James Rickards
* * *
AFTERMATH
Seven Secrets of Wealth Preservation in the Coming Chaos
Contents
Introduction
1. Scattergoods
2. Putting Out Fire with Gasoline
3. Find the Cost of Freedom
4. The Alpha Trap
5. Free Money
6. The Mar-a-Lago Accord
7. Godzilla
8. Aftermath
Conclusion
Acknowledgments
Notes
Selected Sources
Index
About the Author
James Rickards is the New York Times bestselling author of The Road to Ruin, The Death of Money, Currency Wars and The New Case for Gold, which have each been translated into sixteen languages. He is the editor of the newsletter Strategic Intelligence and is a member of the advisory board of the Center for Financial Economics at Johns Hopkins University. As an adviser on international economics and financial threats to the Department of Defense and the US intelligence community, he served as a facilitator of the first-ever financial war games conducted by the Pentagon. He lives in New Hampshire, USA.
AFTERMATH
Praise for The Road to Ruin
‘If you are curious about what the financial Götterdämmerung might look like, you’ve certainly come to the right place. Rickards believes – and provides tantalizing snippets of private conversations with those who dwell in the very eye in the pyramid – that the current world monetary and financial system is on the verge of insolvency and that the world financial elites already have a successor system for which they are laying the groundwork’ Forbes
Praise for Currency Wars
‘The currency wars are heating up. This is a plausible way to view what is going on, and Rickards tells the tale well’ Financial Times
‘Rickards has written one of the scariest books I’ve read this year. Though I was tempted at first to dismiss him as alarmist, his intelligent reasoning soon convinced me that we have more to fear than fear itself. Part history, part primer and analysis, the text covers topics ranging from the “misuse of economics” to complexity theory. The pieces, although disparate, fit together snugly, as in one of those mystery jigsaw puzzles that come with clues in lieu of cover art. The picture that emerges is dark yet comprehensive and satisfying’ Bloomberg Businessweek
Praise for The Death of Money
‘A fast-paced and apocalyptic look at the financial future, taking in financiers’ greed, central banks’ incompetence and impending Armageddon for the dollar. Rickards may be right that “the system is going wobbly”’ Financial Times
Praise for The New Case for Gold
‘Reminds us that wayward policies bring about a search for money that is good as gold. What’s better than gold itself?’ Wall Street Journal
‘Presents compelling evidence that many of the world’s leading monetary authorities implicitly, at least, treat gold as – quite possibly in the future, the key – money’ Forbes
For Ann
Then I watched while the Lamb broke open the first of the seven seals, and I heard one of the four living creatures cry out in a voice like thunder, “Come forward.” I looked, and there was a white horse, and its rider had a bow. He was given a crown, and he rode forth victorious to further his victories.
—Revelation 6:1–2
Introduction
No Way Home
This book is about the aftermath of the 2008 global financial crisis and efforts by central banks first to prevent a complete collapse of capital markets, later to revive self-sustaining growth, then finally to withdraw from continual policy intervention. It also warns that the crisis never really ended and offers a path to preserve wealth in the next phase. Like the Odyssey, this ten-year journey cannot be understood without reference to the struggle that preceded it. We consider the before, the after, and the future of the greatest financial crisis since the Great Depression.
In Homer’s epic poem the Odyssey, Scylla and Charybdis confront the hero, Odysseus, sailing home after the Trojan War. Scylla and Charybdis were the most feared women of Greek mythology. They lived in caves, a bowshot apart on each side of a narrow strait. Although female in nature, they were monsters. Scylla had six heads. Each mouth had rows of razor-sharp teeth that made the shark in Jaws seem tame. Her waist was shrouded with heads of baying dogs. She swam and walked on twelve snaky legs and devoured all within reach.
Less is known about the look of Charybdis, yet her powers were as daunting as Scylla’s. Three times a day Poseidon’s daughter would swallow the sea and spew it out, creating a whirlpool fatal to ships and sailors.
Odysseus is faced with a terrible choice. He must guide his vessel through the strait. Avoiding one peril needs put him in reach of the other. Odysseus orders the crew to steer clear of Charybdis, taking his chances with Scylla. He reasons that a whirlpool portends complete loss, while Scylla is a more selective threat—an ancient exercise in risk management. The gamble pays off. Scylla devours six of the crew. Still, Odysseus and the remnant survive, their vessel intact, to continue their journey home to Ithaca.
This hero’s dilemma, known in modern idiom as “being between Scylla and Charybdis,” is a perfect metaphor for the state of the global economy today and the choices confronting policymakers. Odysseus could coolly calculate his choice based on the nature of the horrors he confronted. Policymakers face similar tough choices now, with no way to gauge which is worse. The history of central bank policy since 2008 is an odyssey back to normalized interest rates and balance sheets. In the original Odyssey, the hero eventually arrives home, despite the dangers. In 2019, central bankers are still wandering, their travels far from over.
This twenty-first-century central bank odyssey was preceded by its own version of the Trojan War. In 2000, Federal Reserve chairman Alan Greenspan faced four challenges in quick succession that caused near deflation. The first was the bursting of the dot-com stock bubble beginning in March 2000. Second was a cyclical recession beginning in the United States in March 2001, part of a global slowdown in developed economies. Third were the 9/11 attacks, which, in addition to their historic geopolitical consequences, caused $40 billion in insurance losses and a one-day 7.1 percent stock market decline. This decline followed the longest trading suspension, September 11–14, 2001, since 1933. Finally, China’s accession to full WTO membership in December 2001 opened world markets to the greatest agglomeration of cheap labor and abundant capital in history. China’s emergence put downward pressure on prices that has not abated.
The result was a flirtation with deflation, a central banker’s worst nightmare. The consumer price index, or CPI, rose 1.55 percent in 2001, the lowest reading since 1986, and before that, 1964. After a slight increase to 2.38 percent in 2002, the CPI dipped again to 1.88 percent in 2003. In response, the annualized Fed Funds effective rate plunged from 6 percent in January 2001 to 1.8 percent by the end of that year. Greenspan then held the Fed Funds effective rate below 2 percent until November 2004 in an effort to slay the deflation dragon.
Deflation is a central banker’s greatest fear because it increases the real value of debt, which leads to defaults that jeopardize bank solvency. Similarly, an increase in the real value of debt shines a light on the growing burden of government debt and calls U.S. solvency into question. Price deflation also produces gains in citizens’ real standard of living that governments cannot effectively tax. Deflation makes cash more valuable, which discourages consumption, the linchpin of economic growth. Worse yet, deflation is a trap that central bankers cannot escape with existing policy tools, what John Maynard Keynes called a liquidity trap.
Greenspan succeeded in defeating deflation. In 2005
, his last full year as Fed chairman, the CPI was back up to 3.42 percent, a comfortable cushion above zero. Yet Greenspan scored a Pyrrhic victory. That three-year stretch of sub-2 percent Fed Funds from 2001 to 2004 was rightly criticized as “too low, for too long.” Low rates gave rise to the housing bubble and subprime mortgage crisis that exploded in 2007. The following year saw the global financial crisis and near destruction of the banking sector and the international monetary system.
What ensued was a more extreme version of Greenspan’s antideflation medicine. The CPI was 0.09 percent in 2008, the year of the crisis, even lower than the 1.55 percent rate that spooked Greenspan in 2001. Greenspan’s successor, Ben Bernanke, took the Fed Funds target rate to 0 percent in December 2008 where it remained until another Fed chair, Janet Yellen, raised the rate to 0.25 percent on December 17, 2015. If Greenspan’s three-year experiment with sub-2-percent rates gave rise to the global financial crisis, what was the world to make of the Bernanke-Yellen policy of 0 percent for seven years?
The zero-interest-rate policy was not the only extraordinary measure taken by Bernanke’s Federal Reserve. Bernanke also engaged in a completely unprecedented money-printing binge called quantitative easing, or QE. The money printing was executed through Fed purchases of long-term securities from bank primary dealers. The purchases were paid for with money from thin air that the Fed simply deposited with the banks through accounting entries.
Quantitative easing came in three rounds. The first, QE1 ran from November 2008 through June 2010. The second, QE2 began in November 2010 and lasted until June 2011. The third round of money printing, QE3, started in September 2012 and lasted until October 2014. As a result of these three rounds of money printing, the base money supply, M0 in Fed parlance, increased from $800 billion to $4.1 trillion. The offsetting asset on the Fed’s books was a $4.1 trillion mountain of U.S. Treasury notes and mortgage-backed securities.
The effects of QE are still debated. Most observers grant that QE1 was a proper central bank response to a liquidity crisis that had reached an acute stage with the Lehman Brothers bankruptcy in September 2008. However, QE2 and QE3 were more like a Bernanke-bred science experiment with no historic precedent.
Critics of QE quickly claimed that money printing on this scale would produce a wave of inflation. The inflation never came, because inflation has little to do with money supply per se. Inflation is a psychological phenomenon based on expectations and a form of adaptive behavior described mathematically as hypersynchronicity. Money supply can be like dry kindling, but inflation will not burst into flames without a catalyst. From 2008 to 2018, that catalyst was missing because consumers were saving, paying off debt, and rebuilding their balance sheets. The velocity or turnover of money plunged after 2008, the continuation of a decline that began in 1998. The psychological scars left by the 2008 market collapse had not healed. Still, the kindling was there. Ten years after the crisis, the risk that saver psychology might shift quickly and cascade into lost confidence in the dollar and rapidly rising inflation as it had in the late 1970s was nascent.
Supporters of QE defended Bernanke by asking rhetorically, “What choice did he have?” In late 2008, the United States was facing the most severe financial and liquidity crisis since 1933. Bernanke’s academic reputation was grounded in his study of the Great Depression, in particular the pivotal year of 1933, when Franklin D. Roosevelt succeeded Herbert Hoover as president. When I met Bernanke in Seoul in 2015, he expressed his admiration of FDR’s role in alleviating the Great Depression. He told me that FDR rarely knew exactly what impact his policies would have and he often made mistakes. Still, in a crisis, FDR felt it better to do something rather than nothing. Hippocrates would disagree, but Bernanke was an economist, not a physician. Like FDR, he was determined to do something to fend off a depression.
There is an academic theory behind Bernanke’s QE, called the portfolio balance channel. The idea is that investor money has to go somewhere. By purchasing long-term Treasury securities, the Fed lowered their total return and made them less attractive to investors. In turn, this made stocks and real estate more attractive on a relative basis. As investor funds flowed to equity and property channels, those assets would be worth more. Higher asset values would provide collateral for more borrowing. The higher asset values would also create a wealth effect that would encourage consumption, as everyday Americans felt richer and more willing to spend freely. In combination, more borrowing and more spending would push inflation to the Fed’s 2 percent target, facilitate normalized interest rates, and drive real GDP growth to its former self-sustaining trend above 3 percent.
None of these results emerged. Inflation measured by the Fed’s preferred yardstick, core personal consumption expenditure, or PCE, year-over-year, remained below 2 percent for six years through 2017. The Fed Funds target rate was still 2.0 percent as late as mid-2018; well below the hoped-for 3.5 percent. Real GDP growth from June 2009, the end of the last recession, through the first quarter of 2018 was less than 2.2 percent, materially below the long-term trend. As academic research on the QE experiment arrived after 2014, the best scholars could say was that it did no harm. There was no consensus that it had done any good.
By 2015, the QE and the zero-interest-rate policies ended. Critics were wrong about inflation; it never arrived. The Fed was wrong about stimulus; trend growth never arrived either. The ten-year episode of low rates and bloated balance sheets did not live up to the worst fears of critics or the great expectations of policymakers.
However, QE and zero rates did have one effect. It was the same effect Greenpsan produced on a smaller scale at the start of the century—asset bubbles. The difference was that Greenspan’s bubble was confined to mortgages, although the ensuing panic knew no bounds because of leverage, derivatives, and the dense interconnectedness of the global banking system. In contrast, by late 2018, the bubbles were everywhere—stocks, bonds, high-end real estate, emerging markets, and Chinese credit. The interconnectedness was greater also. And if the damage in 2008 was caused by low interest rates from 2001 to 2004, now the potential damage was the fruit of low rates and swollen securities holdings of central banks. Indeed, these central bank blunders were not confined to the Fed, but were a signal characteristic of central banks around the world.
By late 2015, central banks were desperate to normalize rates and balance sheets. The definition of “normal” for this purpose was speculative, since there was no precedent for highly abnormal rates and QE policies to begin with. Even the Bank of Japan, which has been experimenting with extreme remedies since 1990, including negative interest rates and asset purchases of equities in addition to government bonds, has given hints of a desire to reverse course. In the case of the Federal Reserve, normal might be a balance sheet of $2.5 trillion, and a Fed Funds target rate of 3.5 percent, both a far cry from the Fed’s position in early 2019.
If 1998 to 2008 was a financial Trojan War, and 2008 to 2018 was an odyssey back to financial normalcy, where are we now? Unhappily we are nowhere near home. In fact, we are now in sight of Scylla and Charybdis. Like Odysseus, Fed chairman Jay Powell must choose a course. Scylla is a global recession and stock market decline of 60 percent; severe, but manageable. Charybdis, the vortex, is a new global liquidity crisis that the international monetary system will not survive.
Outwardly the Fed purports to be sanguine about the prospects for monetary normalization. Both former chair Janet Yellen and new chair Jay Powell have said that interest rate hikes will be gradual. In practice, this means four rate hikes per year, 0.25 percent each, every March, June, September, and December, with occasional pauses prompted by strong signs of disinflation, disorderly markets, or diminution in job creation.
Balance sheet normalization is even more on autopilot than rate hikes. The Fed will not dump its securities holdings. Instead, it refrains from rolling over maturing securities. When the Treasury pays the Fed upon the maturity of a Treasury note, the money received by the Fed simply
disappears. This is the opposite of money printing; it’s money destruction. Instead of QE, we now have QT, or quantitative tightening. The Fed has been transparent about the rate at which they will run off their balance sheet this way, although transparency should not lead to complacency. The balance sheet reduction tempo as of early 2019 is $600 billion per year, equal in impact to four 0.25 percent rate hikes per year. The annual combined impact of the Fed’s rate policy and QT is an annual 2 percent increase in interest rates. For an economy addicted to cheap money, this is cold turkey.
The Fed would have investors believe that the rate hikes are already priced in to capital markets, and QT is a nonevent, running on “background,” in the Fed’s words. The Fed pretends it’s like running an Excel spreadsheet on your laptop while you watch a film from Netflix. That assumption is not correct. The conceit that rate hikes are priced in ignores the complexity of global capital markets. Will other countries whose currencies are pegged formally or informally to the dollar raise rates in lockstep with the Fed to maintain the peg? If so, will those same countries later be forced to break the peg, close their capital accounts, or devalue their currencies? Will disorderly stock markets derail Fed tightening plans, as happened in September 2015, when the Fed postponed the “liftoff,” or in December 2016, when the Fed finally raised rates to save face? These questions limn just a few of the negative outcomes from rate hikes that Fed models cannot resolve.
The view that balance sheet normalization can run on background without disruptive effects is even more flimsy than the rate-hike conceit. The Fed printed almost $4 trillion of new money over six years from 2008 to 2014 to inflate the value of risky assets. Now, the Fed would have investors believe that destroying $2 trillion in even less time will have no negative impact on the value of those same risky assets.
Aftermath Page 1