Treasury and Fed officials dismiss concerns about financial war due to their misapprehension of the statistical properties of risk and their reliance on erroneous equilibrium models. These models assume efficient markets and rational behavior that have no correspondence to real markets. As applied to financial warfare, their view is that enemy attacks on particular stocks or markets will prove self-defeating because rational investors will jump in to buy bargains once the selling pressure begins. Such behavior exists only in relatively calm, unperturbed markets, but in actual panic situations, selling pressure feeds on itself, and buyers are nowhere to be found. A major panic will spread exponentially and lead to total collapse absent an act of force majeure by government.
This panic dynamic has actually commenced twice in the past sixteen years. In September 1998 global capital markets were hours away from total collapse before the completion of a $4 billion, all-cash bailout of the hedge fund Long-Term Capital Management, orchestrated by the Federal Reserve Bank of New York. In October 2008 global capital markets were days away from the sequential collapse of most major banks when Congress enacted the TARP bailout, while the Fed and Treasury intervened to guarantee money-market funds, prop up AIG, and provide trillions of dollars in market liquidity. In neither panic did the Fed’s imaginary bargain hunters show up to save the day.
In short, the Treasury and Fed view of financial warfare exhibits what intelligence analysts call mirror imaging. They assume that since the United States would not launch a financial attack on China, China would not launch an attack on the United States. Far from preventing war, such myopia is a principal cause of war because it fails to comprehend the enemy’s intentions and capabilities. Where financial warfare is concerned, markets are too important to be left to the Treasury and the Fed.
Nor is it necessary to launch a financial war in order for financial warfare capability to be an effective policy instrument. It is only necessary that the threat be credible. A scenario can arise where the U.S. president stands down from military action to defend Taiwan because China has made it clear than any such action would result in the destruction of a trillion dollars or more in U.S. paper wealth. In this scenario, Taiwan is left to its fate. Andy Marshall’s Air-Sea Battle is deterred by China’s weapons of wealth destruction.
Perhaps the greatest financial threat is that these scenarios might play out by accident. In the mid-1960s, at the height of Cold War hysteria about nuclear attacks and Mutual Assured Destruction, two films, Fail-Safe and Dr. Strangelove, dealt with nuclear-war-fighting scenarios between the United States and the Soviet Union. As portrayed in these films, neither side wanted war, but it was launched nonetheless due to computer glitches and actions of rogue officers.
Capital markets today are anything but fail-safe. In fact, they are increasingly failure-prone, as the Knight Capital incident and the curious May 6, 2010, flash crash demonstrate. A financial attack may be launched by accident during a routine software upgrade or drill. Capital markets almost collapsed in 1998 and 2008 without help from malicious actors, and the risk of a similar collapse in coming years, accidental or malicious, is distressingly high.
In 2011 the National Journal published an article called “The Day After” that described in detail the highly classified plans for continuity of U.S. government operations in the face of invasion, infrastructure collapse, or extreme natural disaster. These plans include landing a helicopter squadron on the Washington Mall, near the Capitol, to swoop up the congressional leadership for evacuation to an emergency operations center called Mount Weather in Virginia. Defense Department officials would then be moved to a hardened bunker deep inside Raven Rock Mountain on the Maryland-Pennsylvania border, not far from Camp David.
Much of Marc Ambinder’s reporting involves the chain of command and what happens if certain officials, possibly including the president, are dead or missing. He points out that these contingency plans failed both during the attempted assassination of President Reagan in 1981 and again on 9/11. Recent years have seen improvement in secure communications, but serious ambiguity can still arise in the chain of command, and Ambinder says more failures can be expected in another national crisis.
However, a financial war would present a different kind of crisis, with little or no physical damage. No officials should be dead or missing, and the chain of command should remain intact. Absent collateral infrastructure attacks, communications would flow normally.
Yet the nation would be traumatized just as surely as if an earthquake had leveled a major city, because trillions of dollars of wealth would be lost. Banks and exchanges would close their doors and liquidity in markets would evaporate. Trust would be gone. The Federal Reserve, having used up its dry powder printing over $3 trillion of new money since 2008, would have no capacity or credibility to do more. Social unrest and riots would soon follow.
Andy Marshall and other futurists in the national security community are taking such threats seriously. They receive little or no support from the Treasury or Federal Reserve; both are captive to mirror imaging.
Ironically, solutions are not hard to devise. These solutions involve breaking big banks into units that are not too big to fail; returning to a system of regional stock exchanges, to provide redundancy; and reintroducing gold into the monetary system, since gold cannot be wiped out in a digital flash. The first-order costs of these changes are more than compensated by increased robustness and second-order benefits. None of these remedial steps is under serious consideration by Congress or the White House. For now, the United States is only dimly aware of the threat and nowhere near a solution.
PART TWO
MONEY AND MARKETS
CHAPTER 3
THE RUIN OF MARKETS
The man of system . . . seems to imagine that he can arrange the different members of a great society with as much ease as the hand arranges the different pieces upon a chess-board. He does not consider that in the great chess-board of human society, every single piece has a principle of motion of its own.
Adam Smith
The Theory of Moral Sentiments
1759
The “data” from which the economic calculus starts are never for the whole society “given” to a single mind which could work out the implications and can never be so given.
Friedrich A. Hayek
1945
Any . . . statistical regularity will tend to collapse once pressure is placed on it for control purposes.
Goodhart’s Law
1975
In Shakespeare’s The Merchant of Venice, Salanio asks, “Now, what news on the Rialto?” He’s looking for information, gathering intelligence, and attempting to identify what’s happening in the marketplace. Salanio doesn’t intend to control the business unfolding around him; he knows he cannot. He looks to understand the flow of news, to find his place in the market.
Janet Yellen and the Federal Reserve would do well to be as humble.
The word market invokes images of everything from prehistoric trade goods to medieval town fairs to postmodern digital exchanges with nanosecond-speed bids and offers converging in a computational cloud. In essence, markets are places where buyers and sellers meet to conduct the sale of goods and services. In the world today, place may be an abstracted location, a digital venue; a meeting may amount to nothing more than a fleeting connection. But at their core, markets are unchanged since traders swapped amber for ebony on the shores of the Mediterranean during the Bronze Age.
Still, markets—whether for tangible commodities like gold or for intangibles such as stocks—have always been about deeper processes than the mere exchange of goods and services. Fundamentally, they are about information exchange concerning the price of goods and services. Prices are portable. Once a merchant or trader ascertains a market price, others can use that information to expand or contract output, hire or fire workers, or move to a
nother marketplace with an informational advantage in tow.
Information can have greater value than the underlying transactions from which the information is derived; the multibillion-dollar Bloomberg fortune is based on this insight. How should a venture capitalist price a stake in an enterprise creating an entirely new product? Neither the investor nor the entrepreneur really knows. But information about past outcomes, whether occasional huge gains or frequent failures, gives guidance to the parties and allows an investment to go forward. Information about sales and investment returns is the lubricant and the fuel that allows more sales and investments to take place. An exchange of goods and services may be the result of market activity, but price discovery is the market function that allows an exchange to occur in the first place.
Anyone who has ever walked away from a carpet dealer in a Middle Eastern bazaar, only to be chased down by the dealer yelling, “Mister, mister, I have a better price, very cheap,” knows the charms of price discovery. This dynamic is no different than the digitized, automated, high-frequency trading that takes place in servers adjacent to exchange trading platforms in New York and Chicago. The computer is offering the nanosecond version of “Mister, I have a better price.” Price discovery is still the primary market function.
But markets are home to more than just buyers and sellers, speculators and arbitrageurs. Global markets today seem irresistible to central bankers with plans for better times. Planning is the central bankers’ baleful vanity since, for them, markets are a test tube in which to try out their interventionist theories.
Central bankers control the price of money and therefore indirectly influence every market in the world. Given this immense power, the ideal central banker would be humble, cautious, and deferential to market signals. Instead, modern central bankers are both bold and arrogant in their efforts to bend markets to their will. Top-down central planning, dictating resource allocation and industrial output based on supposedly superior knowledge of needs and wants, is an impulse that has infected political players throughout history. It is both ironic and tragic that Western central banks have embraced central planning with gusto in the early twenty-first century, not long after the Soviet Union and Communist China abandoned it in the late twentieth. The Soviet Union and Communist China engaged in extreme central planning over the world’s two largest countries and one-third of the earth’s population for more than one hundred years combined. The result was a conspicuous and dismal failure. Today’s central planners, especially the Federal Reserve, will encounter the same failure in time. The open issues are, when and at what cost to society?
The impulse toward central planning often springs from the perceived need to solve a problem with a top-down solution. For Russian Communists in 1917, it was the problem of the czar and a feudal society. For Chinese Communists in 1949, it was local corruption and foreign imperialism. For the central planners at central banks today, the problem is deflation and low nominal growth. The problems are real, but the top-down solutions are illusory, the product of hubris and false ideologies.
In the twentieth century, Russians and Chinese adhered to Marxist ideology and the arrogance of the gun. Today central bankers embrace Keynesianism and the arrogance of the Ph.D. Neither Marxist nor Keynesian ideology allows individuals the degrees of freedom necessary to discover those solutions that emerge spontaneously from the fog of complexity characteristic of an advanced economy. Instead, individuals, sensing manipulation and control from central banks, either restrain their economic activity or pursue entirely new, smaller enterprises removed from the sights of central bank market manipulation.
Market participants have been left with speculation, churning, and a game of trying to outthink the thinkers in the boardroom at the Federal Reserve. Lately, so-called markets have become a venue for trading ahead of the next Fed policy announcement, or piggybacking on its stubborn implementation. Since 2008, markets have become a venue for wealth extraction rather than wealth creation. Markets no longer perform true market functions. In markets today, the dead hands of the academic and the rentier have replaced the invisible hand of the merchant or the entrepreneur.
This critique is not new; it is as old as free markets themselves. Adam Smith, in The Theory of Moral Sentiments, a philosophical work from 1759, the dawn of the modern capitalist system, makes the point that no planner can direct a system of arrayed components that are also systems with unique properties beyond the planner’s purview. This might be called the Matryoshka Theory, named for the Russian dolls nested one inside the other and invisible from the outside. Only when the first doll is opened is the next unique doll revealed, and so on through a succession of dolls. The difference is that matryoshka dolls are finite, whereas variety in a modern economy is infinite, interactive, and beyond comprehension.
Friedrich Hayek, in his classic 1945 essay “The Use of Knowledge in Society,” written almost two hundred years after Adam Smith’s work, makes the same argument but with a shift in emphasis. Whereas Smith focused on individuals, Hayek focused on information. This was a reflection of Hayek’s perspective on the threshold of the computer age, when models based on systems of equations were beginning to dominate economic science. Of course, Hayek was a champion of individual liberty. He understood that the information he wrote about would ultimately be created at the level of individual autonomous actors within a complex economic system. His point was that no individual, committee, or computer program would ever have all the information needed to construct an economic order, even if a model of such order could be devised. Hayek wrote:
The peculiar character of the problem of a rational economic order is determined precisely by the fact that the knowledge of the circumstances of which we must make use never exists in concentrated or integrated form but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess. . . . Or, to put it briefly, it is a problem of the utilization of knowledge which is not given to anyone in its totality.
Charles Goodhart first articulated Goodhart’s Law in a 1975 paper published by the Reserve Bank of Australia. Goodhart’s Law is frequently paraphrased along the lines, “When a financial indicator becomes the object of policy, it ceases to function as an indicator.” That paraphrase captures the essence of Goodhart’s Law, but the original formulation was even more incisive because it included the phrase “for control purposes.” (In original form, it reads, “Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.”) This phrase emphasized the point that Goodhart was concerned not only with market intervention or manipulation generally but also on a particular kind of top-down effort by central banks to dictate outcomes in complex systems.
Adam Smith, Friedrich Hayek, and Charles Goodhart all concluded that central planning is not merely undesirable or suboptimal; it is impossible. This conclusion aligns with the more recent theory of computational complexity. This theory classifies computational challenges by their degree of difficulty as measured by the data, computing steps, and processing power needed to solve a given problem set. The theory has rules for assigning such classifications, including those problems that are regarded as impossible to compute because, variously, the data are too voluminous, the processing steps are infinite, all the computational power in the world is insufficient, or all three. Smith, Hayek, and Goodhart all make the point that the variety and adaptability of human action in the economic sphere are a quintessential case of computational complexity that exceeds the capacity of man or machine to optimize. This means not that economic systems cannot approach optimality but that optimality emerges from economic complexity spontaneously rather than being imposed by central banks through policy. Today central banks, especially the U.S. Federal Reserve, are repeating the blunders of Lenin, Stalin, and Mao without the violence, although the violence may come yet through income inequality, social unrest, and a confrontatio
n with state power.
While the Adam Smith and Friedrich Hayek formulations of the economic complexity problem are well known, Charles Goodhart added a chilling coda. What happens when data used by central bankers to set policy is itself the result of prior policy manipulation?
■ The Wealth Effect
Measures of inflation, unemployment, income, and other indicators are carefully monitored by central bankers as a basis on which to make policy decisions. Declining unemployment and rising inflation may signal a need to tighten monetary policy, just as falling asset prices may signal a need to provide more monetary ease. Policy makers respond to economic distress by pursuing polices designed to improve the data. After a while, the data themselves may come to reflect not fundamental economic reality but a cosmetically induced policy result. If these data then guide the next dose of policy, the central banker has entered a wilderness of mirrors in which false signals induce policy, which induces more false signals and more policy manipulation and so on, in a feedback loop that diverges further from reality until it crashes against a steel wall of data that cannot easily be manipulated, such as real income and output.
A case in point is the so-called wealth effect. The idea is straightforward. Two asset classes—stocks and housing—represent most of the wealth of the American people. The wealth represented by stocks is highly visible; Americans receive their 401(k) account statements monthly, and they can check particular stock prices in real time if they so choose. Housing prices are less transparent, but anecdotal evidence gathered from real estate listings and water-cooler chatter is sufficient for Americans to have a sense of their home values. Advocates of the wealth effect say that when stocks and home prices are going up, Americans feel richer and more prosperous and are willing to save less and spend more.
The Death of Money Page 8
