The Death of Money
Wednesday, April 9, 2014
The prospect of the dollar failing, and the international monetary system with it, looks increasingly inevitable. The dollar nearly ceased to function as the world’s reserve currency in 1978, and similar symptoms can be seen today.
Few Americans in our time recall that the dollar nearly ceased to function as the world’s reserve currency in 1978. That year the Federal Reserve dollar index declined to a distressingly low level, and the U.S. Treasury was forced to issue government bonds denominated in Swiss francs. Foreign creditors no longer trusted the U.S. dollar as a store of value. The dollar was losing purchasing power, dropping by half from 1977 to 1981; U.S. inflation was over 50 percent during those five years. Starting in 1979, the International Monetary Fund (IMF) had little choice but to mobilize its resources to issue world money (special drawing rights, or SDRs). It flooded the market with 12.1 billion SDRs to provide liquidity as global confidence in the dollar declined.
We would do well to recall those dark days. The price of gold rose 500 percent from 1977 to 1980. What began as a managed dollar devaluation in 1971, with President Richard Nixon’s abandonment of gold convertibility, became a full-scale rout by the decade’s end.
The efforts of Federal Reserve Chairman Paul Volcker and the newly elected Ronald Reagan would save the dollar. The dollar did not disappear as the world’s reserve currency after 1978, but it was a near run thing.
Now the world is back to the future.
The parallels between 1978 and recent events are eerie but imperfect.
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.
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. And from the Federal Reserve’s perspective, inflation is not a threat; indeed, higher inflation is both the Fed’s answer to the debt crisis and a policy objective.
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.
The world economy is not yet in the “new normal.” Instead, the world is on a journey from old to new with no compass or chart. Turbulence is now the norm.
Danger comes from within and without. We have a misplaced confidence that central banks can save the day; in fact, they are ruining our markets. The value-at-risk models used by Wall Street and regulators to measure the dangers that derivatives pose are risible; they mask overleveraging, which is shamelessly transformed into grotesque compensation that is throwing our society out of balance. When the hidden costs come home to roost and taxpayers are once again stuck with the bill, the bankers will be comfortably ensconced inside their mansions and aboard their yachts. The titans will explain to credulous reporters and bought-off politicians that the new collapse was nothing they could have foreseen.
While we refuse to face truths about debts and deficits, dozens of countries all over the globe are putting pressure on the dollar. We think the gold standard is a historical relic, but there’s a contemporary scramble for gold around the world, and it may signify a move to return to the gold standard. We greatly underestimate the dangers from a cyberfinancial attack and the risks of a financial world war.
Regression analysis and correlations, so beloved by finance quants and economists, are ineffective for navigating the risks ahead. These analyses assume that the future resembles the past to an extent. History is a great teacher, but the quants’ suppositions contain fatal flaws. The first is that in looking back, they do not look far enough. The second flaw involves the quants’ failures to understand scaling dynamics that place certain risk measurements outside history. Since potential risk is an exponential function of system scale, and since the scale of financial systems measured by derivatives is unprecedented, it follows that the risk too is unprecedented.
The economy is broken, and inflation is on its way.
While the word collapse as applied to the dollar sounds apocalyptic, it has an entirely pragmatic meaning. Collapse is simply the loss of confidence by citizens and central banks in the future purchasing power of the dollar. The result is that holders dump dollars, either through faster spending or through the purchase of hard assets. This rapid behavioral shift leads initially to higher interest rates, higher inflation, and the destruction of capital formation. The end result can be deflation (reminiscent of the 1930s) or inflation (reminiscent of the 1970s), or both.
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 coming collapse, like those before, may involve war, gold, or chaos, or it could involve all three. The most imminent threats to the dollar, likely to play out in the next few years, are financial warfare, deflation, hyperinflation, and market collapse. Only nations and individuals who make provision today will survive the maelstrom to come.
In place of fallacious, if popular, methods, complexity theory is the best lens for viewing present risks and likely outcomes. Capital markets are complex systems nonpareil. Complexity theory is relatively new in the history of science, but in its 60 years it has been extensively applied to weather, earthquakes, social networks, and other densely connected systems. The application of complexity theory to capital markets is still in its infancy, but it has already yielded insights into risk metrics and price dynamics that possess greater predictive power than conventional methods.
The next financial collapse will resemble nothing in history. But a more cleared-eyed view of opaque financial happenings in our world can help investors think through the best strategies.
This article is adapted from “The Death of Money: The Coming Collapse of the International Monetary System” by James Rickards, in agreement with Portfolio, an imprint of Penguin Random House. Copyright James Rickards, 2014.
FURTHER READING: Steve Conover adds “Money Printing Isn't Always Inflationary” and Kenneth Gould explains “Sound Money vs. Stable Money.” John Steele Gordon asks “Good as Gold?” and John H. Makin offers “All That Glitters: A Primer on the Gold Standard.”