In this article, we will continue our study of the Introduction in James Rickards' book, "The Death of Money". Last time, we had an overview of what happened in the past. This time, we will see the similarities and differences between current events and the 1970s. However, Rickards' main focus in the remaining part of the Introduction is to provide an overview of the existing threats to the USD as world reserve currency.
Rickards claims that similarities could be seen in the decline of USD, appreciation of gold and the IMF's issuance of SDRs. The absence of inflation is the major distinction. The reasons why inflation is absent today is due to the fact that the US economy is already structurally damaged and that inflation though delayed through QEs will certainly come.
For Rickards, the impending collapse of the USD is not something new. He claims that such collapse already happened three times in the past: 1914, 1939, and 1971. Three major world events are also associated with these dates: WW1, WW2, and Nixon's abandonment of gold convertibility for the USD. As a result of such abandonment, the position of the USD as world reserve currency is now being threatened by currency war, hyperinflation, deflation, and market crash.
Currency war is a threat by way of using derivatives and penetrating exchanges in order to create public panic by selling huge number of shares.
As for inflation, James Rickards describes it as "the stealth destroyer of savings, capital, and economic growth" (p.12). The experience during the 1970s can teach us two lessons concerning inflation: first, that it takes several years for people to realize its impact, and second, that when perception about inflation takes place, it is extremely difficult to reset. Another noteworthy observation concerning inflation is the fast devaluation of the dollar and the appreciation of gold. The major difference is that this time China, Russia, and the IMF are already prepared in facing inflation with gold and SDR.
Deflation on the other hand, is the FR's worst nightmare due to following reasons: (1.) Real gains cannot be easily taxed. (2.) Deflation increases the real value of government debt. (3.) Deflation slows down GDP growth. (4.) It also increases the real value of private debt that may result to defaults and bankruptcies. (5.) Deflation feeds on itself and is nearly impossible for the Fed to reverse. For Rickards, the only solution to avoid deflation is for the US to declare a higher price for gold.
As a whole, market crash can be avoided if large banks are broken and most derivatives are banned. Out of the current crisis, a new monetary system could emerge which is based on gold, SDR, or a regional reserve currency.
"A similar constellation of symptoms to those of 1978 can be seen in the world economy today. In July 2011 the Federal Reserve dollar index hit an all-time low, over 4 percent below the October 1978 panic level. In August 2009 the IMF once again acted as a monetary first responder and rode to the rescue with a new issuance of SDRs, equivalent to $310 billion, increasing the SDRs in circulation by 850 percent. In early September gold prices reached an all-time high, near $1,900 per ounce, up more than 200 percent from the average price in 2006, just before the new depression began" (p. 9).
"The parallels between 1978 and recent events are eerie but imperfect. There was an element ravaging the world then that is not apparent today. It is the dog that didn’t bark: inflation. But the fact that we aren’t hearing the dog doesn’t mean it poses no danger" (ibid.).
"To understand the threats to the dollar, and potential policy responses by the Federal Reserve, it is necessary to see the dollar through the Fed’s eyes. From that perspective, inflation is not a threat; indeed, higher inflation is both the Fed’s answer to the debt crisis and a policy objective" (ibid.).
"This pro-inflation policy is an invitation to disaster, even as baffled Fed critics scratch their heads at the apparent absence of inflation in the face of unprecedented money printing by the Federal Reserve and other major central banks. Many ponder how it is that the Fed has increased the base money supply 400 percent since 2008 with practically no inflation. But two explanations are very much at hand—and they foretell the potential for collapse. The first is that the U.S. economy is structurally damaged, so the easy money cannot be put to good use. The second is that the inflation is coming. Both explanations are true—the economy is broken, and inflation is on its way" (ibid.).
"The coming collapse of the dollar and the international monetary system is entirely foreseeable. This is not a provocative conclusion. The international monetary system has collapsed three times in the past century—in 1914, 1939, and 1971. Each collapse was followed by a tumultuous period. The 1914 collapse was precipitated by the First World War and was followed later by alternating episodes of hyperinflation and depression from 1919 to 1922 before regaining stability in the mid1920s, albeit with a highly flawed gold standard that contributed to a new collapse in the 1930s. The Second World War caused the 1939 collapse, and stability was restored only with the Bretton Woods system, created in 1944. The 1971 collapse was precipitated by Nixon’s abandonment of gold convertibility for the dollar, although this dénouement had been years in the making, and it was followed by confusion, culminating in the near dollar collapse in 1978" (pp. 10-11).
"This book limns the most imminent threats to the dollar, likely to play out in the next few years, which are financial warfare, deflation, hyperinflation, and market collapse. Only nations and individuals who make provision today will survive the maelstrom to come" (p. 11).
"Are we prepared to fight a financial war? The conduct of financial war is distinct from normal economic competition among nations because it involves intentional malicious acts rather than solely competitive ones. Financial war entails the use of derivatives and the penetration of exchanges to cause havoc, incite panic, and ultimately disable an enemy’s economy" (p. 11).
"The modern financial war arsenal includes covert hedge funds and cyber attacks that can compromise order-entry systems to mimic a flood of sell orders on stocks like Apple, Google, and IBM" (ibid.).
"Critics from Richard Cantillon in the early eighteenth century to V. I. Lenin and John Maynard Keynes in the twentieth have been unanimous in their view that inflation is the stealth destroyer of savings, capital, and economic growth" (p. 12).
"Inflation often begins imperceptibly and gains a foothold before it is recognized. This lag in comprehension, important to central banks, is called money illusion, a phrase that refers to a perception that real wealth is being created, so that Keynesian 'animal spirits' are aroused. Only later is it discovered that bankers and astute investors captured the wealth, and everyday citizens are left with devalued savings, pensions, and life insurance" (ibid.).
"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" (p. 12).
"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" (p. 12).
"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" (ibid.).
"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" (p. 13).
"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" (ibid.)
"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" (ibid.).
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" (ibid.).
"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" (ibid).
"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' (p. 14).
"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" (p. 14).
"The case for banning most derivatives 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" (p. 15).
"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" (ibid).
"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" (p. 15)
"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" (ibid.).
"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" (pp. 15-16).
1. What are the similarities and the major difference between 1978 and recent events?
2. What changes took place among the three financial assets in 2011?
3. Why inflation is missing in recent financial events? What are the reasons for such absence?
4. Give the three dates where the financial system collapsed in the past. What three major events are associated with this financial collapse.
5. What are the four major threats to the dollar's supremacy?
6. Briefly explain your own understanding of currency war.
7. What is the unanimous opinion of economists concerning inflation?
8. What is "money illusion"? Why do you think the majority find it difficult to liberate his mind from such illusion?
9. What two lessons can we learn about inflation from the 1960s and 1970s?
10. What similarities and major difference Rickards anticipates that will happen between now and the 1970s once inflation occurs?
11. What is the FR worst nightmare? Why?
12. For Rickards, what is the only solution to avoid deflation?
13. How about the remedy to market collapse?
14. What are the potential alternatives to the existing dollar supremacy?