The central bank of a country adopting the Malaysia Plan can mitigate volatility in the local-currency-to-dollar exchange rate by conducting open-market operations in gold. Using the Malaysia example, if the dollar price of gold were to drop precipitously to, say, $1,200 per ounce, resulting in a weaker ringgit measured in dollars (USD/MYR = 4.2500, assuming $1,200-per-ounce gold and a ringgit-gold peg of MYR5,100 per ounce), the central bank could buy gold with its reserves until gold returned to the original dollar level of $1,268 per ounce at the time the peg was established. Those gold reserves could then be sold for dollars when the dollar price of gold surpasses the $1,268 per ounce level. These gold open-market operations seem counterintuitive (they involve expending dollar reserves while the local currency is weak), yet pursued consistently an accretion of dollar reserves would result as the gold trading profits were realized. Those added reserves could then be used in defense of the ringgit-gold peg as needed. Conversely, if the dollar price of gold rises dramatically, open-market operations would be unnecessary because the gold peg is vindicated as the ringgit (or other local currency) remains strong (versus dollars), while the dollar itself is debased (versus gold and the gold-pegged currencies).
An important benefit to countries adopting the Malaysia Plan is that when two countries peg to gold, those countries’ currencies will be pegged to each other by a simple transitive property. In the above example, the Malaysian ringgit is pegged to gold at MYR5,100 per ounce. If Indonesia took the same approach and pegged their currency, the rupiah (IDR), to gold at IDR17.9 million per ounce of gold (using exchange rates at this writing of IDR/USD = 0.000071, and $1,268 per ounce of gold), then the MYR/IDR exchange rate would also be fixed at 0.000285 ringgits per rupiah. This de facto pegged exchange rate between ringgits and rupiah would obviate currency wars, lower transaction costs, and facilitate cross-border trade and investment between these two important emerging economies. If this practice were to spread to a group of thirty or forty countries, something like the pre-1914 gold standard would emerge, with two important differences. Almost no gold is needed by the participants themselves; instead the market provides the gold for settlements intermediated through dollar-gold transactions. The United States would not participate. In effect, the world would return to a gold standard by free riding on deep, liquid, dollar-denominated markets in gold, and using those markets to intermediate the local currency-gold peg. The world would be betting that the United States cannot long maintain a strong dollar (measured in gold) with high real interest rates, given lackluster growth, near record debt-to-GDP ratios, and adverse demographics. That’s a good bet. The Malaysia Plan’s success would be self-fulfilling, as institutional investors allocated their assets toward economies using gold-pegged currencies and away from those that must out of necessity create inflation to alleviate nonsustainable debt burdens. Currencies of plan participants would constitute a pool of synthetic world money; their fixedness to one another makes them interoperable and alleviates fears of devaluation and currency wars.
The Malaysia Plan is a bottom-up self-help model that does not rely on reserve currency central banks or the IMF for implementation. The plan is a way for emerging economies to get out from under IMF hectoring and dollar hegemony, while at the same time offering an attractive investment environment for institutions. The plan shifts the burden of price adjustment from the poor to the rich (through the dollar-gold exchange) and protects the poor from confiscation through devaluation.
This chapter has identified various ways in which a global monetary reset could occur. These include a new international monetary conference (either cooperative or chaotic), crypto SDRs, gold pegged SDRs, and gold pegged local currencies. There are other ways for a reset to play out, including fiat SDRs, or an autarkic outcome with no global reserve benchmark at all. The global monetary reset is coming. What’s missing is leadership and foresight.
Investment Secret #6: Prepare for asset-backed currencies with physical gold.
John Pierpont Morgan was called to testify before Congress in 1912, in the aftermath of the panic of 1907, on the subject of Wall Street manipulations and what was then called the “money trust,” or banking monopoly, of J. P. Morgan & Co.
In the course of his testimony, Morgan made one of the most profound and lasting remarks in the history of finance. In reply to questions from the congressional committee staff attorney, Samuel Untermyer, the following dialogue ensued:
Untermyer: I want to ask you a few questions bearing on the subject that you have touched upon this morning, as to the control of money.7 The control of credit involves a control of money, does it not?
Morgan: A control of credit? No.
Untermyer: But the basis of banking is credit, is it not?
Morgan: Not always. That is an evidence of banking, but it is not the money itself. Money is gold, and nothing else.
Morgan’s observation that “money is gold, and nothing else” was right in two respects. The first and most obvious is that gold is a form of money. The second and more subtle point, revealed in the phrase “and nothing else,” was that other instruments purporting to be money were really forms of debt, unless they were redeemable into physical gold.
The intermediate-term forecast is that gold will reach ten thousand dollars per ounce in the course of the current gold bull market, which began in December 2015. Investors should keep 10 percent of their investable assets in physical gold, with room left in the portfolio for “paper gold,” in the form of ETFs and mining stocks if desired.
The first step is to determine investable assets. This is not the same as net worth. Investors should exclude home equity, business equity, and other illiquid or intangible assets that constitute your livelihood. Do not take portfolio market risk with your primary income source or the roof over your head. Once you’ve removed those assets, whatever is left are your investable assets. You should then allocate 10 percent of that amount to physical gold. This gold should not be kept in a bank safe-deposit box or bank vault. There is a high correlation between the time you’ll want your gold the most and the time banks are closed by government order. Keep your gold in safe, non-bank storage.
The next step concerns the ten-thousand-dollar-per-ounce forecast for the dollar price of gold. This is straightforward. Excessive Federal Reserve money printing from 2008 to 2015, combined with projected U.S. government deficits after 2018 of over $1 trillion per year for the foreseeable future and a U.S. debt-to-deficit ratio of 105 percent rising to over 110 percent in a few years, leave the U.S. dollar vulnerable to a collapse of confidence on the part of foreign investors and U.S. citizens alike. That collapse of confidence will not happen in a vacuum. It will coincide with a general loss of confidence in all major reserve currencies. This loss of confidence will be exacerbated by malicious efforts on the part of Russia, China, Turkey, Iran, and others to abandon dollars entirely and to bypass the U.S.-dollar payments system. The evolution of oil pricing from dollars to IMF SDRs will be the last nail in the dollar’s coffin.
At that point, either the United States acting on its own or a global conference resembling a new Bretton Woods will turn to gold to restore confidence. Once that route is chosen, the critical factor is to set a nondeflationary price for gold that restores confidence but does not lead to a new depression. The United States, China, Japan, and the Eurozone have a combined M1 money supply of $24 trillion. Those same countries have approximately 33,000 tons of official gold. As noted, a successful gold standard historically requires 40 percent gold backing to maintain confidence. Forty percent of $24 trillion equals $9.6 trillion of gold required to support the money supply. Taking the available 33,000 tons of gold and dividing that into $9.6 trillion gives an implied gold price of just over nine thousand dollars per ounce. Considering that the global M1 money supply continues to grow faster than the quantity of official gold, this implied price will rise over time; ten thousand dollars per ounce is a reasonable estimate of a balanced relationship between gold and
central bank money. The portfolio recommendation is to put 10 percent of investable assets into physical gold as a diversifying asset allocation and as portfolio insurance. The following example demonstrates that insurance aspect.
For purposes of simplification, assume the overall portfolio contains 10 percent gold, 30 percent cash, and 60 percent equities. Obviously those percentages can vary and the equity portion can include private equity and other alternative investments. Here’s how the 10 percent allocation to gold works to preserve wealth:
If gold declines 20 percent, the impact on your overall portfolio is a 2 percent decline (20 percent × 10 percent). That’s not highly damaging and is offset by equity outperformance. Conversely, if gold prices go to ten thousand dollars per ounce, that’s a 650 percent gain from current levels. That price spike gives you a 65 percent gain on your overall portfolio (650 percent × 10 percent). There is a conditional correlation between a state where gold goes up 650 percent and where stocks, bonds, and other assets are declining. For this purpose, assume a scenario similar to the worst of the Great Depression from 1929 to 1932, where stocks fell 85 percent. An 85 percent decline in stocks making up 60 percent of your portfolio produces a portfolio loss of just over 50 percent.
In this scenario, the gains on the gold (650 percent separately and 65 percent in your portfolio) will more than preserve your wealth against an 85 percent decline in stocks comprising 60 percent of your portfolio (85 percent separately and 50 percent in your total portfolio). The 30 percent cash allocation holds wealth constant.
If 60 percent of your portfolio drops 85 percent (equal to the stock market drop in the Great Depression), and 10 percent of your portfolio goes up 650 percent (gold’s expected performance in a monetary reset), you lose 50 percent on your portfolio of stocks, but you make 65 percent on your portfolio on gold. Your total wealth is preserved and even increased slightly. Total portfolio performance in this new depression scenario is a gain of 15 percent. That’s the insurance aspect at work. Investors without an allocation to gold will be hurt badly. Those with a 10 percent allocation will survive the storm with their wealth intact.
CHAPTER SEVEN
Godzilla
A finite time singularity simply means that the mathematical solution to the growth equation … becomes infinitely large at some finite time ….1 This is obviously impossible, and that’s why something has to change.
—Geoffrey West, Scale (2017)
JPMorgan versus Godzilla
I’ve been a Godzilla fan since I saw the 1954 film version of Godzilla on television as a child. Godzilla was a prehistoric sea monster awakened by nuclear radiation after the Second World War. Godzilla initially destroys several Japanese fishing boats at sea. Later he is spotted ashore by villagers on a remote island. The Japanese navy sends frigates and uses depth charges to destroy Godzilla. Still, he survives. Finally, Godzilla comes ashore near Tokyo and uses his sheer size and “atomic breath” to wreak havoc on the city before retreating back into Tokyo Bay. Japanese scientists use an advanced oxygen deprivation device to kill Godzilla at sea. Still, their scientists fear radiation from continued nuclear weapons testing may cause a new Godzilla to arise.
Godzilla’s commercial success led to a long line of sequels from Japanese and U.S. studios, including Godzilla Raids Again (1955) and the classic King Kong vs. Godzilla (1962). King Kong, a gigantic gorilla, was unveiled in the movie King Kong, a 1933 black-and-white film. Both monsters have enduring popularity. In all, thirty-nine Godzilla films and nine King Kong films have been produced.
How tall was Godzilla? The answer depends on which film version you reference. Godzilla was 164 feet tall in the original 1954 film, then grew to 197 feet in the 1998 remake. The tallest Godzilla yet was the 387 foot tall supermonster portrayed in the 2016 film titled Godzilla: Resurgence.
How tall was King Kong? The answer also depends on which film you use. The original King Kong was 24 feet tall when he was in New York, yet strangely was only 18 feet tall on Skull Island, his original home. By the time of Dino De Laurentiis’s 1976 remake, King Kong, the gorilla had grown to 55 feet. The biggest King Kong ever was 147 feet tall, as portrayed in King Kong vs. Godzilla. It seemed the film producers needed King Kong to bulk up a bit to combat the larger lizard, Godzilla.
Behind these film versions of giant lizards and gorillas lies an intriguing question in physics and biology. Can a real King Kong or Godzilla ever emerge on the earth? The tallest land animal on earth, the giraffe, can reach a height of 20 feet, although 15 feet is more typical. Among sea creatures, the blue whale is the largest animal ever known, at 100 feet in length. Among extinct animals, brontosaurus was up to 72 feet long and tyrannosaurus measured 40 feet from head to tail and stood 12 feet tall at the hips. Since these creatures are all real, why not a 147-foot King Kong or a 387-foot Godzilla?
It turns out creatures over twenty feet tall or one hundred feet in length are physically impossible; cardiovascular systems cannot function beyond that scale. The blue whale is the largest creature we have ever seen or ever will. A look at the science of scale behind this conclusion points to questions about the scale of capital markets. The answers may save us from ruin if acted upon soon.
Let’s start with the size constraint. The math and analysis are straightforward. Large land creatures stand on two or four legs. The legs are supported by bones. How much weight can bones support?
For analytic ease, we’ll look at a simple wooden construction such as a house, although the analysis applies to all structures, from steel skyscrapers to human bodies. The strength of structural support in a wooden beam increases by the square of an increase in the lengths of the sides of a cross-sectional area, regardless of the length of the beam. For example, if you double the sides of of a 2″ × 4″ beam, its strength is increased by a factor of 4. This increase in strength is calculated by the square of the increase in size, or 22 = 4.
Increases in volume are governed by a different function. When a structure increases in size, that increase involves three dimensions of height, width, and breadth. Likewise, when a creature grows in size, its body expands in three dimensions of height, width, and breadth; total volume increases. If you double the size of an object, the resulting volume is measured by the cube of the increase, or 23 = 8.
Based on these relationships, the problem is obvious. When an object doubles in size, strength increases at a rate of 22 while volume increases at a rate of 23. If volume is increasing faster than strength, it’s only a matter of time before a building or animal collapses of its own weight. Two superlinear functions increasing by different exponents are what determine the maximum size and height of natural or man-made objects.
Leading physicist Geoffrey West makes this point in his book Scale:
Consider increasing the height of a building or tree by a factor of 10 keeping its shape the same; then the weight needed to be supported increases a thousandfold (103) whereas the strength of the pillar or trunk holding it up increases by only a hundredfold (102).2 Thus, the ability to safely support the additional weight is only a tenth of what it had previously been. Consequently, if the size of the structure, whatever it is, is arbitrarily increased it will eventually collapse under its own weight. There are limits to size and growth.
This is why the tallest skyscrapers taper near the top. The taper reduces the volume increase relative to the height increase somewhat, and allows the structure to support greater height with a smaller exponential increase in volume. Still, the cubic volume increase is greater than the square of the beam cross-section increase, so scaling limits based on strength and volume are eventually reached.
What of the length of the largest creature? Whales have bones but they do not support weight in the same manner as a land creature. The buoyancy of a whale in the water does a great deal to support the weight. Still, there are limits to growth. Why can’t a blue whale be two-hundred- or three-hundred-feet long?
For this answer, physicists introduce the idea
of the “terminal unit.” A terminal unit is the interface between the larger biological organs (or building structure) and units of energy delivered at the smallest scale. For a living creature such as a blue whale or a human being, the terminal unit is the blood cell. It’s at the level of the individual blood cell that energy in the form of oxygen is transferred to muscles and waste is removed. A blue whale may weigh two thousand times a typical human, yet the blue whale and human blood cells are the same size. Regardless of the size of an organism, the terminal unit (the blood cell) is the same size. This rule applies in buildings also. The terminal unit is the standard wall outlet into which lamps, computers, chargers, and printers are plugged. Whether you are considering a one-story house or a one-hundred-story skyscraper, the terminal unit (the wall outlet) is the same size. Skyscrapers do not have gigantic wall sockets; they’re the same size as the ones in your apartment.
While the terminal unit may be the same, the distance from the energy source to the terminal unit is not the same. In larger structures or creatures, there are exponentially more tubes, wires, arteries, or channels through which the energy flows to get from the central source to the place where the energy is needed. Passage through those channels, especially at branches, uses energy. As the creature expands in size, the amount of energy used to move blood to all parts of the body (the terminal units) exceeds the energy available. At that point, the creature dies for lack of oxygen to all of its tissues. Evolution solves this problem by insuring creatures don’t grow that large to begin with, since they won’t survive. This evolutionary feedback loop is another limit to growth.
Aftermath Page 24