The Death of Money

In finance, there is no crystal ball for predicting one outcome, then proceeding on a single path. Still, it is possible to describe multiple paths and the mileposts along each one. Intelligence analysts call these mileposts “indications and warnings.” Once the indications and warnings are specified, events must be observed closely, not as a passing parade of superficial headlines but as part of a dynamic systems analysis.

Investor Mohamed El-Erian of bond giant PIMCO popularized the phrase “new normal” to describe the global economy after the 2008 financial crisis. He is half right. The old normal is gone, but the new normal has not yet arrived. The global economy has fallen out of its old equilibrium but has not stabilized in a new one. The economy is in a phase transition from one state to another.

This is illustrated by applying heat to a pot of water until it boils. Water and steam are both steady states, albeit with different dynamics. In between water and steam is a stage where the water’s surface is turbulent with bubbles rising, then falling back. Water is the old normal; steam is the new normal. Right now the world economy is neither—it is the turbulent surface deciding whether to fall back to water or rise to steam. Monetary policy is a matter of turning up the heat.

Certain phase transitions are irreversible. When wood burns and turns to ash, that is a phase transition, but there is no easy way to turn ash back into wood. The Federal Reserve believes that it is managing a reversible process. It believes that deflation can be turned to inflation, and then to disinflation, with the right quantity of money and the passage of time. In this, it is mistaken.

The Federal Reserve does not understand that money creation can be an irreversible process. At a certain point, confidence in money can be lost, and there is no way to reconstitute it; an entirely new system must rise in its place. A new international monetary system will rise from the ashes of the old dollar system, just as the dollar system rose from the ashes of the British Commonwealth at Bretton Woods in 1944, even before the flames of the Second World War had been extinguished.

The crux of the problem in the global financial system today is not money but debt. Money creation is being used as a means to deal with defaulted debt. By 2005 the United States, led by bankers whose self-interest blinded them to any danger, poisoned the world with excessive debt in mortgages and lines of credit to borrowers who could not repay. By itself, the mortgage problem was large but manageable. Unmanageable were the trillions of dollars in derivatives created from the underlying mortgages and trillions more in repurchase agreements, and commercial paper used to finance the mortgage-backed-securities inventories supporting the derivatives.

When the inevitable crash came, the losses were not apportioned to those responsible—the banks and bondholders—but were passed on to the public through federal finance. From 2009 to 2012, the U.S. Treasury ran a $5 trillion cumulative deficit, and the Federal Reserve printed $1.2 trillion of new money. Similar deficit and money-printing programs were launched around the world, as derivatives creation by banks continued unabated. Only a portion of the private debt defaults were written off.

The bankers’ jobs and bonuses were preserved, but nothing was achieved for the benefit of citizens. A private debt problem had been replaced with public debt larger than the private debt had ever been. These debts are unpayable in real terms, and defaults will soon follow. The defaults by smaller nations like Greece, Cyprus, and Argentina will be through nonpayment of bonds and losses for bank depositors. Defaults for larger nations such as the United States will come from across-the-board inflation that will steal from savers, depositors, and bondholders alike.

Adding to the challenges are the warnings of a revival of an almost-forgotten phenomenon. Deflation, a condition not widely seen in advanced economies since the 1930s, has taken hold, upsetting the central bankers’ inflation playbook. Deflation is rooted in depressionary psychology. Investors were shocked and frightened by events in 2008, and their immediate reaction was to stop spending, avoid risk, and move to cash. This reaction set the deflationary dynamic in motion. Much has been made about rising stock prices and housing prices since 2009, but a close examination of both shows that stock market volumes have been low, with leverage quite high. These are indications that the rising indexes are really asset bubbles, driven by professional traders and speculators, principally hedge funds, and that participation by everyday citizens has been shallow. Likewise, rising home prices have been held up not by traditional family formation but by investor pools purchasing large housing tracts with leverage, restructuring homeowner debt, or converting mortgages to rentals. Cash flows can make these pools attractive bondlike investments, but no one should mistake this financial engineering for a healthy, normalized housing market. Rising asset prices are fine for headlines and talking heads but do nothing to break the deflationary mind-set of typical investors and savers.

The fact that central banks are pursuing inflation, and cannot achieve it, is a gauge of the persistence of the underlying deflation. Money printing in the cause of defeating deflation may result in a loss of confidence in the fiat currency system. If the deflationary mind-set is broken, the inflationary mood may run ahead of central bank capabilities and prove impossible to contain or reverse. In the case of either persistent deflation or runaway inflation, we risk losing exactly what Paul Volcker warned was most valuable: confidence. Loss of confidence in a monetary system can rarely be restored.

Very likely, a new system will be needed, with a new foundation that can engender new confidence. The gold-backed dollar replaced sterling in stages between 1925 and 1944. The paper dollar replaced the gold-backed dollar in stages between 1971 and 1980. In each case, confidence was temporarily lost but was regained with a new store of value.

Whether the loss of confidence in the dollar results from external threats or internal neglect, investors should ask two questions: What comes next? and How can wealth be preserved in the transition?

■ Three Paths

The dollar’s demise will take one of three paths. The first is world money, the SDR; the second is a gold standard; and the third is social disorder. Each of these outcomes can be foreseen, and each presents an asset-allocation strategy best able to preserve wealth.

The substitution of SDRs for dollars as the global reserve currency is already under way, and the IMF has laid out a ten-year transition plan that the United States has informally endorsed. This blueprint involves increasing the amount of SDRs in circulation and building out an infrastructure of SDR-denominated investable assets, issuers, investors, and dealers. Over time the dollar’s weight in the SDR basket will be reduced in favor of the Chinese yuan.

The plan, as laid out by the IMF, exemplifies George Soros’s preferred modus operandi as described by his favorite philosopher, Karl Popper. Soros and Popper call it “piecemeal engineering” and consider it their preferred form of social engineering. The Soros-Popper ideal is to make large changes in small, scarcely noticeable increments, which can be advanced or postponed, as circumstances require. Popper wrote:

Under the Soros-Popper method, the IMF’s goal of SDR world money, initiated in 1969, could easily extend to 2025 or whenever, as Popper specified, “conditions are more favorable.”

Ironically, this gradual method is not the most likely scenario for SDRs to replace the dollar. Instead, a financial panic in the next several years, caused by derivatives exposure and bank interconnectedness, may trigger a global liquidity crisis worse than the 1998 and 2008 crises. This time the Fed’s balance sheet, already bloated and stretched to the limit, will not be flexible enough to reliquefy the interbank market. SDRs will be pressed into service to stabilize the system as was done in 1979 and 2009. The emerging circumstances will mean the process will be carried out on a crash basis, without reference to the carefully constructed infrastructure now contemplated. Existing infrastructure from institutions such as DTCC and SWIFT will be pressed into service to facilitate the new SDR market.

Chinese acquiescence will be needed to use the SDR in this way, and in exchange for its approval, China will insist that SDRs be used not to save the dollar, as was done in the past, but to replace the dollar as quickly as possible. This process will play out in a matter of months, light speed by the standards of the international monetary system. The transition will be inflationary in dollar terms, not because of new dollar printing but because the dollar will be devalued against the SDR. From then on the U.S. economy will face severe structural adjustments as it finds it must earn its SDRs through competition in the global marketplace rather than through printing reserves at will.

In this scenario, savings in the form of bank deposits, insurance policies, annuities, and retirement benefits will be largely wiped out.

A return to a gold standard is another way out of the labyrinth of incessant money printing. This could arise from extreme inflation, where gold is needed to restore confidence, or extreme deflation, where gold is revalued by governments to raise the general price level. The gold standard will certainly not be a matter of choice but may be pursued as a matter of necessity when confidence collapses. A first approximation of an equilibrium, nondeflationary gold price is $9,000 per ounce, although higher and lower values are feasible depending on the gold standard’s design specifications. The circulating currency will not be gold coins but rather dollars (if the United States takes the lead) or SDRs (if the IMF is the intermediating institution). This gold-backed SDR would be quite different from the paper SDR, but the implications for the dollar are the same. Any movement toward gold dollars or gold SDRs will be inflationary because gold will have to be revalued sharply higher in order to support world trade and finance with existing stocks of gold. As with the paper-SDR scenario, inflation resulting from the devaluation of the dollar against gold will wipe out savings of all kinds.

Social disorder is the third possible path. Social disorder involves riots, strikes, sabotage, and other dysfunctions. It is distinct from social protest because disorder involves illegality, violence, and property destruction. The disorder could be a reaction to extreme hyperinflation, which would widely and properly be seen as state-sanctioned theft. Social disorder could be a reaction to extreme deflation likely to be accompanied by bankruptcies, unemployment, and slashes in social welfare payments. Disorder could also arise in the aftermath of financial warfare or systemic collapse, when citizens realize their wealth has disappeared into a fog of hacking, manipulation, bail-ins, and confiscation.

Social disorder is impossible to predict because it is an emergent property of a complex system. Social disorder arises spontaneously from the most complex system of all—society—a system larger and more complex than the financial and digital components within it. The money riots will take the authorities by surprise. Once societal disintegration begins, it will be difficult to arrest.

If social disintegration is not predictable, the official response is. It will take the form of neofascism, the substitution of state power for liberty. This process is already well advanced in fairly calm times and will accelerate when violence erupts. As author Radley Balko has documented in Rise of the Warrior Cop, the state is well armed with SWAT teams, drones, armored personnel carriers, digital surveillance, tear gas, flash-bang grenades, and high-tech battering rams. Citizens will belatedly discover that every E-ZPass tollbooth in America can rapidly be converted into an interdiction point and that every traffic camera does double duty as a license plate scanner. The 2013 IRS and NSA scandals show how quickly trusted government agencies could be subverted for illegal surveillance and selective politically motivated oppression.

Republicans and Democrats are equally complicit in the rise of neofascism. Author Jonah Goldberg has documented fascism’s history and shown that its origins in the early twentieth century were socialist in nature. Fascism’s original exponent, Benito Mussolini, was regarded in his own time as a man of the left. Today the distinction between Left and Right as the face of fascism is less important than the distinction between those who favor state power and those who support liberty. Former New York City mayor Michael Bloomberg is a case in point. At various times he has been a Republican, a Democrat, and an independent. Throughout his tenure he exhibited what might be called the “friendly fascist” temperament. His attempted ban on large sweetened sodas in New York City was a typical state-power exercise at the expense of liberty, albeit much ridiculed. More ominous was his remark “I have my own army in the NYPD—the seventh largest army in the world.”

The use of neofascist tactics to suppress political money riots would require no new legislation. The statutory authority has existed since the Trading with the Enemy Act of 1917, which was expanded and updated by the International Emergency Economic Powers Act (IEEPA) of 1977. President Franklin Roosevelt used the Trading with the Enemy Act to confiscate gold from American citizens in 1933. He did not specify who the “enemy” was; presumably it was those who owned gold. Every president since Jimmy Carter has used IEEPA to freeze and seize assets in U.S. banks. In more dire future circumstances, gold could be confiscated, bank accounts frozen, capital controls imposed, and exchanges closed. Wage and price controls could be used to suppress inflation, and modern digital surveillance could be used to disrupt black markets and incarcerate black marketeers. The money riots would be squashed quickly.

In the ontology of state power, order comes before liberty or justice.

■ Seven Signs

Investors must be alert for the indications and warnings of which path the economy is traversing. There are seven critical signs.

The first sign is the price of gold. Although the price of gold is manipulated by central banks, any disorderly price movements are a signal that the manipulation scheme is disintegrating, despite efforts at leasing, unallocated sales, and futures sales. A rapid price rise from the $1,500-per-ounce level to the $2,500-per-ounce level will not be a bubble but rather a sign that a physical buying panic has commenced and that official shorting operations are not producing the desired dampening effect. Conversely, if gold moves to the $800-per-ounce level or lower, this is a good sign of severe deflation, potentially devastating to leveraged investors in all asset classes.

Gold’s continued acquisition by central banks. Purchases by China in particular are a second sign of the dollar’s demise. The announcement by China in late 2014 or early 2015 that it has acquired over 4,000 tonnes of gold will be a landmark in this larger trend and a harbinger of inflation.

IMF governance reforms. This third sign will mean larger voting power for China, and U.S. legislation to convert committed U.S. lines of credit into so-called quotas at the IMF. Any changes in the SDR currency-basket composition that reduce the dollar’s share will be a dollar inflation early warning. The same is true for concrete steps in the SDR infrastructure build-out. If global corporate giants such as Caterpillar and General Electric issue SDR-denominated bonds, which are acquired in portfolio by sovereign wealth funds or regional development banks, this will mark the acceleration of the baseline SDR-as-world-money plan.

The failure of regulatory reform. A fourth sign will be bank lobbyists’ defeat of efforts by U.S. regulators and Congress to limit the size of big banks, reduce bank asset concentration, or curtail investment banking activities. Glass-Steagall’s repeal in 1999 was the original sin that led directly to the housing market collapse in 2007 and the Panic of 2008. Efforts are under way in Congress to reinstate Glass-Steagall’s main provisions. The bank lobbyists are mobilized to halt such reforms and also block derivatives regulation, higher capital requirements, and limits on banker bonuses. Bank lobbyists dominate Congress, and there is no reason to believe reform efforts will achieve more than superficial success. Absent reform, the scale and interconnectedness of bank positions will continue to grow from very high levels and at rates much faster than the real economy. The result will be another systemic and unanticipated failure, larger than the Fed’s capacity to contain it. The panic’s immediate impact will be highly deflationary as assets, including gold, are dumped wholesale to raise cash. This deflationary bout will be followed quickly by inflation, as the IMF pumps out SDRs to reliquefy the system.

System crashes. A fifth sign will be more frequent episodes like the May 6, 2010, flash crash in which the Dow Jones Index fell 1,000 points in minutes; the August 1, 2012, Knight Trading computer debacle, which wiped out Knight’s capital; and the August 22, 2013, closure of the NASDAQ Stock Market. From a systems analysis perspective, these events are best understood as emergent properties of complex systems. These debacles are not the direct result of banker greed, but they are the maligned ghost in the machine of high-speed, highly automated, high-volume trading. Such events should not be dismissed as anomalies; they should be expected. An increasing tempo to such events could indicate either that trading systems are going wobbly, moving to disequilibrium, or perhaps that Chinese or Iranian army units are perfecting their cyberassault capabilities through probes and feints. In time, a glitch will spin out of control and close markets. As with the systemic risk scenario, the result is likely to be immediate deflation due to asset sales, followed by inflation as the Fed and IMF fire brigades douse the flames with a flood of new money.

The end of QE and Abenomics. The sixth sign will be a sustained reduction in U.S. or Japanese asset purchases, giving deflation a second wind, suppressing asset prices and growth. This happened in the United States when QE1 and QE2 were ended, and again in 2012 when the Bank of Japan reneged on a promised easing. However, as asset purchases are curtailed, a new increase should be expected within a year as deflationary effects develop. This would be another iteration of the stop-go monetary policies pursued by the Fed since 2008 and by the Bank of Japan since 1998. Continual flirting with deflation makes inflation harder to achieve. A more likely scenario is that money printing will continue in both nations long after 2 percent inflation is achieved. At that point, the risks are all on the side of much higher inflation as the change in expectations becomes difficult to reverse, especially in the United States.

A Chinese collapse. The seventh sign will be financial disintegration in China as the wealth-management-product Ponzi scheme collapses. China’s degree of financial interconnectedness with the rest of the world is lower than that of the major U.S. and European banks, so a collapse in China would be mainly a local affair, in which the Communist Party will use reserves held by its sovereign wealth funds to assuage savers and recapitalize banks. However, the aftermath will include a resumption of Chinese efforts to cap or even devalue the yuan in foreign exchange markets to promote exports, create jobs, and restore wealth lost in the collapse. In the short run, this will prove deflationary as underpriced Chinese goods once again flood into global supply chains. In the longer run, Chinese deflation will be met with U.S. and Japanese inflation, as both countries print money to offset any appreciation in the yen or the dollar. At that point, the currency wars will be reignited, never really having gone away.

Not all of these seven signs may come to pass. The appearance of some signs may negate or delay others. They will not come in any particular order. When any one sign does appear, investors should be alert to the specific consequences described and the investment implications.

■ Five Investments

In the face of extreme inflation, extreme deflation, or a condition of social disorder, which investment portfolio is most likely to remain robust? The following assets have a proven ability to perform well in inflation and deflation and have stood the test of time in periods of social disorder from the Thirty Years’ War to the Third Reich.

Gold. An allocation to gold of 10 to 20 percent of investable assets has much to commend it. The allocation should take physical form as coins or bullion in order to avoid the early terminations and cash settlements that are likely to affect paper gold markets in the future. Secure logistics, easily accessed by the investor, should be considered, but bank storage should be avoided, because gold stored in banks will not be accessible when most needed. An allocation above 20 percent is not recommended because gold is highly volatile and subject to manipulation, and there are other investable assets that perform the same wealth-preservation functions. A useful way to think about gold’s insurance function is that a 500 percent return on 20 percent of a portfolio provides a 100 percent portfolio hedge. Gold does well in inflation, until interest rates are raised above inflation rates. In deflation, gold initially declines in nominal terms, although it may outperform other asset classes. If deflation persists, gold rises sharply as governments devalue paper currency to produce inflation by fiat. Gold offers high value for weight and is portable in the unfortunate event that social unrest requires flight.

Land. This investment includes undeveloped land in prime locations or land with agricultural potential, but it does not include land with structures. As with gold, land will perform well in an inflationary environment until nominal interest rates exceed inflation. Land’s nominal value may decline in deflation, but development costs decline more rapidly. This means that the land can be developed cheaply at the bottom of a deflationary phase and provide large returns in the inflation that is likely to follow. The Empire State Building and Rockefeller Center, both in New York City, were built during the Great Depression and benefited from low labor and material costs at the time. Both projects have proved excellent investments ever since.

Fine art. This includes museum-quality paintings and drawings but is not intended to include the broader range of collectibles such as automobiles, wine, or memorabilia. Fine art offers gold’s return profile in both inflation and deflation, without being subject to the manipulation that affects gold. Central banks are not concerned with disorderly price increases in the art market and do not intervene to stop them. Investors should focus on established artists, avoiding fads that may fall out of favor. Paintings are also portable and offer extremely high value for weight. A $10 million painting that weighs two pounds is worth $312,500 per ounce, over two hundred times gold’s value by weight, and will not set off metal detectors. High-quality art can be acquired for more modest sums than $10 million through pooled investment vehicles that offer superb returns, although such vehicles lack the liquidity and portability of outright art ownership.

Alternative funds. This includes hedge funds and private equity funds with specified strategies. Hedge fund strategies that are robust to inflation, deflation, and disorder include long-short equity, global macro, and hard-asset strategies that target natural resources, precious metals, water, or energy. Private equity strategies should likewise involve hard assets, energy, transportation, and natural resources. Funds relying on financial stocks, emerging markets, sovereign debt, and credit instruments carry undue risk on the paths that lie ahead. Hedge funds and private equity funds offer various degrees of liquidity, although certain funds may offer no liquidity for five to seven years. Manager selection is critical and is much easier said than done. On balance, these funds should find their place in a portfolio because the benefits of diversification and talented management outweigh the lack of liquidity.

Cash. This seems a surprising choice in a world threatened with runaway inflation and crashing currencies. But cash has a place, at least for the time being, because it is an excellent deflation hedge and has embedded optionality, which gives the holder an ability to pivot into other investments on a moment’s notice. A cash component in a portfolio also reduces overall portfolio volatility, the opposite of leverage. Investors searching for an ideal cash currency could consider the Singapore dollar, the Canadian dollar, the U.S. dollar, and the euro. Cash may not be the best investment after a calamity, but it can serve the investor well until the calamity emerges. The challenge, of course, is being attentive to the indications and warnings and making a timely transition to one of the alternatives already mentioned.

On the whole, a portfolio of 20 percent gold, 20 percent land, 10 percent fine art, 20 percent alternative funds, and 30 percent cash should offer an optimal combination of wealth preservation under conditions of inflation, deflation, and social unrest, while providing high risk-adjusted returns and reasonable liquidity. But no portfolio intended to achieve these goals works for the “buy-and-hold” investor. This portfolio must be actively managed. As indications and warnings become more pronounced, and as greater visibility is offered on certain outcomes, the portfolio must be modified in sensible ways. If gold reaches $9,000 per ounce, there may then come a time to sell gold and acquire more land. If inflation emerges more rapidly than expected, it may make sense to convert cash to gold. A private equity fund that performs well for five years might be redeemed without reinvestment because conditions could be more perilous by then. Precise outcomes and portfolio performance cannot be known in advance, so constant attention to the seven signs and a certain flexibility in outlook are required.

Although the scenarios described in this book are dire, they are not necessarily tomorrow’s headlines. Much depends on governments and central banks, and those institutions have enormous staying power even while pursuing ultimately ruinous policies. The world has seen worse crises than financial collapse and lived to tell the tale. But when the crash comes, it will be better to be among those who have braced for the storm. We are not helpless; we can begin now to prepare to weather the inevitable outcome of the hubris of central banks.