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Thursday, June 26, 2014

Reading List: The Death of Money

Rickards, James. The Death of Money. New York: Portfolio / Penguin, 2014. ISBN 978-1-59184-670-3.
In his 2011 book Currency Wars (November 2011), the author discusses what he sees as an inevitable conflict among fiat currencies for dominance in international trade as the dollar, debased as a result of profligate spending and assumption of debt by the government that issues it, is displaced as the world's preeminent trading and reserve currency. With all currencies backed by nothing more than promises made by those who issue them, the stage is set for a race to the bottom: one government weakens its currency to obtain short-term advantage in international trade, only to have its competitors devalue, setting off a chain of competitive devaluations which disrupt trade, cause investment to be deferred due to uncertainty, and destroy the savings of those holding the currencies in question. In 2011, Rickards wrote that it was still possible to avert an era of currency war, although that was not the way to bet. In this volume, three years later, he surveys the scene and concludes that we are now in the early stages of a collapse of the global monetary system, which will be replaced by something very different from the status quo, but whose details we cannot, at this time, confidently predict. Investors and companies involved in international commerce need to understand what is happening and take steps to protect themselves in the era of turbulence which is ahead.

We often speak of “globalisation” as if it were something new, emerging only in recent years, but in fact it is an ongoing trend which dates from the age of wooden ships and sail. Once ocean commerce became practical in the 18th century, comparative advantage caused production and processing of goods to be concentrated in locations where they could be done most efficiently, linked by the sea lanes. This commerce was enormously facilitated by a global currency—if trading partners all used their own currencies, a plantation owner in the West Indies shipping sugar to Great Britain might see his profit wiped out if the exchange rate between his currency and the British pound changed by the time the ship arrived and he was paid. From the dawn of global trade to the present there has been a global currency. Initially, it was the British pound, backed by gold in the vaults of the Bank of England. Even commerce between, say, Argentina and Italy, was usually denominated in pounds and cleared through banks in London. The impoverishment of Britain in World War I began a shift of the centre of financial power from London to New York, and after World War II the Bretton Woods conference established the U.S. dollar, backed by gold, as the world's reserve and trade currency. The world continued to have a global currency, but now it was issued in Washington, not London. (The communist bloc did not use dollars for trade within itself, but conducted its trade with nations outside the bloc in dollars.) In 1971, the U.S. suspended the convertibility of the dollar to gold, and ever since the dollar has been entirely a fiat currency, backed only by the confidence of those who hold it that they will be able to exchange it for goods in the future.

The international monetary system is now in a most unusual period. The dollar remains the nominal reserve and trade currency, but the fraction of reserves held and trade conducted in dollars continues to fall. All of the major currencies: the dollar, euro, yen, pound, yuan, rouble—are pure fiat currencies unbacked by any tangible asset, and valued only against one another in ever-shifting foreign exchange markets. Most of these currencies are issued by central banks of governments which have taken on vast amounts of debt which nobody in their right mind believes can ever be paid off, and is approaching levels at which even a modest rise in interest rates to historical mean levels would make the interest on the debt impossible to service. There is every reason for countries holding large reserves of dollars to be worried, but there isn't any other currency which looks substantially better as an alternative. The dollar is, essentially, the best horse in the glue factory.

The author argues that we are on the threshold of a collapse of the international monetary system, and that the outlines of what will replace it are not yet clear. The phrase “collapse of the international monetary system” sounds apocalyptic, but we're not talking about some kind of Mad Max societal cataclysm. As the author observes, the international monetary system collapsed three times in the last century: in 1914, 1939, and 1971, and life went on (albeit in the first two cases, with disastrous and sanguinary wars), and eventually the financial system was reconstructed. There were, in each case, winners and losers, and investors who failed to protect themselves against these turbulent changes paid dearly for their complacency.

In this book, the author surveys the evolving international financial scene. He comes to conclusions which may surprise observers from a variety of perspectives. He believes the Euro is here to stay, and that its advantages to Germany coupled with Germany's economic power will carry it through its current problems. Ultimately, the countries on the periphery will consider the Euro, whatever its costs to them in unemployment and austerity, better than the instability of their national currencies before joining the Eurozone. China is seen as the victim of its own success, with financial warlords skimming off the prosperity of its rapid growth, aided by an opaque and deeply corrupt political class. The developing world is increasingly forging bilateral agreements which bypass the dollar and trade in their own currencies.

What is an investor to do faced with such uncertainty? Well, that's far from clear. The one thing one shouldn't do is assume the present system will persist until you're ready to retire, and invest your retirement savings entirely on the assumption nothing will change. Fortunately, there are alternative investments (for example, gold and silver, farm land, fine art, funds investing in natural resources, and, yes, cash in a variety of currencies [to enable you to pick up bargains when other assets crater]) which will appreciate enormously when the monetary system collapses. You don't have to (and shouldn't) bet everything on a collapse: a relatively small hedge against it will protect you should it happen.

This is an extensively researched and deep investigation of the present state of the international monetary system. As the author notes, ever since all currencies were severed from gold in 1971 and began to float against one another, the complexity of the system has increased enormously. What were once fixed exchange rates, adjusted only when countries faced financial crisis, have been replaced by exchange rates which change in milliseconds, with a huge superstructure of futures, options, currency swaps, and other derivatives whose notional value dwarfs the actual currencies in circulation. This is an immensely fragile system which even a small perturbation can cause to collapse. Faced with a risk whose probability and consequences are impossible to quantify, the prudent investor takes steps to mitigate it. This book provides background for developing such a plan.

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