 13.5 percent in 1980 to 1.9 percent in 1986. The good news was such that Hollywood released no Rollover 2. By the mid-1980s, the fire was out, and the age of King Dollar had begun. The dollar had not disappeared as the world’s reserve currency after 1978, but it was a near run thing.
Now the world is back to the future.
A similar constellation of symptoms to those of 1978 can be seen in the world economy today. In July 2011 the Federal Reserve dollar index hit an all-time low, over 4 percent below the October 1978 panic level. In August 2009 the IMF once again acted as a monetary first responder and rode to the rescue with a new issuance of SDRs, equivalent to $310 billion, increasing the SDRs in circulation by 850 percent. In early September gold prices reached an all-time high, near $1,900 per ounce, up more than 200 percent from the average price in 2006, just before the new depression began. Twenty-first-century popular culture enjoyed its own version of Rollover, a televised tale of financial collapse called Too Big to Fail.
The parallels between 1978 and recent events are eerie but imperfect. There was an element ravaging the world then that is not apparent today. It is the dog that didn’t bark: inflation. But the fact that we aren’t hearing the dog doesn’t mean it poses no danger. Widely followed U.S. dollar inflation measures such as the consumer price index have barely budged since 2008; indeed, mild deflation has emerged in certain months. Inflation has appeared in China, where the government revalued the currency to dampen it, and in Brazil, where price hikes in basic services such as bus fares triggered riots. Food price inflation was also a contributing factor to pro
tests in the Arab Spring’s early stages. Still, U.S. dollar inflation has remained subdued.
Looking more closely, we see a veritable cottage industry that computes U.S. price indexes using pre-1990 methodologies, and alternative baskets of goods and services that are said to be more representative of the inflation actually facing Americans. They offer warning signs, as the alternative methods identify U.S. inflation at more like 9 percent annually, instead of the 2 percent readings of official government measures. Anyone shopping for milk, bread, or gasoline would certainly agree with the higher figure. As telling as these shadow statistics may be, they have little impact on international currency markets or Federal Reserve policy. To understand the threats to the dollar, and potential policy responses by the Federal Reserve, it is necessary to see the dollar through the Fed’s eyes. From that perspective, inflation is not a threat; indeed, higher inflation is both the Fed’s answer to the debt crisis and a policy objective.
This pro-inflation policy is an invitation to disaster, even as baffled Fed critics scratch their heads at the apparent absence of inflation in the face of unprecedented money printing by the Federal Reserve and other major central banks. Many ponder how it is that the Fed has increased the base money supply 400 percent since 2008 with practically no inflation. But two explanations are very much at hand—and they foretell the potential for collapse. The first is that the U.S. economy is structurally damaged, so the easy money cannot be put to good use. The second is that the inflation is coming. Both explanations are true—the economy is broken, and inflation is on its way.
The Death of Money examines these events in a distinctive way. The chapters that follow look critically at standard economic tools such as equilibrium models, so-called value-at-risk metrics, and supposed correlations. You will see that the general equilibrium models in widespread use are meaningless in a state of perturbed equilibrium or dual equilibria. The world economy is not yet in the “new normal.” Instead, the world is on a journey from old to new with no compass or chart. Turbulence is now the norm.
Danger comes from within and without. We have a misplaced confidence that central banks can save the day; in fact, they are ruining our markets. The value-at-risk models used by Wall Street and regulators to measure the dangers that derivatives pose are risible; they mask overleveraging, which is shamelessly transformed into grotesque compensation that is throwing our society out of balance. When the hidden costs come home to roost and taxpayers are once again stuck with the bill, the bankers will be comfortably ensconced inside their mansions and aboard their yachts. The titans will explain to credulous reporters and bought-off politicians that the new collapse was nothing they could have foreseen.
While we refuse to face truths about debts and deficits, dozens of countries all over the globe are putting pressure on the dollar. We think the gold standard is a historical relic, but there’s a contemporary scramble for gold around the world, and it may signify a move to return to the gold standard. We greatly underestimate the dangers from a cyberfinancial attack and the risks of a financial world war.
Regression analysis and correlations, so beloved by finance quants and economists, are ineffective for navigating the risks ahead. These analyses assume that the future resembles the past to an extent. History is a great teacher, but the quants’ suppositions contain fatal flaws. The first is that in looking back, they do not look far enough. Most data used on Wall Street extend ten, twenty, or thirty years into the past. The more diligent analysts will use hundred-year data series, finding suitable substitutes for instruments that did not exist that far back. But the two greatest civilizational collapses in history, the Bronze Age collapse and the fall of the Roman Empire, occurred sixteen hundred years apart, and the latter was sixteen hundred years ago. This is not to suggest civilization’s imminent collapse, merely to point out the severely limited perspective offered by most regressions. The other flaw involves the quants’ failures to understand scaling dynamics that place certain risk measurements outside history. Since potential risk is an exponential function of system scale, and since the scale of financial systems measured by derivatives is unprecedented, it follows that the risk too is unprecedented.
While the word collapse as applied to the dollar sounds apocalyptic, it has an entirely pragmatic meaning. Collapse is simply the loss of confidence by citizens and central banks in the future purchasing power of the dollar. The result is that holders dump dollars, either through faster spending or through the purchase of hard assets. This rapid behavioral shift leads initially to higher interest rates, higher inflation, and the destruction of capital formation. The end result can be deflation (reminiscent of the 1930s) or inflation (reminiscent of the 1970s), or both.
The coming collapse of the dollar and the international monetary system is entirely foreseeable. This is not a provocative conclusion. The international monetary system has collapsed three times in the past century—in 1914, 1939, and 1971. Each collapse was followed by a tumultuous period. The 1914 collapse was precipitated by the First World War and was followed later by alternating episodes of hyperinflation and depression from 1919 to 1922 before regaining stability in the mid-1920s, albeit with a highly flawed gold standard that contributed to a new collapse in the 1930s. The Second World War caused the 1939 collapse, and stability was restored only with the Bretton Woods system, created in 1944. The 1971 collapse was precipitated by Nixon’s abandonment of gold convertibility for the dollar, although this dénouement had been years in the making, and it was followed by confusion, culminating in the near dollar collapse in 1978.
The coming collapse, like those before, may involve war, gold, or chaos, or it could involve all three. This book limns the most imminent threats to the dollar, likely to play out in the next few years, which are financial warfare, deflation, hyperinflation, and market collapse. Only nations and individuals who make provision today will survive the maelstrom to come.
In place of fallacious, if popular, methods, this book considers complexity theory to be the best lens for viewing present risks and likely outcomes. Capital markets are complex systems nonpareil. Complexity theory is relatively new in the history of science, but in its sixty years it has been extensively applied to weather, earthquakes, social networks, and other densely connected systems. The application of complexity theory to capital markets is still in its infancy, but it has already yielded insights into risk metrics and price dynamics that possess greater predictive power than conventional methods.
As you will see in the pages that follow, the next financial collapse will resemble nothing in history. But a more clear-eyed view of opaque financial happenings in our world can help investors think through the best strategies. In this book’s conclusion you will find some recommendations, but deciding upon the best course to follow will require comprehending a minefield of risks, while poised at a crossroads, pondering the death of the dollar.
Beyond mere market outcomes, consider financial war.
■ 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 Cantillon 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 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.
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