The Death of Money

by James Rickards

  Beyond the world of alternative currencies lies the world of transactions without currencies at all: the electronic barter market. Barter is one of the most misunderstood of economic concepts. A large economic literature is devoted to the inefficiencies of barter, which requires the simultaneous coincidence of wants between the two bartering parties. If one party wanted to trade wheat for nails, and the counterparty wanted wheat but had only rope to trade, the first party might accept the rope and go in search of someone with nails who wanted rope. In this telling, money was an efficient medium of exchange that solved the simultaneity problem because one could sell her wheat for money and then use the money to buy nails without having to barter the rope. But as author David Graeber points out, the history of barter is mostly a myth.

  Economists since Adam Smith have assumed that barter was the historical predecessor of money, but there is no empirical, archaeological, or other evidence for the existence of a widespread premoney barter economy. In fact, it appears that premoney economies were based largely on credit—the promise to return value in the future in exchange for value delivered today. The ancient credit system allowed intertemporal exchanges, as it does today, and solved the problem of the simultaneous coincidence of wants. Historical barter is one more example of economists developing theories with scant attachment to reality.

  Mythical history notwithstanding, barter is a rapidly growing form of economic exchange today, because networked computers solve the simultaneity problem. One recent example involved the China Railway Corporation, General Electric, and Tyson Foods. China Railway had a customer, a poultry processor, that filed for bankruptcy, resulting in the railroad taking possession of frozen turkeys pledged as collateral. General Electric was selling gas turbine-electric locomotives to the railroad, and China Railway inquired if it could pay for the locomotives with the frozen turkeys. GE, which has an eighteen-person e-barter trading desk, quickly ascertained that Tyson Foods China would take delivery of the turkeys for cash. China Railway delivered the turkeys to Tyson Foods, which paid cash to GE, and then GE delivered the locomotives to China Railway. The transaction between GE and China Railway was effectively the barter of turkeys for turbines, with no money changing hands. Cashless barter may not have been part of the past, but it will increasingly be part of the future.

  The bitcoin and barter examples both illustrate that the dollar grows less essential every day. This is also seen in the rise of regional trade currency blocs, such as Northeast Asia and the China–South America connection. Three-way trade among China, Japan, and Korea, and the bilateral trade between China and its respective trading partners in South America, are among the largest and fastest-growing trading relationships in the world. None of the currencies involved—yuan, yen, won, real, or peso—are close to becoming reserve currencies. But all serve perfectly well as trade currencies for transactions that would previously have been invoiced in dollars. Trade currencies are used as a temporary way to keep score in the balance of trade, while reserve currencies come with deep pools of investable assets used to store wealth. Even if these local currencies are used for trade and not as reserves, each transaction represents a diminution in the role of the dollar.

  To paraphrase Hemingway, confidence in the dollar is lost slowly at first, then quickly. Virtual currencies, new trade currencies, and the absence of currency (in the case of barter) are all symptoms of the slow, gradual loss of confidence in the dollar. They are the symptoms but not the cause. The causes of declining confidence in the dollar are the dual specter of inflation and deflation, the perception on the part of many that the dollar is no longer a store of value but a lottery ticket, potentially worth far more, or far less, than face value for reasons beyond the holder’s control. Panic gold buying, and the emergency issuance of SDRs to restore liquidity when it comes, will signal the stage of a rapid loss of confidence.

  Volcker was right in his assertion that confidence is indispensable to the stability of any fiat currency system. Unfortunately, the academics who are now responsible for monetary policy focus exclusively on equilibrium models and take confidence too much for granted.

  ■ Failure of Imagination

  Following the 9/11 attacks in New York and Washington, D.C., the U.S. intelligence community was reproached for its failure to detect and prevent the hijacking plots. These criticisms reached a crescendo when it was revealed that the CIA and the FBI had specific intelligence linking terrorists and flying lessons but failed to share the information or connect the dots.

  New York Times columnist Tom Friedman offered the best description of what went wrong: “Sept. 11 was not a failure of intelligence or coordination. It was a failure of imagination.” Friedman’s point was that even if all the facts had been known and shared by the various intelligence agencies, they still would have missed the plot because it was too unusual and too evil to fit analysts’ preconceived notions of terrorist capabilities.

  A similar challenge confronts U.S. economic policy makers today. Data on economic performance, unemployment, and the buildup of derivatives inside megabanks are readily available. Conventional economic models abound, and the analysts applying those models are among the best and brightest in their field. There is no lack of information and no shortage of intelligence; the missing piece is imagination. Fed and Wall Street analysts, tied to the use of models based on past business cycles, seem incapable of imagining the dangers actually confronting the U.S. economy. The 9/11 attacks demonstrated that the failure to imagine the worst often results in a failure to prevent it.

  The worst economic danger confronting the United States is deceptively simple. It looks like this:

  (-1) – (-3) = 2

  In this equation, the first term represents nominal growth, the second term represents inflation or deflation, and the right side of the equation equals real growth. A more familiar presentation of this equation is:

  5 – 2 = 3

  In this familiar form, the equation says that we begin with 5 percent nominal growth, then subtract 2 percent inflation, in order to reach 3 percent real growth. Nominal growth is the gross value of goods and services produced in the economy, and inflation is a change in the price level that does not represent real growth. To arrive at real growth, one subtracts inflation from the nominal value. This same inflation adjustment can be applied to asset values, interest rates, and many other data points. One must subtract inflation from the stated or nominal value in order to get the real value.

  When inflation turns to deflation, the price adjustment becomes a negative value rather than a positive one, because prices decline in a deflationary environment. The expression (-1) – (-3) = 2 describes nominal growth of negative 1 percent, minus a price change of negative 3 percent, producing positive 2 percent real growth. In effect, the impact of declining prices more than offsets declining nominal growth and therefore produces real growth. This condition has almost never been seen in the United States since the late nineteenth century. But it is neither rare elsewhere nor impossible in the United States; in fact, it has been Japan’s condition for parts of the past twenty-five years.

  The first thing to notice about this equation is that there is real growth of 2 percent, which is weak by historic standards but roughly equal to U.S. growth since 2009. As an alternative scenario, using the formula above, assume annual deflation of 4 percent, as actually occurred from 1931 to 1933. Now the expression is (-1) – (-4) = 3. In this case, real growth would be 3 percent, much closer to trend and arguably not at depressionary levels. However, a condition of high deflation, zero interest rates, and continuing high unemployment closely resembles a depression. This is an example of the through-the-looking-glass quality of economic analysis in a world of deflation.

  Despite possible real growth, the U.S. Treasury and the Federal Reserve fear deflation more than any other economic outcome. Deflation means a persistent decline in price levels for goods and services
. Lower prices allow for a higher living standard even when wages are constant, because consumer goods cost less. This would seem to be a desirable outcome, based on advances in technology and productivity that result in certain products dropping in price over time, such as computers and mobile phones. Why is the Federal Reserve so fearful of deflation that it resorts to extraordinary policy measures designed to cause inflation? There are four reasons for this fear.

  The first is deflation’s impact on government debt repayment. Debt’s real value may fluctuate based on inflation or deflation, but the nominal value of a debt is fixed by contract. If one borrows $1 million, then one must repay $1 million plus interest, regardless of whether the real value of $1 million is greater or less due to deflation or inflation. U.S. debt is at a point where no feasible combination of real growth and taxes will finance repayment of the amount owed. But if the Fed can cause inflation—slowly at first to create money illusion, and then more rapidly—the debt will be manageable because it will be repaid in less valuable nominal dollars. In deflation, the opposite occurs, and the real value of the debt increases, making repayment more difficult.

  The second problem with deflation is its impact on the debt-to-GDP ratio. This ratio is the debt amount divided by the GDP amount, both expressed in nominal terms. Debt is continually increasing in nominal terms because of continuing budget deficits that require new financing, and interest payments that are financed with new debt. However, as shown in the previous example, real growth can be positive even if nominal GDP is shrinking, provided deflation exceeds nominal growth. In the debt-to-GDP ratio, when the debt numerator expands and the GDP denominator shrinks, the ratio increases. Even without calculating entitlements, the U.S. debt-to-GDP ratio is already at its highest level since the Second World War; including entitlements makes the situation far worse. Over time, the impact of deflation could drive the U.S. debt-to-GDP ratio above the level of Greece, closer to that of Japan. Indeed, this deflationary dynamic is one reason the Japanese debt-to-GDP ratio currently exceeds 220 percent, by far the highest of any developed economy. One impact of such sky-high debt-to-GDP ratios on foreign creditors is ultimately a loss of confidence, higher interest rates, worse deficits because of the higher interest rates, and finally an outright default on the debt.

  The third deflation concern has to do with the health of the banking system and systemic risk. Deflation increases money’s real value and therefore increases the real value of lenders’ claims on debtors. This would seem to favor lenders over debtors, and initially it does. But as deflation progresses, the real weight of the debt becomes too great, and debtor defaults surge. This puts the losses back on the bank lenders and causes bank insolvencies. Thus the government prefers inflation, since it props up the banking system by keeping banks and debtors solvent.

  The fourth and final problem with deflation is its impact on tax collection. This problem is illustrated by comparing a worker making $100,000 per year in two different scenarios. In the first scenario, prices are constant and the worker receives a $5,000 raise. In the second scenario, prices drop 5 percent and the worker receives no raise. On a pre-tax basis, the worker has the same 5 percent increase in her standard of living in both scenarios. In the first scenario, the improvement comes from a higher wage, and in the second it comes from lower prices, but the economic result is the same. Yet on an after-tax basis, these scenarios produce entirely different outcomes. The government taxes the raise, say, at a 40 percent rate, but the government cannot tax the declining prices. In the first scenario, the worker keeps only 60 percent of the raise after taxes. But in the second scenario, she keeps 100 percent of the benefit of lower prices. If one assumes inflation in the first example, the worker may be even worse off because the part of the raise remaining after taxes is diminished by inflation, and the government is better off because it collects more taxes, and the real value of government debt declines. Since inflation favors the government and deflation favors the worker, governments always favor inflation.

  In summary, the Federal Reserve prefers inflation because it erases government debt, reduces the debt-to-GDP ratio, props up the banks, and can be taxed. Deflation may help consumers and workers, but it hurts the Treasury and the banks and is firmly opposed by the Fed. This explains Alan Greenspan’s extraordinary low-interest-rate policies in 2002 and Ben Bernanke’s zero-rate policy beginning in 2008. From the Fed’s perspective, aiding the economy and reducing unemployment are incidental by-products of the drive to inflate. The consequence of these deflationary dynamics is that the government must have inflation, and the Fed must cause it.

  The dynamics amount to a historic collision between the natural forces of deflation and government’s need for inflation. So long as price index data show that deflation is a threat, the Fed will continue with its zero-rate policy, money printing, and efforts to cheapen the dollar in foreign exchange markets in order to import inflation through higher import prices. When the data show a trend toward inflation, the Fed will allow the trend to continue in the hope that nominal growth will become self-sustaining. This will cause inflation to take on a life of its own through behavioral feedback loops not included in Fed models.

  Japan is a large canary in a coal mine in this regard. The Asian nation has undergone persistent core deflation since 1999 but also saw positive real growth from 2003 to 2007 and negative nominal growth in 2001 and 2002. Japan has not experienced the precise combination of negative nominal growth, deflation, and positive real growth on a persistent basis, but it has flirted with all those elements throughout the past fifteen years. To break out of this coil, Japan’s new prime minister, Shinzo Abe, elected in December 2012, declared his policy of the “three arrows”: money printing to cause inflation, deficit spending, and structural reforms. A corollary to this policy was to weaken the exchange value of the yen to import inflation, mostly through higher prices for energy imports.

  The initial response to “Abenomics” was highly favorable. In the five months following Abe’s election, the yen, measured against dollars, dropped 17 percent, from 85 to 1 to 102 to 1, while the Japanese Nikkei stock index rose 50 percent. The combination of a cheaper yen, the wealth effect from rising stock prices, and the promise of more money printing and deficit spending seemed like a page from a central banker’s playbook on how to break out of a deflationary spiral.

  Despite the burst of market enthusiasm for Abenomics, a cautionary note was raised in a speech on May 31, 2013, in Seoul, South Korea, by one of the most senior figures in Japanese finance, Eisuke Sakakibara, a former deputy finance minister, nicknamed “Mr. Yen.” Sakakibara emphasized the importance of real growth even in the absence of nominal growth and pointed out that the Japanese people are wealthy and have prospered personally despite decades of low nominal growth. He made the often-overlooked point that because of Japan’s declining population, real GDP per capita will grow faster than real aggregate GDP. Far from a disaster story, a Japan that has deflation, depopulation, and declining nominal GDP can nevertheless produce robust real per capita GDP growth for its citizens. Combined with the accumulated wealth of the Japanese people, this condition can result in well-to-do society even in the face of nominal growth that would cause most central bankers to flood the economy with money.

  Sakakibara is not unaware of the impact of deflation on the real value of debt. The Japanese debt-to-GDP ratio is mitigated by zero interest rates, which prevent the debt from compounding rapidly. Most Japanese government debt is owned by the Japanese themselves, so a foreign financing crisis of the kind that struck Thailand in 1997 and Argentina in 2000 is unlikely. Sakakibara’s most telling point is that Japan’s growth problems are structural, not cyclical, and therefore cyclical remedies such as money printing will not work; he sees no chance of Japanese inflation hitting the 2 percent target rate.

  Sakakibara’s insights, that monetary remedies will not solve structural problems, and that real growth is more impor
tant than nominal growth, are being ignored by central banks in both the United States and Japan. The Federal Reserve and the Bank of Japan will pursue the money-printing pseudoremedy as far as possible until investors finally lose confidence in their currencies, their bonds, or both. Japan, the canary, will likely suffer this crisis first.

  The Federal Reserve’s supporters ask defensively, What else could the Fed have done? If the Fed had not resorted to extraordinary money creation in 2008 and the years since, it does seem likely that asset prices would have plunged further, unemployment would have been significantly higher, and GDP growth significantly worse. A sharp contraction with rising bankruptcies and crashing industrial output, akin to the depression of 1920, might have resulted. In short, the Fed defenders argue, there really was no choice except to create money on an unprecedented scale.

  In this view, the problems of executing an exit strategy from monetary expansion are more manageable than the problems of economic depression. Defenders assert that the Fed took the right path in 2008 and persevered with great skill. This is the mainstream view that has resulted in the contemporary lore of Bernanke-as-hero, a halo that has now been transferred to Janet Yellen.

  The history of depressions in the United States from 1837 onward supports another perspective on the Fed’s actions. Under this view, the Fed should have provided only enough liquidity to mitigate the worst phase of the financial panic in late 2008. Thereafter the Fed should have capped the amount of excess reserves and normalized interest rates in a range of 1 to 2 percent. Most of the large banks—including Citibank, Morgan Stanley, and Goldman Sachs—should have been temporarily nationalized, their stockholders wiped out, and their bondholders subject to principal reductions as needed to restore capital. Nonperforming assets could have been stripped from these banks in receivership, then placed in a long-term government trust, to be liquidated for the taxpayers’ benefit as circumstances permitted. Management of the banks should have been fired, while enforcement actions and criminal prosecutions were pursued against them as the facts warranted. Finally asset prices, particularly housing and stocks, should have been allowed to fall to much lower levels than were seen in 2009.