Currency Wars: The Making of the Next Global Crisis

by James Rickards

  The war game had been many months in the making, and I had been part of the strategy sessions and game design that preceded the actual game. Although a well-designed war game will try to achieve unexpected results and simulate the fog of real war, it nevertheless requires some starting place and a set of rules in order to avoid descending into chaos. APL’s game design team was among the best in the world at this, but a financial game required some completely new approaches, including access to Wall Street expertise, which the typical physicist or military planner does not have. My role was to fill that gap.

  My association with the lab started in December 2006 in Omaha, Nebraska, where I was attending a strategy forum hosted by U.S. Strategic Command, or STRATCOM. I presented a paper on the new science of market intelligence, or what intelligence experts call MARKINT, which involves analyzing capital markets to find actionable intelligence on the intentions of market participants. Hedge funds and investment banks had been using these methods for years to gain information advantage on takeovers and government policy shifts. Now, along with my partners, Chris Ray, a seasoned options trader and risk manager, and Randy Tauss, recently retired after thirty-five years with the CIA, we had developed new ways to use these techniques in the national security realm to identify potential terrorist attacks in advance and to gain early warning of attacks on the U.S. dollar. Several members of the APL Warfare Analysis Lab had been in attendance at the Omaha event and later contacted me about ways we might work together to integrate MARKINT concepts with their own research.

  So it was not a surprise when I received a call in the summer of 2008 to join a global financial seminar sponsored by the Office of the Secretary of Defense and hosted by APL. It was scheduled for that September, its stated purpose to “examine the impact of global financial activities on national security issues.” This was one of a series of such seminars planned by the Defense Department to be held throughout the late summer and fall of that year as preparation for the financial war game itself. Defense wanted to know if such a game was even possible—if it made sense. They needed to think about the appropriate “teams.” Would they be countries, sovereign wealth funds, banks or some combination? They also needed to think about remote but still plausible scenarios for the players to enact. A list of expert participants had to be developed and some recruitment might be needed to reach out to those who had not been involved with war games before. Finally, rules had to be established for the actual play.

  To protect the top secret work that goes on inside the lab, the security procedures for visitors there are as strict as at any U.S. government defense or intelligence installation, starting with advance clearance and background checks. Upon arrival, visitors are quickly sorted into two categories, “No Escort” or “Escort Required,” reflected in different-colored badges. The practical impact of this has mainly to do with trips to the coffee machine, but the implicit understanding is that those with the No Escort badges hold current high-security clearances from their home directorates or government contractors. BlackBerrys, iPhones and other digital devices have to be deposited at the security desk to be retrieved upon departure. X-ray scanners, metal detectors, multiple security perimeters and armed guards are routine. Once inside, you are truly in the bubble of the military-intelligence complex.

  At the September meeting, there were about forty attendees in total, including a number of distinguished academics, think tank experts, intelligence officials and uniformed military. I was one of five asked to give a formal presentation that day, and my topic was sovereign wealth funds, or SWFs. Sovereign wealth funds are huge investment pools established by governments to invest their excess reserves, many with assets in the hundred-billion-dollar range or higher. The reserves are basically hard currency surpluses, mostly dollars, which governments have earned by exporting natural resources or manufactured goods. The largest reserves are held by oil-producing countries such as Norway or Arab states and by manufacturing export powerhouses such as China or Taiwan. Traditionally these reserves were managed by the central banks of those countries in a highly conservative manner; investments were limited to low-risk, liquid instruments such as U.S. Treasury bills. This strategy offered liquidity but did not provide much income, and it tended to concentrate a large amount of the portfolio in just one type of investment. In effect, the surplus countries were placing all their eggs in one basket and not getting very much in return. Because of the drastic increase in the size of reserves beginning in the 1990s, partly as the result of globalization, surplus countries began to seek out ways of getting higher returns on their investments. Central banks were not well equipped to do this because they lacked the investment staff and portfolio managers needed to select stocks, commodities, private equity, real estate and hedge funds, which were the key to higher returns. So the sovereign wealth funds began to emerge to better manage these investments; the earliest SWFs were created some decades ago, but most have come into being in the past ten years, with their government sponsors giving them enormous allocations from their central bank reserves with a mandate to build diversified portfolios of investments from around the world.

  In their basic form, sovereign wealth funds do make economic sense. Most assets are invested professionally and contain no hidden political agenda, but this is not always the case. Some purchases are vanity projects, such as Middle Eastern investments in the McLaren, Aston Martin and Ferrari Formula 1 racing teams, while other investments are far more politically and economically consequential. During the first part of the depression that began in 2007, sovereign wealth funds were the primary source of bailout money. In late 2007 and early 2008, SWFs invested over $58 billion to prop up Citigroup, Merrill Lynch, UBS and Morgan Stanley. China was considering an additional $1 billion investment in Bear Stearns in early 2008 that was abandoned only when Bear Stearns neared collapse in March of that year. When these investments were decimated in the Panic of 2008 the U.S. government had to step in with taxpayer money to continue the bailouts. The sovereign wealth funds lost vast fortunes on these early investments, yet the stock positions and the influence that came with them remained.

  My presentation focused on the dark side of SWF investments, how they could operate through what intelligence analysts call cutouts, or front companies, such as trusts, managed accounts, private Swiss banks and hedge funds. With these fronts in place, sovereign wealth funds could then be used to exercise malign influence over target companies in order to steal technology, sabotage new projects, stifle competition, engage in bid rigging, recruit agents or manipulate markets. I did not assert that such activities were common, let alone the norm, but rather that such activities were possible and the United States needed to develop a stronger watch function to protect its national security interests. Along with these specific threats, I suggested an even greater threat: a full-scale attack on Western capital markets to disable the engine of capitalist society. My presentation included metrics and system specifications to monitor sovereign wealth fund behavior, to look for behind-the-scenes malign acts and to identify financial choke points—the information age equivalents of the Suez Canal or the Strait of Hormuz—which could be monitored to prevent or fight off future financial attacks.

  By the end of the two-day event, the Defense Department officials in attendance seemed satisfied that the lab had developed a solid core of experts, subjects and threat analysis with which to take the war game to the next level.

  The core group of experts met again at the lab the following month to continue developing the financial war game. In addition to the APL hosts and our sponsors from the Department of Defense, there were representatives from other cabinet-level departments, including Commerce and Energy; several major universities, including the Naval War College; think tanks, including the Peterson Institute and RAND Corporation; other physics labs, including Los Alamos; and senior military officers from the staff of the Joint Chiefs.

  At this point I noticed the absence of representatives with any actua
l capital markets experience. I was the only one in the room with a lengthy career on Wall Street that included time at investment banks, hedge funds and exchanges. If we were going to conduct a financial war, we needed people who knew how to use financial weapons—such as front running, inside information, rumors, “painting the tape” with misleading price quotes, short squeezes and the rest of the tricks on which Wall Street thrives. We needed people who, in the immortal words of legendary banker John Gutfreund, were ready “to bite the ass off a bear” when it came to trading currencies, stocks and derivatives. There was no lack of testosterone among the uniformed military or the spies in the room, but they knew no more about destroying a country with credit default swaps than the average stock trader knew about the firing sequence for an ICBM. If this project was going to succeed, I had to persuade Defense to let me recruit some of my peers to make the game more realistic and more valuable for them.

  At the October session, I gave a presentation on futures and derivatives to explain how these leveraged instruments could be used to manipulate underlying physical markets, including those in strategic commodities such as oil, uranium, copper and gold. I also explained how the prohibition of derivatives regulation in the Commodity Futures Modernization Act, legislation led by Senator Phil Gramm and signed by President Clinton in 2000, had opened the door to exponentially greater size and variety in these instruments that were now hidden off the balance sheets of the major banks, making them almost impossible to monitor. I finished with a picture of how cutouts, sovereign wealth funds and derivatives leverage could be combined to launch a financial Pearl Harbor for which the United States was completely unprepared. The pregame seminars were beginning to achieve their purpose; the military, intelligence and diplomatic experts were now on the same page as the financial types. The threat of financial warfare was becoming clearer.

  Our third group planning session took place in mid-November; this time there were a few new faces, including senior officials from the intelligence community. We were no longer contemplating the feasibility of a financial war game; by now it was game on and we were specifically focused on game design. I presented detailed financial warfare scenarios and made a pitch that the game design should incorporate unpredictable outcomes that would surprise both attackers and defenders due to the complex dynamics of capital markets. By the conclusion, the Defense Department and the APL game design team had received enough input from the experts to complete the final design. All that remained was to select the participants, set the date and let the game begin.

  After some delays and uncertainty during the changeover of administrations, the Obama administration gave the go-ahead to proceed as planned. The formal invitations went out in late January 2009. The war game would be played over two days, March 17 and 18, at the APL Warfare Analysis Laboratory inside the imposing war room it had used in many past simulations.

  All war games have certain elements in common. They involve two or more teams, or cells, which are customarily designated either by the names of countries involved or by colors. A typical game might involve a red cell, usually bad guys, versus a blue cell, the good guys, although some games have multiple sides. One critical cell is the white cell, which consists of a game director and participants designated as umpires or referees. The white cell decides if a particular game move is allowed and also determines who wins or loses during each round of the game. Generally the game designers attribute specific goals or objectives to each cell; thereafter the players are expected to make moves that logically advance those objectives rather than move off in unexplained directions. The game design team will also use political scientists, military strategists and other analysts to describe the initial conditions affecting all the players—in effect, they determine the starting line. Finally, some system of power metrics is devised so that the relative strength of each cell can be established at the beginning of the game, in the same way that some armies are larger than others or some economies have greater industrial potential at the start of any war.

  Once in play, the participants will then direct the moves for each cell, with the white cell adding or subtracting points from each competing cell based on its assessment of the success or failure of each move. Other design features include specifying the number of days over which the game will be conducted and the number of moves on each day. This is an important practical constraint, because many of the outside experts find it difficult to be away from their other professional duties for more than two or three days at a time.

  I was not a war game expert but I was the designated Wall Street expert, so I worked side by side with the game designers to fit the world I knew into the categories, timelines, rules and budgets that they had within their parameters. One of my main goals was to make sure that the game design allowed for unconventional scenarios. I knew that a real financial attack would not involve anything as obvious as dumping Treasury notes on the open market, because the president has near dictatorial powers to freeze any accounts that try to disrupt the market in that way. An attack would almost certainly involve hard-to-identify cutouts and hard-to-track derivatives. Above all, a financial attack would almost certainly involve the dollar itself. Destroying confidence in the dollar would be far more effective than dumping any particular dollar-denominated instrument. If the dollar collapsed, all dollar-denominated markets would collapse with it and the president’s powers to freeze accounts would be moot. I wanted to make sure the game design would allow for a true currency war and not just a war of stocks, bonds and commodities.

  The final pieces were falling into place. The team decided we would definitely play a U.S. cell, a Russia cell and a China cell. In addition, there would be a Pacific Rim cell, which would include Japan, South Korea, Taiwan and Vietnam, among others. This was not ideal because as separate states South Korea and Taiwan, for instance, could take very different positions depending on the issue involved, but these kinds of compromises were necessary to stick to our budget and get the game off the ground. There would also be a gray cell, to represent the rest of the world. (I was not sure how pleased real Europeans would be to learn that they did not get their own cell and would have to share their platform with the IMF, hedge funds and the Cayman Islands.) Finally, of course, was the all-powerful white cell, directing course and calling the shots as the game played out.

  The game would have three moves played over two days. Two moves would be played on day one and one additional move on day two, with time at the end for debriefing. The cells would have private facilities to use as their “capitals” for deciding each move, and there would be plenary sessions in the war room, where the cells would make their moves and their opponents would respond. The white cell would preside over the plenary sessions and award or subtract power points to each cell’s “national power index.” Cells could conduct bilateral summits or negotiations with other cells at designated locations while each turn was being played.

  Most intriguingly, each cell would have a set of wild cards that allowed for actions and responses not included in the opening set of scenarios for each turn. Although this was being conducted for the first time on a tight budget and the results were far from clear at the outset, the combination of summit conferences and wild cards was enough to suggest that we might show the Pentagon how real unconventional financial warfare could occur.

  As we completed our overview, I again pointed out that we were top-heavy with military, intelligence and think tank participants but didn’t have anyone from Wall Street except me. I knew we were going to get very predictable action-response functions by inviting the usual suspects. These people are brilliant on macroeconomics and strategy, but none of them really understands how capital markets function in the trenches. I told them I wanted to recruit some investment bankers and hedge fund people to join us. There was room in the budget for two more participants, they said, and I could have my pick.

  My first recruit was Steve Halliwell, a seasoned banker and private equity investor.
Steve is trim, dapper, animated and highly recognizable with his thick-framed glasses and shaved head. He is the epitome of the Old Russia Hand, having made his first trip to Russia in 1963 during the Kennedy-Khrushchev era as an early exchange student while an undergraduate at Wesleyan. He later went to grad school at Columbia and had a long career at Citibank, where he was involved in opening Citibank’s Moscow branch, before he launched one of the first U.S.–Russia investment funds in the 1990s. Steve’s supply of Russian anecdotes is inexhaustible and he tells each one in vivid detail with a strong sense of humor. He speaks Russian like a native and has a dense network of connections in that country as a result of his banking and investment activities. Steve and I had spent a week in Moscow in the winter of 2008 doing market research for some hedge fund clients of mine. The trip was memorable for the beauty of the nighttime snowfall on Red Square and copious amounts of vodka and caviar consumed with our Russian hosts. I knew he’d be perfect to play the Russian side in the Pentagon’s financial game. He readily agreed to come on board.

  Now I had one more recruitment to make. Since Steve was a private equity fund guy and a more long-term investor, I wanted someone closer to the day-to-day action of the markets, someone who understood what are called “technicals”—that is, short-term supply and demand imbalances that could push security prices away from their fundamental values and catch supposedly rational investors off guard. I needed someone who knew every trick in the book when it came to handling the kind of huge orders that could push markets around and steamroll the unsuspecting. I called a friend who had been in the trenches for over thirty years and was known on the Street as “O.D.”

  I had known Bill O’Donnell for decades, going back to our days at Greenwich Capital, the primary dealer in government bonds. Bill is one of the smartest salespeople around and always has a smile—except when he’s working hard on an order for a customer. He’s never in a bad mood and never loses his temper, which is unusual on a trading floor. Sporting wavy salt-and-pepper hair, preppy clothes and good looks, Bill has an easygoing demeanor that makes him one of the most well-liked people in the bond business, otherwise known for its share of off-putting type A personalities. He loves the business and has seen it all, from the beginning of the bull market in 1982 through the housing bubble years beginning in 2002. When I called him in 2009, he was working as head of interest rate strategy for banking giant UBS at their North American headquarters in Stamford, Connecticut.