It may be that it’s not possible to write a book today about banking, even a good book, without resorting to the kind of populist rancor that always speaks to the greed of Wall Street. If so, then it’s unfortunate because books like Currency Wars, by James Rickards, will be dismissed by bankers without a fair hearing. This may already be happening. In its review, the Financial Times’ investment editor wrote that Rickards’ thesis “is a plausible way to view what is going on, and Rickards tells the tale well. But when he presents his criticism he will lose many readers.”
Those bankers who are able to deal with Rickards’ criticisms will take a fascinating journey through the history of international finance, as well as a dizzying spin through the key economic theories that underlie contemporary bank practices. They will also engage a book (and author) which has been generally well received by the mainstream financial media; is ranked in Amazon’s current top five economics best-sellers, along with Michael Lewis’ Boomerang; and is contributing to the federal regulatory thinking that will shape banking for years to come.
The big picture
James Rickards is a regular television and print commentator who has been a financial war games consultant to the Pentagon, helping to identify responses to acts of economic warfare by our enemies—and challenges to U.S. financial hegemony by our own trading partners. Rickards’ fears that currency wars can trigger shooting wars became far more realistic on New Year’s Day 2012, when citizens of the western democracies awoke to reports that the Iranian Navy had test-fired new long-range missiles. Defense analysts saw this as a show of defiance against tough U.S. economic sanctions that had recently been imposed on the Iranian central bank, resulting in a two-day drop of 12% in the value of the riyal, on top of a 30% drop in the preceding few weeks.
Just days earlier, financial editors were writing of plans by China and Japan to allow their producers to exchange yuan and yen directly without using U.S. dollar intermediaries. Similar bilateral initiatives have been announced between China and Thailand, and Japan and India, all of which are intended to reduce their dependence on the dollar as reserve currency. Not too surprisingly, China, Russia and Iran also hammered out agreements to circumvent U.S. sanctions on Iran by settling their trading debts in their own national currencies, or in gold. In fact, bilateral currency swap agreements were on the rise throughout the world in a year during which financial markets had grown restless with the dollar’s ongoing devaluation, amid concerns about the Euro’s very survival as a viable currency.
As timely and powerful as his thesis may be, Rickards overlooks the power of American corporations and defense contractors to protect the dollar’s role in global markets. U.S. firms’ refusal to repatriate their overseas profits may be viewed harshly by many as a tax ploy. But those corporate earnings stimulate supplier cash flows, which also add to the world’s dollar supply. So does the personal spending and logistic support for 317,000 active duty U.S. military forces on overseas deployments.
In its way, a military history
The headline currency deals were struggles in “Currency War III,” which Rickards says began when the Federal Reserve enacted Quantitative Easing in order to protect asset prices.
“QE was a policy bomb dropped on the global economy in 2009, and its successor, promptly dubbed QE2, was dropped in late 2010,” Rickards writes. “The impact on the world monetary system was swift and effective. By using quantitative easing to generate inflation abroad, the United States was increasing the cost structure of almost every major exporting nation and fast-growing economy in the world all at once.”
As an unintended consequence of our trading partners’ insistence on undervalued currencies, the inflationary aspects of quantitative easing have been transmuted directly into their economies. The resultant rise in prices has contributed to dissatisfaction among the local populace, most notably leading to the Arab Spring. Rickards shows that in a global market economy the monetary actions taken by any large central bank, but particularly by the Fed, have repercussions for the economies of their trading partners, as well as for those of the partners of their partners.
Beyond monetary policy, Rickards argues that all fiscal stimulus enacted in the form of deficit spending without restraints leads to income inequality that undermines the social balance both locally and globally. (By way of background, Rickards contends that Currency War I ran from 1921-1936, and that Currency War II ran from 1967-1987.)
Misuse of economics
Far more than just a macro-level critic, Rickards shows the depth of his thinking by drilling down to the assumptions underlying the theories that policy makers use to justify their actions, as well as those that bank risk managers use to limit their exposure to the effects of those policies and market reactions. He exposes the overlooked assumptions and unintended consequences of Keynesianism, monetarism, Efficient Market Theory, Value at Risk, and the Fed’s dual mandate to prevent high unemployment and inflation.
Rickards explains the complex accounting used by the Fed and the Treasury to bolster the Fed’s balance sheet, but which is also said to be masking the potential enormity of mark-to-market losses yet to be recorded in the collateral taken during the TARP and quantitative easing programs.
Rickards writes: “The United States now has a system in which the Treasury runs nonsustainable deficits and sells bonds to keep from going broke. The Fed prints money to buy those bonds and incurs losses by owning them. Then the Treasury takes IOUs back from the Fed to keep the Fed from going broke. It is quite the high-wire act, and amazing to behold. The Treasury and the Fed resemble two drunks leaning on each other so neither one falls down.”
Competing academic studies are presented which argue both in favor of, and in opposition to the theories underlying the Obama Administration’s trillion-dollar 2009 and 2010 deficits. For his part, Rickards adopts a rebuttal argument that focuses on the principle that governments must create money in order to stimulate growth through their spending initiatives. The creation of that money, in his opinion, inevitably leads to inflation.
In particular, the concept of the Keynesian multiplier rests on the assumption that a dollar of government deficit spending can produce more than a dollar of total economic output after all secondary effects are taken into account.
But Rickards is not convinced.
He rebuts: “The multiplier is the Bigfoot of economics--something that many assume exists but is rarely, if ever, seen.”
Rickards cites the “seminal yet still underappreciated” theory of Prof. Carl Christ, who pointed out in the 1960s that only economies that start with a balanced budget will benefit from deficit spending. Today, with the U.S. having started its stimulus programs with a large trade and budget deficit, “The increased debt from the failed Keynesian stimulus became a cause célèbre in the currency wars. These wars were primarily about devaluing a country’s currency, which is a form of default. A country defaults to its foreign creditors when its claims suddenly become worth less through devaluation. A country defaults to its own people through inflation and higher prices for imported goods. “America’s infatuation with the Keynesian illusion has now resulted in U.S. power being an illusion. America can only hope that nothing bad happens. Yet given the course of events in the world, that seems a slim reed on which to lean.”
With a stiletto run through the Keynesians, the author then skewers the efficient market theory, which “escaped from the lab and infected the entire trading apparatus of Wall Street and the modern banking system.” He writes that “flawed theories” helped produce the 1987 stock market crash, the 1998 collapse of Long-Term Capital Management (LTCM), and the Panic of 2008.
As the former General Counsel of LTCM, Rickards knows firsthand about the weaknesses of financial modeling. In a powerful vivisection of Value at Risk (VaR), he calls it “the invisible thread that allowed the banks, ratings agencies and investors to assume that their positions were safe [and] everything was under control.”
Rickards asserts that “VaR did not measure risk; it buried it behind a wall of equations that intimidated regulators who should have known better.”
This is a compelling argument, for which the only defense can be: Maybe it ain’t so great, but it’s the best we have right now.
The next big thing
As an alternative to traditional econometric modeling, Rickards explains that the interconnectedness of the financial markets, a phenomenon that regulators have pointed to as a major contributor to the tsunami-like spread of global market disruptions, can only be appreciated within the context of complex systems analysis. To illustrate, the author notes that at the origin of the subprime mortgage mortgage crisis in 2007, Japanese analysts found that stocks on the Tokyo market were collapsing in lockstep with the U.S. mortgage market. The linkage existed because investors were selling liquid Japanese stocks to meet margin calls on their mortgage positions.
With similar examples, Rickards shows that complexity analysis treats the long and short positions of traders as a cumulative gross exposure, not the net risk presumed by VaR analysis.
“Every dollar of notional value represents some linkage between agents in the system,” writes Rickards. “Every dollar of notional value creates some interdependence. The counterparty fails, what started out as a net position for a particular bank instantaneously becomes a gross position, because the single quote hedge has disappeared. Fundamentally, the risk is in the gross position, not the net.”
Rickards believes that solutions to the problem of complex risk involve shrinkage of the system or balancing the internal components. “Either de-scale the system or have smaller banks with the same total system assets.” He asserts that this is an imperative. “Based on theoretical scaling metrics, the next collapse will not be stopped by governments, because it will be larger than governments. The 5 m seawall will face the 10 m tsunami and the wall will fall.”
The coming tumult
Rickards believes that the unchecked creation of fiat money has resulted in income inequality that threatens the social balance. He cites reports that 20 million American job-seekers were out of work in 2010, while 25 hedge fund managers made $22 billion. More Americans work for the government than in all construction, farming, fishing, forestry, manufacturing, mining, and utilities jobs combined.
Special drawing rights are being seen as an alternative to the dollar as a reserve currency, along with baskets of non-dollar currencies. Rickards picks up on the fact that the IMF raised its SDR borrowing capacity from $250 billion to $580 billion in four years. “The day of the global central bank has well and truly arrived,” he asserts.
Rickards’ estimates of the intrinsic value of gold reaching, at some point, double and triple current levels has received much media coverage. By tying the value of gold to various definitions of money, Rickards claims that actions taken after the crisis of 2008 actually helped governments hide real inflation in an ever-more-complicated set of quasi-currencies.
He concludes that the danger of the currency wars resides in the threat that they will morph into real, shooting wars:
“If remedial policies are not adopted and events do spiral out of control, the Pentagon will inevitably be called upon to restore order in ways that the Treasury and Fed cannot. The threats in vision in the Pentagon’s 2009 financial wargame are becoming more real by the day.”
It is unfortunate that the author in the course of his reasoning joins in the populist rancor against greedy bankers and corrupt elites. Actually, Rickards’ eloquent elaboration of the challenges of complex systems gives rise to my more charitable view of financial practitioners: That human nature seeks logical planks, especially those upon which we can build a worldview that does not require re-examination over morning coffee.
Given a world so complex, we must often take the lessons of our elders as gospel, especially when imparted by Nobel laureates. In that context, it is not so much an intent to use economic theory to cheat our trading partners, as it is an effort to construct a cohesive defense for the assets so painstakingly accumulated, even in the midst of the chaos that the author himself fears will worsen over the coming years. He makes a compelling case that discussion of these issues is something many have a stake in:
“What works and what does not in economics is no longer just a matter of academic debate when 44 million Americans are on food stamps. Claims by economic theorists about multipliers, rationality, efficiency, correlation and normally distributed risk are not mere abstractions. Such claims have become threats to the well-being of the nation. Signal failures of economics have arisen in Federal Reserve policy, Keynesianism, monetarism and financial economics.”
A cerebral exercise
There is much to recommend in Currency Wars, despite Rickards’ gloomy forecast for the global economy and sour view of its principal actors.
The entire case is reminiscent of dark times in centuries past, like today with powerful reformers in control, of which Dickens wrote: “So much was closing in about the women who sat knitting, knitting, that they their very selves were closing in around a structure yet unbuilt, where they were to sit knitting, knitting, counting dropping heads.”
As the Financial Times reviewer wrote: “Let’s hope that he’s wrong.”