The Death of Money (38 page)

The potentially destabilizing factor is that the amount of gold subject
to paper contracts is one hundred times the amount of physical gold backing those
contracts. As long as holders remain in paper contracts, the system is in equilibrium.
If holders in large numbers were to demand physical delivery, they could be snowflakes
on an unstable mountain of paper gold. When other holders realize that the physical
gold will run out before they can redeem their contracts for bullion, the slide can
cascade into an avalanche, a de facto bank run, except the banks in this case are
the gold warehouses that support the exchanges and ETFs. This is what happened in
1969 as European trading partners of the United States began cashing in dollars for
physical gold. President Nixon shut the window on these redemptions in August 1971.
If he had not done so, the U.S. gold vaults at Fort Knox would have been stripped
bare by the late 1970s.

A similar dynamic commenced on October 4, 2012, when spot gold prices hit an interim
peak of $1,790 per ounce. From there, gold fell over 12 percent in the next six months.
Then gold crashed an additional 23.5 percent, falling to $1,200 per ounce by late
June. Far from scaring off buyers, the gold crash made gold look cheap to millions
of individual buyers around the world. They lined up at banks and boutiques, quickly
stripping supplies. Buyers of standard 400-ounce and 1-kilo bars found there were
no sellers; they had to wait almost thirty days for new bars to be produced by the
refineries. The Swiss refineries Argor-Heraeus and Pamp moved to around-the-clock
shifts to keep up with gold demand. Massive redemptions took place in gold ETFs, not
because all investors were bearish on gold but because some wanted to obtain bullion
from the ETF warehouses. COMEX warehouses holding gold for futures contract settlements
saw inventories drawn down to levels last seen in the Panic of 2008. Gold futures
contracts went into
backwardation,
a highly unusual condition in which gold for spot delivery is more expensive than
gold for forward delivery; the opposite usually prevails because the forward seller
has to pay for storage and insurance. This was another sign of acute physical shortages
and high demand for immediate access to physical gold.

If a gold-buying panic were to break out today, there is no single gold window for
the president to close. Instead, a multitude of contractual clauses, in fine print
rarely studied by gold buyers, would be called into play. Gold futures exchanges have
the ability to convert contracts to cash
liquidation only and to shut off the physical delivery channels. Gold bullion banks
can also settle gold forward contracts for cash and deny buyers the ability to convert
to allocated gold. The “early termination” and force majeure clauses buried in contracts
could be used by banks that sold more gold than they had on hand. The result would
be that investors would receive a cash settlement up to the contract termination date,
but not more. Investors would get some cash but no bullion and would miss the price
surge sure to follow.

While physical gold was in short supply and high demand by early 2014, this did not
necessarily mean that a superspike in gold prices was imminent. Not every snowslide
turns into an avalanche; at times the avalanche awaits different initial conditions.
Central banks still have enormous resources, including potential physical sales with
which to suppress gold prices in the short run. Still, an alarm has gone off. The
central banks’ ability to keep a lid on gold prices has been challenged, and a new
willingness of paper gold buyers to demand physical gold has emerged. As China’s gold-buying
operations continue apace, the entire international monetary system is tottering on
the knife-edge of China’s aspirations and the global demand for physical gold.

While the gold price oscillates between the forces of physical demand and central
bank manipulation, another greater catastrophe is looming: the Federal Reserve is
on the brink of insolvency, if not already over the brink. This conclusion comes not
from a Fed critic but from Frederic S. Mishkin, one of the most eminent monetary economists
in the world and mentor to Ben Bernanke and other Fed governors and economists. In
his February 2013 paper “Crunch Time: Fiscal Crises and the Role of Monetary Policy,”
written with several colleagues,
Mishkin warns that the Fed is dangerously close to the point where its independence
is fatally compromised and its sole remaining purpose is to monetize deficit spending
by causing inflation.

Mishkin and his coauthors make better use of complexity theory and recursive functions
in their analysis than any of their peers. They point out the feedback loop in sovereign
finance among larger deficits, followed by higher borrowing costs, which cause even
larger deficits and still higher borrowing costs, and so on, until a death spiral
begins. At that point, countries are faced with the unpalatable choice of either reducing
deficits through so-called austerity measures or defaulting on the debts. Mishkin
argues that austerity can hurt nominal growth, worsening the debt-to-GDP ratio, and
possibly causing a debt default in the course of trying to stop one.

The alternative, in Mishkin’s view, is for a central bank to keep interest rates under
control by engaging in monetary ease, while politicians enact long-term deficit solutions.
In the meantime, short-term deficits can be tolerated to avoid the austerity curse.
Short-term monetary and fiscal ease work in tandem to keep an economy growing, while
long-term fiscal reform reverses the death spiral.

Mishkin says this approach works fine in theory, but he brings us back to the real
world of dysfunctional political systems that have come to rely on monetary ease to
avoid hard choices on the fiscal side. Mishkin calls this condition “fiscal dominance.”
His paper describes the resulting crisis:

In the extreme, unsustainable fiscal policy means that the government’s intertemporal
budget constraint will have to be satisfied by issuing monetary liabilities, which
is known as
fiscal dominance,
or, alternatively, by a default on the government debt. Fiscal dominance forces the
central bank to pursue inflationary monetary policy even if it has a strong commitment
to control inflation, say with an inflation target. . . . Fiscal dominance at some
point in the future forces the central bank to monetize the debt, so that despite
tight monetary policy in the present, inflation will increase. . . .

Ultimately, the central bank is without power to avoid the consequences of an unsustainable
fiscal policy. . . . If the central bank is paying for its open-market purchases of
long-term government debt with newly created reserves, . . . then ultimately all the
open-market purchase does is exchange long-term government debt (in the form of the
initial Treasury debt) for overnight government debt (in the form of interest-bearing
reserves). It is well understood . . . that any swap of long-term for short-term debt
in fact makes the government more vulnerable to . . . a self-fulfilling flight from
government debt, or in the case of the U.S., to a self-fulfilling flight from the
dollar. . . .

Fiscal dominance puts a central bank between a rock and a hard place. If the central
bank does not monetize the debt, then interest rates on the government debt will rise
sharply. . . . Hence, the central bank will in effect have little choice and will
be forced to purchase the government debt and monetize it, eventually leading to a
surge in inflation.

Mishkin and his coauthors point to another collapse in the making, independent of
debt monetization and inflation. As the Fed buys longer-term debt with newly printed
money, its balance sheet incurs large mark-to-market losses as interest rates rise.
The Fed does not disclose these losses until it actually sells the bonds as part of
an exit strategy, although independent analysts can estimate the size of the losses
from information that is publicly available.

Monetization of debt leaves the Fed with a Hobson’s choice. If the United States tips
into deflation, the debt-to-GDP ratio will worsen because there is insufficient nominal
growth. If the United States tips into inflation, the debt-to-GDP ratio will worsen
due to higher interest rates on U.S. debt. If the Fed fights inflation by selling
assets, it will recognize losses on the bond sales, and its insolvency will become
apparent. This insolvency can erode confidence and cause higher interest rates on
its own. Fed bond losses will also worsen the debt-to-GDP ratio since the Fed can
no longer remit profits to the Treasury, which increases the deficit. There appears
to be no way out of a sovereign debt crisis for the United States; the paths are all
blocked. The Fed avoided a measure of pain in 2009 with its monetary exertions and
market manipulations, but the pain was stored up for another day. That day is here.

Global monetary elites and the Fed, the IMF, and the BIS are playing for time. They
need time for the United States to achieve long-term fiscal reform. They need time
to create the global SDR market. They need time to facilitate China’s acquisition
of gold. The problem is that no time remains. A run on gold has begun before China
has what it needs. The collapse of confidence in the dollar has begun before the SDR
is ready to take its place. The Fed’s insolvency is looming. As the dollar’s 9/11
moment approaches, the system is blinking red.

CONCLUSION

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:

The piecemeal engineer will, accordingly, adopt the method . . . whose advocacy may
easily become a means of continually postponing action until a later date, when conditions
are more favourable. . . .

Blueprints for piecemeal engineering are comparatively simple. They are blueprints
for single institutions. . . .

I do not suggest that piecemeal engineering cannot be bold, or that it must be confined
to “smallish” problems.

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.”