The Death of Money

by James Rickards

  Two lessons from the 1960s and 1970s are highly pertinent today. The first is that inflation can gain substantial momentum before the general public notices it. It was not until 1974, nine years into an inflationary cycle, that inflation became a potent political issue and prominent public policy concern. This lag in momentum and perception is the essence of money illusion.

  Second, once inflation perceptions shift, they are extremely difficult to reset. In the Vietnam era, it took nine years for everyday Americans to focus on inflation, and an additional eleven years to reanchor expectations. Rolling a rock down a hill is much faster than pushing it back up to the top.

  More recently, since 2008 the Federal Reserve has printed over $3 trillion of new money, but without stoking much inflation in the United States. Still, the Fed has set an inflation target of at least 2.5 percent, possibly higher, and will not relent in printing money until that target is achieved. The Fed sees inflation as a way to dilute the real value of U.S. debt and avoid the specter of deflation.

  Therein lies a major risk. History and behavioral psychology both provide reason to believe that once the inflation goal is achieved and expectations are altered, a feedback loop will emerge in which higher inflation leads to higher inflation expectations, to even higher inflation, and so on. The Fed will not be able to arrest this feedback loop because its dynamic is a function not of monetary policy but of human nature.

  As the inflation feedback loop gains energy, a repetition of the late 1970s will be in prospect. Skyrocketing gold prices and a crashing dollar, two sides of the same coin, will happen quickly. The difference between the next episode of runaway inflation and the last is that Russia, China, and the IMF will stand ready with gold and SDRs, not dollars, to provide new reserve assets. When the dollar next falls from the high wire, there will be no net.

  ■ Deflation

  There has been no episode of persistent deflation in the United States since the period from 1927 to 1933; as a result, Americans have practically no living memory of deflation. The United States would have experienced severe deflation from 2009 to 2013 but for massive money printing by the Federal Reserve. The U.S. economy’s prevailing deflationary drift has not disappeared. It has only been papered over.

  Deflation is the Federal Reserve’s worst nightmare for many reasons. Real gains from deflation cannot easily be taxed. If a school administrator earns $100,000 per year, prices are constant, and she receives a 5 percent raise, her real pretax standard of living has increased $5,000, but the government taxes the increase, leaving less for the individual. But if her earnings are held constant, and prices drop 5 percent, she has the same $5,000 increase in her standard of living, but the government cannot tax the gain because it comes in the form of lower prices rather than higher wages.

  Deflation increases the real value of government debt, making it harder to repay. If deflation is not reversed, there will be an outright default on the national debt, rather than the less traumatic outcome of default-by-inflation. Deflation slows nominal GDP growth, while nominal debt rises every year due to budget deficits. This tends to increase the debt-to-GDP ratio, placing the United States on the same path as Greece and making a sovereign debt crisis more likely.

  Deflation also increases the real value of private debt, creating a wave of defaults and bankruptcies. These losses then fall on the banks, causing a banking crisis. Since the primary mandate of the Federal Reserve is to prop up the banking system, deflation must be avoided because it induces bad debts that threaten bank solvency.

  Finally, deflation feeds on itself and is nearly impossible for the Fed to reverse. The Federal Reserve is confident about its ability to control inflation, although the lessons of the 1970s show that extreme measures may be required. The Fed has no illusions about the difficulty of ending deflation. When cash becomes more valuable by the day, deflation’s defining feature, people and businesses hoard it and do not spend or invest. This hoarding crushes aggregate demand and causes GDP to plunge. This is why the Fed has printed over $3 trillion of new money since 2008—to bar deflation from starting in the first place. The most likely path of Federal Reserve policy in the years ahead is the continuation of massive money printing to fend off deflation. The operative assumption at the Fed is that any inflationary consequences can be dealt with in due course.

  In continuing to print money to subdue deflation, the Fed may reach the political limits of printing, perhaps when its balance sheet passes $5 trillion, or when it is rendered insolvent on a mark-to-market basis. At that point, the Fed governors may choose to take their chances with deflation. In this dance-with-the-Devil scenario, the Fed would rely on fiscal policy to keep aggregate demand afloat. Or deflation may prevail despite money printing. This can occur when the Fed throws money from helicopters, but citizens leave it on the ground because picking it up entails debt. In either scenario, the United States would suddenly be back to 1930 facing outright deflation.

  In such a circumstance, the only way to break deflation is for the United States to declare by executive order that gold’s price is, say, $7,000 per ounce, possibly higher. The Federal Reserve could make this price stick by conducting open-market operations on behalf of the Treasury using the gold in Fort Knox. The Fed would be a gold buyer at $6,900 per ounce and a seller at $7,100 per ounce in order to maintain a $7,000-per-ounce price. The purpose would not be to enrich gold holders but to reset general price levels.

  Such moves may seem unlikely, but they would be effective. Since nothing moves in isolation, this kind of dollar devaluation against gold would quickly be reflected in higher dollar prices for everything else. The world of $7,000 gold is also the world of $400-per-barrel oil and $100-per-ounce silver. Deflation’s back can be broken when the dollar is devalued against gold, as occurred in 1933 when the United States revalued gold from $20.67 per ounce to $35.00 per ounce, a 41 percent dollar devaluation. If the United States faces severe deflation again, the antidote of dollar devaluation against gold will be the same, because there is no other solution when printing money fails.

  ■ Market Collapse

  The prospect of a market collapse is a function of systemic risk independent of fundamental economic policy. The risk of market collapse is amplified by regulatory incompetence and banker greed. Complexity theory is the proper framework for analyzing this risk.

  The starting place in this analysis is the recognition that capital markets exhibit all four of complex systems’ defining qualities: diversity of agents, connectedness, interdependence, and adaptive behavior. Concluding that capital markets are complex systems has profound implications for regulation and risk management. The first implication is that the proper measurement of risk is the gross notional value of derivatives, not the net amount. The gross size of all bank derivatives positions now exceeds $650 trillion, more than nine times global GDP.

  A second implication is that the greatest catastrophe that can occur in a complex system is an exponential, nonlinear function of systemic scale. This means that as the system doubles or triples in scale, the risk of catastrophe is increasing by factors of 10 or 100. This is also why stress tests based on historic episodes such as 9/11 or 2008 are of no value, since unprecedented systemic scale presents unprecedented systemic risk.

  The solutions to this systemic risk overhang are surprisingly straightforward. The immediate tasks would be to break up large banks and ban most derivatives. Large banks are not necessary to global finance. When large financing is required, a lead bank can organize a syndicate, as was routinely done in the past for massive infrastructure projects such as the Alaska pipeline, the original fleets of supertankers, and the first Boeing 747s. The benefit of breaking up banks would not be that bank failures would be eliminated, but that bank failure would no longer be a threat. The costs of failure would become containable and would not be permitted to metastasize so as to threaten the system. The case for banning most deri
vatives is even more straightforward. Derivatives serve practically no purpose except to enrich bankers through opaque pricing and to deceive investors through off-the-balance-sheet accounting.

  Whatever the merits of these strategies, the prospects for dissolving large banks or banning derivatives are nil. This is because regulators use obsolete models or rely on the bankers’ own models, leaving them unable to perceive systemic risk. Congress will not act because the members, by and large, are in thrall to bank political contributions.

  Banking and derivatives risk will continue to grow, and the next collapse will be of unprecedented scope because the system scale is unprecedented. Since Federal Reserve resources were barely able to prevent complete collapse in 2008, it should be expected that an even larger collapse will overwhelm the Fed’s balance sheet. Since the Fed has printed over $3 trillion in a time of relative calm, it will not be politically feasible to respond in the future by printing another $3 trillion. The task of reliquefying the world will fall to the IMF, because the IMF will have the only clean balance sheet left among official institutions. The IMF will rise to the occasion with a towering issuance of SDRs, and this monetary operation will effectively end the dollar’s role as the leading reserve currency.

  ■ A Deluge of Dangers

  These threats to the dollar are ubiquitous. The endogenous threats are the Fed’s money printing and the specter of galloping inflation. The exogenous threats include the accumulation of gold by Russia and China (about which more in chapter 9) that presages a shift to a new reserve asset.

  There are numerous ancillary threats. If inflation does not emerge, it will be because of unstoppable deflation, and the Fed’s response will be a radical reflation of gold. Russia and China are hardly alone in their desire to break free from the dollar standard. Iran and India may lead a move to an Asian reserve currency, and Gulf Cooperation Council members may chose to price oil exports in a new regional currency issued by a central bank based in the Persian Gulf. Geopolitical threats to the dollar may not be confined to economic competition but may turn malicious and take the form of financial war. Finally, the global financial system may simply collapse on its own without a frontal assault due to its internal complexities and spillover effects.

  For now, the dollar and the international monetary system are synonymous. If the dollar collapses, the international monetary system will collapse as well; it cannot be otherwise. Everyday citizens, savers, and pensioners will be the main victims in the chaos that follows a collapse, although such a collapse does not mean the end of trade, finance, or banking. The major financial players, whether they be nations, banks, or multilateral institutions, will muddle through, while finance ministers, central bankers, and heads of state meet nonstop to patch together new rules of the game. If social unrest emerges before financial elites restore the system, nations are prepared with militarized police, armies, drones, surveillance, and executive orders to suppress discontent.

  The future international monetary system will not be based on dollars because China, Russia, oil-producing countries, and other emerging nations will collectively insist on an end to U.S. monetary hegemony and the creation of a new monetary standard. Whether the new monetary standard will be based on gold, SDRs, or a network of regional reserve currencies remains to be seen. Still, the choices are few, and close study of the leading possibilities can give investors an edge and a reasonable prospect for preserving wealth in this new world.

  The system has spun out of control; the altered state of the economic world, with new players, shifting allegiances, political ineptitude, and technological change has left investors confused. In The Death of Money you will glimpse the dollar’s final days and the resultant collapse of the international monetary system, as well as take a prospective look at a new system that will rise from the ashes of the old.

  PART ONE

  MONEY AND GEOPOLITICS

  CHAPTER 1

  PROPHESY

  One of our biggest fears is that something happens today, and when we do the autopsy we find that two weeks ago we had it, [but] we didn’t know because it was buried in something else that wasn’t getting processed.

  B. “Buzzy” Krongard

  CIA executive director

  September 1, 2001

  The unconditional evidence supports the proposition that there was unusual trading in the option markets leading up to September 11, which is consistent with the terrorists or their associates having traded on advance knowledge of the impending attacks.

  Allen M. Poteshman

  University of Illinois at Urbana-Champaign

  2006

  Never believe anything until it has been officially denied.

  Claud Cockburn

  British journalist

  ■ Trading in Plain Sight

  “No one trades alone.” An axiom of financial markets, this truism means that every trade leaves transaction records there to be seen. If one knows where to look and how to examine the history and data, much can be learned not only about quotidian sales of stock by the obvious players, large and small, but about more troubling truths and trends. The market evidence surrounding 9/11—most of which is little understood by the public—is a case in point.

  The secure meeting rooms at the CIA’s Langley headquarters—windowless, quiet, and cramped—are called “vaults” by those who use them. On September 26, 2003, John Mulheren and I were seated side by side in a fourth-floor vault in the headquarters complex. Mulheren was one of the most legendary stock traders in Wall Street history. I was responsible for modeling terrorist trading for the CIA, part of a broad inquiry into stock trading on advance knowledge of the 9/11 attacks.

  I looked in his eyes and asked if he believed there was insider trading in American Airlines stock immediately prior to 9/11. His answer was chilling: “It was the most blatant case of insider trading I’ve ever seen.”

  Mulheren started his stock trading career in the early 1970s and, at age twenty-five, became one of the youngest managing directors ever appointed at Merrill Lynch. He was found guilty of insider trading in 1990 as part of the trading scandals of the 1980s, but the verdict was overturned on appeal. His conviction was based on testimony provided by Ivan Boesky, himself a notorious insider trader. During the case, Mulheren had been apprehended by police at his Rumson, New Jersey, estate as he set out with a loaded assault rifle in his car to kill Boesky in broad daylight.

  Mulheren was expert in options trading and the mathematical connections between the prices of options and the prices of the underlying stocks on which the options were written. He was also a seasoned trader in takeover stocks and knew that deal information was often leaked in advance, an open invitation to insider trading. No one knew more about the linkage between insider trading and telltale price signals than Mulheren.

  When we met at Langley, Mulheren was CEO of Bear Wagner, one of seven New York Stock Exchange specialist firms at the time. Recently, specialist firms have faded in importance, but on 9/11 they were the most important link between buyers and sellers. Their job was to make a market and stabilize prices. Specialists used options markets to lay off the risk they took in their market making. They were a crucial link between New York stock trading and Chicago options trading.

  Mulheren’s firm was the designated market maker in American Airlines stock at the time of the 9/11 attacks. When the planes hit the twin towers, Mulheren saw the smoke and flames from his office near the World Trade Center and understood immediately what had happened. While others speculated about a “small plane, off-course,” Mulheren furiously sold S&P 500 futures. In the ninety minutes between the time of the attack and the time the futures exchange closed, Mulheren made $7 million shorting stocks. He later donated all the gains to charity.

  Mulheren was an eyewitness: he watched both the unfolding of the 9/11 attack and the insider trading that preceded it. H
is presence at Langley in 2003 was part of a CIA project whose roots reached back to a time before the attack itself.

  ■ The Terror Trade

  September 5, 2001, was the day Osama bin Laden learned that the attacks on New York and Washington would take place on 9/11. The countdown to terror had begun. There were four trading days left before the streets around the New York Stock Exchange would be choked with death and debris. Terrorist traders with inside information on the attack had only those few days to execute strategies to profit from the terror. Insider trading on advance knowledge of the 9/11 plot was in full swing by September 6.

  Bin Laden was financially sophisticated, having been raised in one of the wealthiest families in Saudi Arabia. The other leaders of Al Qaeda, including the 9/11 hijackers, were not drawn from the ranks of the ignorant and impoverished; they were doctors and engineers. Many lived in developed countries such as Germany and the United States. Al Qaeda was financially backed by wealthy Saudis who traded stocks on a regular basis.

  Al Qaeda’s familiarity with the workings of the New York Stock Exchange is well known. In an interview with a Pakistani journalist just weeks after the 9/11 attacks, Bin Laden made the following comments, which show how closely he drew the connection between terror and trading:

  I say the events that happened on Tuesday 11th September on New York and Washington, that is truly a great event in all measures. . . . And if the fall of the towers . . . was an event that was huge, then consider the events that followed it . . . let us talk about the economic claims which are still continuing. . . .

  The losses on the Wall Street Market reached 16%. They said that this number is a record, which has never happened since the opening of the market more than 230 years ago. . . . The gross amount that is traded in that market reaches 4 trillion dollars. So if we multiply 16% with $4 trillion to find out the loss that affected the stocks, it reaches $640 billion of losses from stocks, with Allah’s grace.