The Death of Money (9 page)

In these financial warfare scenarios, an attack could be so large that the NYSE would
be overwhelmed and have to close down entirely. The ensuing panic would produce hundreds
of billions of dollars in paper losses.

*  *  *

While thinkers in the national security community have expressed concerns about financial
war, officials at the U.S. Treasury and Federal Reserve routinely pour cold water
on the threat analysis. Their rejoinder begins with estimates of the market impact
of financial war, then concludes that the Chinese or other major powers would never
engage in it because it would produce massive losses on their own
portfolios. This view reflects a dangerous official naïveté. The Treasury view supposes
that the purpose of financial war is financial gain. It is not.

The purpose of financial war is to degrade an enemy’s capabilities and subdue the
enemy while seeking geopolitical advantage in targeted areas. Making a portfolio profit
has nothing to do with a financial attack. If the attacker can bring an opponent to
a state of near collapse and paralysis through a financial catastrophe while advancing
on other fronts, then the financial war will be judged a success, even if the attacker
incurs large costs. All wars have costs, and many wars are so destructive that recovery
takes years or decades. This does not mean wars do not happen or that those initiating
them do not find advantage despite the costs.

Consider the following calculations. If China lost 25 percent on the value of its
reserves as the result of a financial war with the United States, the cost to China
would be about $750 billion. A fleet of twelve state-of-the art Ford-Class aircraft
carriers, comparable to the envisioned U.S. carrier force, would cost over $400 billion
to build and deploy once all construction, operating, overhaul, and other life-of-the-vessel
costs were taken into account. The costs of securing those aircraft carriers with
destroyers, submarines, and other support vessels, as well as the land-based systems
and staff needed to operate the fleet, raise the costs to a significantly higher level.
In short, the economic cost of confronting the United States in financial warfare
may not be higher than confronting it at sea and in the air, and the damage inflicted
may be even greater. China does not have a fleet of state-of-the-art aircraft carriers,
but it does have cash and computers, and it will choose its own battlespace.

China could protect its reserves against asset freezes or devaluation in the event
of a financial war by converting its paper wealth to gold—an option it is now pursuing
aggressively. Every gold bullion acquisition by China reduces its financial vulnerability
and tilts the trade-off between portfolio losses and armament costs in favor of financial
war. China’s possible intentions may be inferred from its status as the world’s largest
gold buyer.

The U.S. Treasury and Federal Reserve view also fails to account for intertemporal
effects. An attack that is costly in the short run can be quite profitable in the
long run. Whatever losses China might suffer on its
portfolio in a financial war could be quickly reversed during peace talks or in a
negotiated settlement. Seized accounts could be unfrozen, and market losses could
be turned into gains, once conditions normalized. Meanwhile China’s geopolitical gains
in areas like Taiwan or the East China Sea could be permanent, and it is the U.S.
economy that might suffer most in such a contest and take years to recover.

Treasury and Fed officials dismiss concerns about financial war due to their misapprehension
of the statistical properties of risk and their reliance on erroneous equilibrium
models. These models assume efficient markets and rational behavior that have no correspondence
to real markets. As applied to financial warfare, their view is that enemy attacks
on particular stocks or markets will prove self-defeating because rational investors
will jump in to buy bargains once the selling pressure begins. Such behavior exists
only in relatively calm, unperturbed markets, but in actual panic situations, selling
pressure feeds on itself, and buyers are nowhere to be found. A major panic will spread
exponentially and lead to total collapse absent an act of force majeure by government.

This panic dynamic has actually commenced twice in the past sixteen years. In September
1998 global capital markets were hours away from total collapse before the completion
of a $4 billion, all-cash
bailout of the hedge fund Long-Term Capital Management, orchestrated by the Federal
Reserve Bank of New York. In October 2008 global capital markets were days away from
the sequential collapse of most major banks when Congress enacted the TARP bailout,
while the Fed and Treasury intervened to guarantee money-market funds, prop up AIG,
and provide trillions of dollars in market liquidity. In neither panic did the Fed’s
imaginary bargain hunters show up to save the day.

In short, the Treasury and Fed view of financial warfare exhibits what intelligence
analysts call
mirror imaging
. They assume that since the United States would not launch a financial attack on
China, China would not launch an attack on the United States. Far from preventing
war, such myopia is a principal cause of war because it fails to comprehend the enemy’s
intentions and capabilities. Where financial warfare is concerned, markets are too
important to be left to the Treasury and the Fed.

Nor is it necessary to launch a financial war in order for financial warfare capability
to be an effective policy instrument. It is only
necessary that the threat be credible. A scenario can arise where the U.S. president
stands down from military action to defend Taiwan because China has made it clear
than any such action would result in the destruction of a trillion dollars or more
in U.S. paper wealth. In this scenario, Taiwan is left to its fate. Andy Marshall’s
Air-Sea Battle is deterred by China’s weapons of wealth destruction.

Perhaps the greatest financial threat is that these scenarios might play out by accident.
In the mid-1960s, at the height of Cold War hysteria about nuclear attacks and Mutual
Assured Destruction, two films,
Fail-Safe
and
Dr. Strangelove
, dealt with nuclear-war-fighting scenarios between the United States and the Soviet
Union. As portrayed in these films, neither side wanted war, but it was launched nonetheless
due to computer glitches and actions of rogue officers.

Capital markets today are anything but fail-safe. In fact, they are increasingly failure-prone,
as the Knight Capital incident and the curious May 6, 2010, flash crash demonstrate.
A financial attack may be launched by accident during a routine software upgrade or
drill. Capital markets almost collapsed in 1998 and 2008 without help from malicious
actors, and the risk of a similar collapse in coming years, accidental or malicious,
is distressingly high.

In 2011 the
National Journal
published an article called “The Day After” that described in detail
the highly classified plans for continuity of U.S. government operations in the face
of invasion, infrastructure collapse, or extreme natural disaster. These plans include
landing a helicopter squadron on the Washington Mall, near the Capitol, to swoop up
the congressional leadership for evacuation to an emergency operations center called
Mount Weather in Virginia. Defense Department officials would then be moved to a hardened
bunker deep inside Raven Rock Mountain on the Maryland-Pennsylvania border, not far
from Camp David.

Much of Marc Ambinder’s reporting involves the chain of command and what happens if
certain officials, possibly including the president, are dead or missing. He points
out that these contingency plans
failed
both during the attempted assassination of President Reagan in 1981 and again on
9/11. Recent years have seen improvement in secure communications, but serious ambiguity
can still arise in the chain of command, and Ambinder says more failures can be expected
in another national crisis.

However, a financial war would present a different kind of crisis, with little or
no physical damage. No officials should be dead or missing, and the chain of command
should remain intact. Absent collateral infrastructure attacks, communications would
flow normally.

Yet the nation would be traumatized just as surely as if an earthquake had leveled
a major city, because trillions of dollars of wealth would be lost. Banks and exchanges
would close their doors and liquidity in markets would evaporate. Trust would be gone.
The Federal Reserve, having used up its dry powder printing over $3 trillion of new
money since 2008, would have no capacity or credibility to do more. Social unrest
and riots would soon follow.

Andy Marshall and other futurists in the national security community are taking such
threats seriously. They receive little or no support from the Treasury or Federal
Reserve; both are captive to mirror imaging.

Ironically, solutions are not hard to devise. These solutions involve breaking big
banks into units that are not too big to fail; returning to a system of regional stock
exchanges, to provide redundancy; and reintroducing gold into the monetary system,
since gold cannot be wiped out in a digital flash. The first-order costs of these
changes are more than compensated by increased robustness and second-order benefits.
None of these remedial steps is under serious consideration by Congress or the White
House. For now, the United States is only dimly aware of the threat and nowhere near
a solution.

MONEY AND MARKETS

THE RUIN OF MARKETS

The man of system . . . seems to imagine that he can arrange the different members
of a great society with as much ease as the hand arranges the different pieces upon
a chess-board. He does not consider that in the great chess-board of human society,
every single piece has a principle of motion of its own.

Adam Smith

The Theory of Moral Sentiments

1759

The “data” from which the economic calculus starts are never for the whole society
“given” to a single mind which could work out the implications and can never be so
given.

Friedrich A. Hayek

1945

Any . . . statistical regularity will tend to collapse once pressure is placed on
it for control purposes.

Goodhart’s Law

1975

In Shakespeare’s
The Merchant of Venice,
Salanio asks, “Now, what news on the Rialto?” He’s looking for information, gathering
intelligence, and attempting to identify what’s happening in the marketplace. Salanio
doesn’t intend to control the business unfolding around him; he knows he cannot. He
looks to understand the flow of news, to find his place in the market.

Janet Yellen and the Federal Reserve would do well to be as humble.

The word
market
invokes images of everything from prehistoric trade goods to medieval town fairs
to postmodern digital exchanges with nanosecond-speed bids and offers converging in
a computational cloud. In essence,
markets are places where buyers and sellers meet
to conduct the sale of goods and services. In the world today,
place
may be an abstracted location, a digital venue; a
meeting
may amount to nothing more than a fleeting connection. But at their core, markets
are unchanged since traders swapped amber for ebony on the shores of the Mediterranean
during the Bronze Age.

Still, markets—whether for tangible commodities like gold or for intangibles such
as stocks—have always been about deeper processes than the mere exchange of goods
and services. Fundamentally, they are about
information exchange
concerning the price of goods and services. Prices are portable. Once a merchant or
trader ascertains a market price, others can use that information to expand or contract
output, hire or fire workers, or move to another marketplace with an informational
advantage in tow.

Information can have greater value than the underlying transactions from which the
information is derived; the multibillion-dollar Bloomberg fortune is based on this
insight. How should a venture capitalist price a stake in an enterprise creating an
entirely new product? Neither the investor nor the entrepreneur really knows. But
information about past outcomes, whether occasional huge gains or frequent failures,
gives guidance to the parties and allows an investment to go forward. Information
about sales and investment returns is the lubricant and the fuel that allows more
sales and investments to take place. An exchange of goods and services may be the
result of market activity, but price discovery is the market function that allows
an exchange to occur in the first place.

Anyone who has ever walked away from a carpet dealer in a Middle Eastern bazaar, only
to be chased down by the dealer yelling, “Mister, mister, I have a better price, very
cheap,” knows the charms of price discovery. This dynamic is no different than the
digitized, automated, high-frequency trading that takes place in servers adjacent
to exchange trading platforms in New York and Chicago. The computer is offering the
nanosecond version of “Mister, I have a better price.” Price discovery is still the
primary market function.

But markets are home to more than just buyers and sellers, speculators and arbitrageurs.
Global markets today seem irresistible to central bankers with plans for better times.
Planning is the central bankers’ baleful vanity since, for them, markets are a test
tube in which to try out their interventionist theories.

Central bankers control the price of money and therefore indirectly influence every
market in the world. Given this immense power, the ideal central banker would be humble,
cautious, and deferential to market signals. Instead, modern central bankers are both
bold and arrogant in their efforts to bend markets to their will. Top-down central
planning, dictating resource allocation and industrial output based on supposedly
superior knowledge of needs and wants, is an impulse that has infected political players
throughout history. It is both ironic and tragic that Western central banks have embraced
central planning with gusto in the early twenty-first century, not long after the
Soviet Union and Communist China abandoned it in the late twentieth. The Soviet Union
and Communist China engaged in extreme central planning over the world’s two largest
countries and one-third of the earth’s population for more than one hundred years
combined. The result was a conspicuous and dismal failure. Today’s central planners,
especially the Federal Reserve, will encounter the same failure in time. The open
issues are, when and at what cost to society?

The impulse toward central planning often springs from the perceived need to solve
a problem with a top-down solution. For Russian Communists in 1917, it was the problem
of the czar and a feudal society. For Chinese Communists in 1949, it was local corruption
and foreign imperialism. For the central planners at central banks today, the problem
is deflation and low nominal growth. The problems are real, but the top-down solutions
are illusory, the product of hubris and false ideologies.

In the twentieth century, Russians and Chinese adhered to Marxist ideology and the
arrogance of the gun. Today central bankers embrace Keynesianism and the arrogance
of the Ph.D. Neither Marxist nor Keynesian ideology allows individuals the degrees
of freedom necessary to discover those solutions that emerge spontaneously from the
fog of complexity characteristic of an advanced economy. Instead, individuals, sensing
manipulation and control from central banks, either restrain their
economic activity or pursue entirely new, smaller enterprises removed from the sights
of central bank market manipulation.

Market participants have been left with speculation, churning, and a game of trying
to outthink the thinkers in the boardroom at the Federal Reserve. Lately, so-called
markets have become a venue for trading ahead of the next Fed policy announcement,
or piggybacking on its stubborn implementation. Since 2008, markets have become a
venue for wealth extraction rather than wealth creation. Markets no longer perform
true market functions. In markets today, the dead hands of the academic and the rentier
have replaced the invisible hand of the merchant or the entrepreneur.

This critique is not new; it is as old as free markets themselves. Adam Smith, in
The Theory of Moral Sentiments,
a philosophical work from 1759, the dawn of the modern capitalist system, makes the
point that no planner can direct a system of arrayed components that are also systems
with unique properties beyond the planner’s purview. This might be called the Matryoshka
Theory, named for the Russian dolls nested one inside the other and invisible from
the outside. Only when the first doll is opened is the next unique doll revealed,
and so on through a succession of dolls. The difference is that
matryoshka
dolls are finite, whereas variety in a modern economy is infinite, interactive, and
beyond comprehension.

Friedrich Hayek, in his classic 1945 essay “The Use of Knowledge in Society,” written
almost two hundred years after Adam Smith’s work, makes the same argument but with
a shift in emphasis. Whereas Smith focused on individuals, Hayek focused on information.
This was a reflection of Hayek’s perspective on the threshold of the computer age,
when models based on systems of equations were beginning to dominate economic science.
Of course, Hayek was a champion of individual liberty. He understood that the information
he wrote about would ultimately be created at the level of individual autonomous actors
within a complex economic system. His point was that no individual, committee, or
computer program would ever have all the information needed to construct an economic
order, even if a model of such order could be devised. Hayek wrote:

The peculiar character of the problem of a rational economic order is determined precisely
by the fact that the knowledge of the
circumstances of which we must make use never exists in concentrated or integrated
form but solely as the dispersed bits of incomplete and frequently contradictory knowledge
which all the separate individuals possess. . . . Or, to put it briefly, it is a problem
of the utilization of knowledge which is not given to anyone in its totality.

Charles Goodhart first articulated Goodhart’s Law in a 1975 paper published by the
Reserve Bank of Australia. Goodhart’s Law is frequently paraphrased along the lines,
“When a financial indicator becomes the object of policy, it ceases to function as
an indicator.” That paraphrase captures the essence of Goodhart’s Law, but the original
formulation was even more incisive because it included the phrase “for control purposes.”
(In original form, it reads, “Any observed statistical regularity will tend to collapse
once pressure is placed upon it for control purposes.”) This phrase emphasized the
point that Goodhart was concerned not only with market intervention or manipulation
generally but also on a particular kind of top-down effort by central banks to dictate
outcomes in complex systems.

Adam Smith, Friedrich Hayek, and Charles Goodhart all concluded that central planning
is not merely undesirable or suboptimal; it is
impossible
. This conclusion aligns with the more recent theory of computational complexity.
This theory classifies computational challenges by their degree of difficulty as measured
by the data, computing steps, and processing power needed to solve a given problem
set. The theory has rules for assigning such classifications, including those problems
that are regarded as impossible to compute because, variously, the data are too voluminous,
the processing steps are infinite, all the computational power in the world is insufficient,
or all three. Smith, Hayek, and Goodhart all make the point that the variety and adaptability
of human action in the economic sphere are a quintessential case of computational
complexity that exceeds the capacity of man or machine to optimize. This means not
that economic systems cannot approach optimality but that optimality
emerges
from economic complexity spontaneously rather than being
imposed
by central banks through policy. Today central banks, especially the U.S. Federal
Reserve, are repeating the blunders of Lenin, Stalin, and Mao without the violence,
although the violence may come yet through income inequality, social unrest, and a
confrontation with state power.

While the Adam Smith and Friedrich Hayek formulations of the economic complexity problem
are well known, Charles Goodhart added a chilling coda. What happens when data used
by central bankers to set policy is itself the result of prior policy manipulation?

■
The Wealth Effect

Measures of inflation, unemployment, income, and other indicators are carefully monitored
by central bankers as a basis on which to make policy decisions. Declining unemployment
and rising inflation may signal a need to tighten monetary policy, just as falling
asset prices may signal a need to provide more monetary ease. Policy makers respond
to economic distress by pursuing polices designed to improve the data. After a while,
the data themselves may come to reflect not fundamental economic reality but a cosmetically
induced policy result. If these data then guide the next dose of policy, the central
banker has entered a wilderness of mirrors in which false signals induce policy, which
induces more false signals and more policy manipulation and so on, in a feedback loop
that diverges further from reality until it crashes against a steel wall of data that
cannot easily be manipulated, such as real income and output.

A case in point is the so-called wealth effect. The idea is straightforward. Two asset
classes—stocks and housing—represent most of the wealth of the American people. The
wealth represented by stocks is highly visible; Americans receive their 401(k) account
statements monthly, and they can check particular stock prices in real time if they
so choose. Housing prices are less transparent, but anecdotal evidence gathered from
real estate listings and water-cooler chatter is sufficient for Americans to have
a sense of their home values. Advocates of the wealth effect say that when stocks
and home prices are going up, Americans feel richer and more prosperous and are willing
to save less and spend more.

The wealth effect is one pillar supporting the Fed’s zero-interest-rate policy and
profligate money printing since 2008. The transmission channels are easy to follow.
If rates are low, more Americans can afford mortgages, which increases home buying,
resulting in higher prices for homes.
Similarly, with low rates, brokers offer cheap margin loans to clients, which result
in more stock buying and higher stock prices.

There are also important substitution effects. All investors like to receive a healthy
return on their savings and investments. If bank accounts are paying close to zero,
Americans will redirect those funds to stocks and housing in search of higher returns,
which feeds on itself, resulting in higher prices for stocks and housing. At a superficial
level, the zero-interest-rate and easy-money policies have produced the intended outcomes.
Stock prices more than doubled from 2009 to 2014, and housing prices began rebounding
sharply in mid-2012. After four years of trying to manipulate asset prices, the Fed
appeared to have succeeded by 2014. The wealth was being created, at least on paper,
but to what effect?