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Friday, November 25, 2011

Reading List: Currency Wars

Rickards, James. Currency Wars. New York: Portfolio / Penguin, 2011. ISBN 978-1-59184-449-5.
Debasement of currency dates from antiquity (and doubtless from prehistory—if your daughter's dowry was one cow and three goats, do you think you'd choose them from the best in your herd?), but currency war in the modern sense first emerged in the 20th century in the aftermath of World War I. When global commerce—the first era of globalisation—became established in the 19th century, most of the trading partners were either on the gold standard or settled their accounts in a currency freely convertible to gold, with the British pound dominating as the unit of account in international trade. A letter of credit financing a shipload of goods exported from Argentina to Italy could be written by a bank in London and traded by an investor in New York without any currency risk during the voyage because all parties denominated the transaction in pounds sterling, which the Bank of England would exchange for gold on demand. This system of global money was not designed by “experts” nor managed by “maestros”—it evolved organically and adapted itself to the needs of its users in the marketplace.

All of this was destroyed by World War I. As described here, and in more detail in Lords of Finance (August 2011), in the aftermath of the war all of the European powers on both sides had expended their gold and foreign exchange reserves in the war effort, and the United States had amassed a large fraction of all of the gold in the world in its vaults and was creditor in chief to the allies to whom, in turn, Germany owed enormous reparation payments for generations to come. This set the stage for what the author calls Currency War I, from 1921 through 1936, in which central bankers attempted to sort out the consequences of the war, often making disastrous though well-intentioned decisions which, arguably, contributed to a decade of pre-depression malaise in Britain, the U.S. stock market bubble and 1929 crash, the Weimar Germany hyperinflation, and its aftermath which contributed to the rise of Hitler.

At the end of World War II, the United States was in an even more commanding position than at the conclusion of the first war. With Europe devastated, it sat on an even more imposing hoard of gold, and when it convened the Bretton Woods conference in 1944, with the war still underway, despite the conference's list of attendees hailing from 44 allied nations, it was clear that the Golden Rule applied: he who has the gold makes the rules. Well, the U.S. had the gold, and the system adopted at the conference made the U.S. dollar central to the postwar monetary system. The dollar was fixed to gold at the rate of US$35/troy ounce, with the U.S. Treasury committed to exchanging dollars for gold at that rate in unlimited quantities. All other currencies were fixed to the dollar, and hence indirectly to gold, so that except in the extraordinary circumstance of a revaluation against the dollar, exchange rate risk would not exist. While the Bretton Woods system was more complex than the pre-World War I gold standard (in particular, it allowed central banks to hold reserves in other paper currencies in addition to gold), it tried to achieve the same stability in exchange rates as the pure gold standard.

Amazingly, this system, the brainchild of Soviet agent Harry Dexter White and economic charlatan John Maynard Keynes, worked surprisingly well until the late 1960s, when profligate deficit spending by the U.S. government began to cause foreign holders of an ever-increasing pile of dollars to trade them in for the yellow metal. This was the opening shot in what the author deems Currency War II, which ran from 1967 through 1987, ending in the adoption of the present system of floating exchange rates among currencies backed by nothing whatsoever.

The author believes we are now in the initial phase of Currency War III, in which a perfect storm of unsustainable sovereign debt, economic contraction, demographic pressure on social insurance schemes, and trade imbalances creates the preconditions for the kind of “beggar thy neighbour” competitive devaluations which characterised Currency War I. This is, in effect, a race to the bottom with each unanchored paper currency trying to become cheaper against the others to achieve a transitory export advantage. But, of course, as a moment's reflection will make evident, with currencies decoupled from any tangible asset, the only limit in a race to the bottom is zero, and in a world where trillions of monetary units can be created by the click of a mouse without even the need to crank up the printing press, this funny money is, in the words of Gerald Celente, “not worth the paper it isn't printed on”.

In financial crises, there is a progression from:

  1. Currency war
  2. Trade war
  3. Shooting war

Currency War I led to all three phases. Currency War II was arrested at the “trade war” step, although had the Carter administration and Paul Volcker not administered the bitter medicine to the U.S. economy to extirpate inflation, it's entirely possible a resource war to seize oil fields might have ensued. Now we're in Currency War III (this is the author's view, with which I agree): where will it go from here? Well, nobody knows, and the author is the first to acknowledge that the best a forecaster can do is to sketch a number of plausible scenarios which might play out depending upon precipitating events and the actions of decision makers in time of crisis. Chapter 11 (how appropriate!) describes the four scenarios Rickards sees as probable outcomes and what they would mean for investors and companies engaged in international trade. Some of these may be breathtaking, if not heart-stopping, but as the author points out, all of them are grounded in precedents which have already occurred in the last century.

The book begins with a chilling wargame in which the author participated. Strategic planners often remain stuck counting ships, troops, and tanks, and forget that all of these military assets are worthless without the funds to keep them operating, and that these assets are increasingly integrated into a world financial system whose complexity (and hence systemic risk, either to an accidental excursion or a deliberate disruption) is greater than ever before. Analyses of the stability of global finance often assume players are rational and therefore would not act in a way which was ultimately damaging to their own self interest. This is ominously reminiscent of those who, as late as the spring of 1914, forecast that a general conflict in Europe was unthinkable because it would be the ruin of all of the combatants. Indeed, it was, and yet still it happened.

The Kindle edition has the table of contents and notes properly linked, but the index is just a list of unlinked terms.

Posted at November 25, 2011 23:18