The Death of Money (2 page)

■
Inflation

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.

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.

The 1960s and 1970s are a good case study in money illusion. From 1961 through 1965,
annual U.S. inflation averaged 1.24 percent. In 1965 President Lyndon Johnson began
a massive bout of spending and incurred
budget deficits with his “guns and butter” policy of an expanded war in Vietnam and
Great Society benefits. The Federal Reserve accommodated this spending, and that accommodation
continued through President Nixon’s 1972 reelection. Inflation was gradual at first;
it climbed to 2.9 percent in 1966 and 3.1 percent in 1967. Then it spun out of control,
reaching 5.7 percent in 1970, finally peaking at 13.5 percent in 1980. It was not
until 1986 that inflation returned to the 1.9 percent level more typical of the early
1960s.

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 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.

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.