Status Report

In the same way that we have no choice but to appreciate our disruptive “Learning Opportunities,” the folks who’ve been abandoned by the economic malaise of the last seven years are, in a perverse way, getting a head start on the rest of us.  While on the surface the US scheme of flooding the World with dollars is appearing to finally yield some positive results, it’s best not to forget the bottom line – mostly because it could spring up and bite us in the butt at any moment.  Here’s a good summary…

“The prospect of a market collapse is a function of systemic risk independent of fundamental economic policy.  The risk of market collapse is amplified by regulatory incompetence and banker greed.  Complexity theory is the proper framework for analyzing this risk.

“The starting place in this analysis is the recognition that capital markets exhibit all four of complex systems’ defining qualities: diversity of agents, connectedness, interdependence, and adaptive behavior.  Concluding that capital markets are complex systems has profound implications for regulation and risk management.  The first implication is that the proper measurement of risk is the gross notional value of derivatives, not the net amount.  The gross size of all bank derivatives positions now exceeds $650 trillion, more than nine times global GDP.

“A second implication is that the greatest catastrophe that can occur in a complex system is an exponential, nonlinear function of systemic scale.  This means that as the system doubles or triples in scale, the risk of catastrophe is increasing by factors of 10 or 100.  This is also why stress tests based on historic episodes such as 9/11 or 2008 are of no value, since unprecedented systemic scale presents unprecedented systemic risk.

“The solutions to this systemic risk overhang are surprisingly straightforward.  The immediate tasks would be to break up large banks and ban most derivatives.  Large banks are not necessary to global finance.  When large financing  is required, a lead bank can organize a syndicate, as was routinely done in the past for massive infrastructure projects such as the Alaska pipeline, the original fleets of supertankers, and the first Boeing 747s.

“The benefit of breaking up banks would not be that bank failures would be eliminated but that bank failure would no longer be a threat.  The costs of failure would become containable and would not be permitted to metastasize so as to threaten the system.  The case for banning most derivatives is even more straightforward.  Derivatives serve practically no purpose except to enrich bankers through opaque pricing and to deceive investors through off-balance-sheet accounting.

“Whatever the merits of these strategies, the prospects for dissolving large banks or banning derivatives are nil.  This is because regulators use obsolete models or rely on the bankers’ own models, leaving them unable to perceive systemic risk.  Congress will not act because the members, by and large, are in thrall to bank political contributions.

“Banking and derivatives risk will continue to grow, and the next collapse will be of unprecedented scope because the system scale is unprecedented.  Since Federal Reserve resources were barely able to prevent complete collapse in 2008, it should be expected that an even larger collapse will overwhelm the Fed’s balance sheet.  Since the Fed has printed over $3 trillion in a time of relative calm, it will not be politically feasible to respond in the future by printing another $3 trillion.  The task of reliquefying the world will fall to the IMF, because the IMF will have the only clean balance sheet left among official institutions.  The IMF will rise to the occasion with a towering issuance of SDRs, and this monetary operative will effectively end the dollar’s role as the leading reserve currency.

“These threats to the dollar are ubiquitous.  The endogenous threats are the Fed’s money printing and the specter of galloping inflation.  The exogenous threats include the accumulation of gold by Russia and China that presages a shift to a new reserve asset.

“There are numerous ancillary threats.  If inflation does not emerge, it will be because of unstoppable deflation and the Fed’s response will be a radical relation of gold.  Russia and China are hardly alone in their desire to break free from the dollar standard.  Iran and India may lead a move to an Asian reserve currency, and Gulf Cooperation Council members may choose to price oil exports in a new regional currency issued by a central bank based in the Persian Gulf.  Geopolitical threats to the dollar may not be confined to economic competition but may turn malicious and take the form of financial war.  Finally, the global financial system may simply collapse on its own without a frontal assault due to its internal complexities and spillover effects.

“For now, the dollar and the international monetary system are synonymous.  If the dollar collapses, the international monetary system will collapse as well; it cannot be otherwise.  Everyday citizens, savers, and pensioners will be the main victims in the chaos that follow a collapse, although such a collapse does not mean the end of trade, finance, or banking.  The major financial players, whether they be nations, banks, or multilateral institutions, will muddle through, while finance ministers, central bankers, and heads of state meet nonstop to patch together new rules of the game.  If social unrest emerges before financial elites restore the system, nations are prepared with militarized police, armies, drones, surveillance, and executive orders to suppress discontent.”

–James Rickards, The Death of Money, pp.11-13.

When the dollar collapses, we all become Survivalists, not out of choice but out of necessity.

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