From the Dark Side
Over the past few months, I’ve forced myself to read from among the plague of doom and gloom books that have been published since the Great Recession of 2008-2009. Think of it as a vaccination to strengthen my psychological immune system. (That’s why I’m passing my thoughts on to you, dear reader.)
The quality of the analyses I’ve read has varied, from rambling to erudite. There are some very smart people in the black sunrise industry, and there are a few people who are just a wee bit the other side of misguided. The author who impressed me most is James Rickards. His latest book, The Death of Money1 is a sequel to his first, Currency Wars2. Each book can stand alone, but they’re better read back to back. In this essay, I’ll focus on the overall message of both books, without trying to negotiate either the overlap or the differences.
The Death of Money could be to our time what Harry Browne’s, How to Profit From the Coming Devaluation3 was to the 1970’s; except that, unlike Browne, Rickards doesn’t tell his readers how to invest. Harry Browne’s book was published in 1970, just before President Nixon removed the last formal link between the U.S. dollar and gold in 1971. In the days immediately after Nixon’s de facto credit default, the dollar was devalued by more than 20%. In the decade that followed, the greenback lost well over half of its 1971 purchasing power. Unfortunately, in many ways, we seem to be repeating the worst economic policy mistakes of the Nixon/Carter era.
From the late 1960’s through the late 1970’s, every sentient being on earth knew that our main economic challenge was inflation. But the Federal Reserve (the Fed) and most academic economists had insisted that top-down banking could manage the economy more efficiently than a free market. They generally blamed exogenous events like the war in Vietnam and Arab oil embargoes for the escalating rate of inflation. Those things certainly didn’t help, but Harry Browne showed that it was the Fed’s monetization of federal budget deficits (money printing) that ultimately led to dollar devaluation and hyperinflation.
Now as then, the vast majority of academic economists and the Fed share a shaman’s idea of how the world works. James Rickards calls it “Keynesianism and the arrogance of the PhD.” He’s being generous. As I’ve watched the Fed’s operations over the past four decades, it’s become clear to me—as Rickards explains in considerable detail—that they don’t really know what they’re doing. But to be fair, they’ve also been given a virtually impossible task.
James Rickards asks a lot from his readers with the depth of his analysis, but he’s not overly prone to jargon. He is an attorney, a portfolio manager, an investment banker, and he consults with the Pentagon and major corporations. He was the chief negotiator of the Fed’s settlement with Long Term Capital Management, when that firm’s leveraged bond market bets threatened to bring down the world financial system back in 1998. In other words, his résumé reads like a who’s who of international finance. One wonders if he ever sleeps.
It’s Rickard’s contention that the Fed and other central banks are trying to solve deflationary problems, which in the present situation are structural—including, but not limited to cronyism, regulatory overreach, aging populations, out-of-control entitlement spending, and government debts and deficits—with a cyclical solution; e.g. money printing. The Fed is actually doing its best to create inflation, with a target of 2% or more. Therefore, he says they’re quite willing to err on the side of too much money printing, as opposed to too little. He says that the Fed’s econometricians think they’re dialing up a household thermostat, but in reality, they’re tinkering with the control panel on a nuclear reactor. The danger of overheating is much greater than the Fed thinks. Once inflation reaches critical mass (above 2.5%), they won’t be able to dial it down; crowd psychology will take over, and inflation will spiral out of control. That’s a familiar argument, one that both former Fed chairman Alan Greenspan and Harry Browne often made. And, it’s a real possibility.
Rickards’ more frightening complaint is that the world’s too-big-to-fail institutions are now exposed to more than $650 trillion in derivative securities risk; nine times world GDP. Rickards says that Wall Street, the Fed, and the International Monetary Fund (IMF), are using the wrong risk models. Their models assume that the derivatives mostly cancel each other out, thereby reducing overall risk to the financial system. But, as we should have learned from AIG and others in 2008, he says, they should be using risk models based on the relatively new science of “complexity”, which, I confess, I found fascinating. But, Rickards says, despite complexity theory, and the compounding nature of the risks it explains, the solution to the derivatives hazard is simple and straightforward: Break up the too-big-to-fail banks and ban most derivative products. I won’t hold my breath waiting for either of those things to happen. My guess is that if Rickards’ analysis of derivatives risk is correct, nuclear may again be the appropriate metaphor, but in the sense of a meltdown, not an explosion. The other aspect of the “too-big-to-fail” problem may not be size at all, but regulatory favoritism.
You may have noticed the chart on the back of this newsletter. My sweetie says it’s monetarily obscene, but it reflects the aforementioned attempt by the Fed to offset the continuing deflationary effects of the housing finance bust of the late 2000’s. Similar stories are playing out in Japan and in Europe, especially Japan. That’s the main difference between the 1970’s and now: For today’s central bankers and politicians, the threat of a 1930’s style deflationary collapse is more terrifying than the threat of a 1970s hyperinflation. Inflation increases government tax receipts; deflation erodes them.
The U.S. dollar has functioned as the world’s reserve currency since (and despite) the 1971 Nixon convertibility default. It has served reasonably well, but according to Rickards, the Fed’s recent actions have threatened the dollar’s stability once again. The saving grace, so far, is that no other currency is even in the same league with the dollar. Still, as the chart shows, the Fed has printed more than $3 trillion since 2008, quadrupling the size of its balance sheet. Rickards says that if the Fed were a regulated bank, and it was forced to disclose the true market value of its bond portfolio, it would be bankrupt. So he asks, what will they do if there’s another crisis? They can’t print another $3 trillion without destroying the dollar altogether; or can they? Rickards says that the next global financial crisis will be bigger than the Fed, so it will be up to the IMF to bring order out of chaos. I warned you that this was the scary part, didn’t I?
Yes, James Rickards draws a fairly bleak picture of the dollar’s future, but he assures us that we’ve been through this kind of thing before and survived. He’s right about that, and if necessary, we’ll survive to thrive, yet again. In the next issue of this newsletter, I’ll share a more positive analysis with you. So please, don’t let this message from the dark side upset you; and especially, don’t jump out the window. Indulge me just a bit longer, and go to page seven. mh
1 The Death of Money, James Rickards, Portfolio/Penguin, April 2014.
2 Currency Wars, James Rickards, Portfolio hardcover, November 2011.
3 How You Can Profit From the Coming Devaluation, Harry Browne, Arlington House, August 1970.