By Robert Stowe England
James G. Rickards is a lawyer, economist and investment banker with 35 years of experience on Wall Street. His new book The Death of Money, published by the Penguin Group, is a New York Times bestseller. His first book, Currency Wars, published in 2011, and was also a Times bestseller. In his new book he explores further the consequences of the weak dollar policy pursued by the Federal Reserve Bank, coupled with the huge run up in deficits and debt by the United States, and the failure of Congress and the Obama Administration to devise policies that would spur faster economic growth. Rickards is a portfolio manager at West Shore Group, LLC, Haddonfield, N.J., an investment fund set up in 2013, and an adviser on international economics and financial threats to the Department of Defense and the U.S. intelligence community. He gained first-hand experience on the front lines of a financial crisis as counsel for the hedge fund Long-Term Capital Management, when he was principal negotiator in the 1998 bailout of the fund by the Federal Reserve Bank of New York.
Q: Obviously the Federal Reserve and the dollar are at the center of the story in your new book. What are the most important things Washington needs to understand to face the reality of a possible dollar collapse and possibly prevent it?
Rickards: Part of the thesis of the book is the fact that the people in charge – meaning the Treasury and the Fed, other central bankers and monetary elites – actually have very limited comprehension, if any, as to how dangerous the situation is. The idea that the elites see the danger and the everyday investor doesn’t – I would stand that on its head. And say it’s beginning to sink in to the everyday investor that there are serious problems and they need to take precautions because the central bankers are driving the bus over the cliff. But they don’t see the cliff.
Q: What are the things the people in charge of monetary and dollar policy in Washington least understand? What are they missing?
Rickards: Well, they’re missing everything. Let me say what I mean by that. All policy, at least the way it’s done today by central bankers, is based on some paradigm as to how the economy works, some specific models as to how certain functions and factors work within the economy. And if you get your model wrong – worst yet, if you get your paradigm wrong, then your policy is going to be wrong every time. And that is problem.
The central bankers are sort of a closed circuit. They all went to the same schools. You could pick five schools. You can say M.I.T. [Massachusetts Institute of Technology], Harvard [University], [University of] Chicago, Stanford [University], and maybe Yale [University] and [the University of California at] Berkeley and maybe throw in a couple of others. And then go around the world and look at all the major central banks and where they went to school. They went to one of those five places. They took the same courses. They had the same professors. In a lot of cases they were each other’s professors. Stan Fisher walked into the Board of Governors having been thesis adviser to some of the other members. So, you have a groupthink problem.
They’re using general stochastic equilibrium models, which do not sync into reality. Their paradigm is they have an equilibrium model. There’s some perturbation that throws the economy out of equilibrium. And what you do is apply policy that gets it back to equilibrium and once it gets back to equilibrium the clock starts ticking again and it’s all good. That’s kind of how they think about things.
But, in fact, the economy is a complex system. And if you look at complexity theory and I do that in The Death of Money and also in my first book Currency Wars, and I’ve done a lot of research along those lines, you see that what happens in complex systems is they kind of mimic an equilibrium system for awhile and then they just go off on a tangent and there are the so-called black swans. And I don’t really like the phrase black swan because it is amorphous and inexact. But that’s as good a term as any that everyday readers can understand. But the textbook term for that is emergent properties, which means that things just seem to come out of nowhere. There’s nothing about perfect information in the system that would allow you to infer what’s coming next because, as I say, it just kind of pops up out of nowhere.
And when it happens it’s an irreversible process. In many cases you can’t make it go back to what it was. And so therefore risk management in a complex system is all about mitigating the scale of the system so that you don’t have these mega-catastrophes in the first place. Whereas in an equilibrium system, if you think that printing money is the right policy to affect equilibrium, you may actually print so much money that you increase the scale of the system and increase the probability of a catastrophic result.
So, they’ve got the wrong model. I mean that’s empirical. It’s not just an opinion. You can look at the time series of prices in any market. It’s not normally distributed. It’s a power curve that signifies a complex dynamic underneath. And if you dig deeply, that’s exactly what you find. So, it’s not a surprise that they get it wrong every time. The Fed has a one year forecast that they do every year. It’s one year forward. So, in 2009 they’ll forecast 2010. And 2010, they’ll forecast 2011 and so forth. If you look at the last four years, they’ve been wrong every year by orders of magnitude – not just a little bit wrong, but completely wrong. [They forecast will] say 3.5 percent, it comes it at 2.4. It’ll say 3 percent. It comes in at 1.9. Those are big errors, big orders of magnitude in something like forecasting GDP, which is only ever going to go between something like negative 3 and plus 6, and it’s not a wide range.
So, if you go back to 2007, just look at [former Fed Chairman Ben] Bernanke’s own words taken from the minutes of the FOMC [Federal Open Market Committee] meeting where first he says the housing crisis will blow over. As late as 2008 they didn’t understand the magnitude of it. They underestimated the duration of it. Once they got a couple of years into it, they began to appreciate the duration, but they were still applying the wrong policy because this is a structural problem. We’re in a depression that began in 2007 and will continue indefinitely. And they’re applying a liquidity or cyclical solution. You can’t solve a structural problem with a cyclical solution. You need a structural solution. So they’re still applying to wrong medicine.
So, I would say the biggest problem in the world today in finance and economics is that the people in charge are using the wrong paradigm, the wrong understanding of how the world works, the wrong models, and they are applying the wrong medicine and we’re going to get disastrous results.
Q: Your book suggests there seem to be so many forces in play that the system has reached criticality. That is, things have become so critical that almost anything could set off a crisis or meltdown. If policy makers were on top of this, what should they be doing?
A: Well, that’s a very good question. They should be doing a lot of things, some of which in the short run would be painful, which is one reason they don’t do them. Your description of what I’m writing is actually a very succinct way to put it. The system is actually reaching criticality – what can you do about that? Well, the first thing they can do is to back away from it. Raise interest rates. Begin to reward savers instead of punishing savers. Begin moving to more of a savings and investment kind of model rather than a borrowing and debt and consumption driven model. And reverse QE as fast as they can and not just reduce purchases as they are doing now. They’re still printing money. They’re just printing at a slower pace.
They should actually get rid of some money and take it out of the system by reversing QE. Then they should normalize interest rates. Normalize the balance sheet and then say to the Congress, hey, look, this is not something that we the Fed can solve. Money printing does not create jobs. Cyclical programs don’t solve structural problems. You, the Congress please do your job and [come up with] actual structural solutions. You say what are those? It would be a basket of things involving fiscal policy, labor policy, labor mobility, various cost uncertainties that are being imposed on the economy, the Keystone pipeline. There’s a long list of things to do there.
Q: You talk about de-scaling the complex system to reduce risk and uncertainty.
Rickards: You need to break up the system. I know I use the [single snow flake causing an] avalanche metaphor but I try to make the point that it’s more than a metaphor. The dynamics and the math are actually the same, just in a different phenomenological space. So what does the ski patrol do when you see snow building up and it’s going to cause an avalanche and kill some skiers? Well, they explode dynamite. They fire a cannon into it or throw some explosives and a charge and they break it up at a time when no one is skiing below and make it harmless and then after that the skiers can enjoy the skiing.
As applied to banks, that would mean breaking up the banks. Just take JPMorgan for Exhibit A and break it into five banks. It used to be when I started in banking that what is today JPMorgan was five different banks. It was Manufacturers Hanover, Chemical, the old J. P. Morgan, Chase Manhattan and Wachovia. This is not nostalgia on my part. This is what you would do prevent collapse and then you could say, hey, if one of these five banks were to fail, that might be a little painful but it’s not going to take down the system. Put them all together. They whole thing fails and obviously it does and then the government has to intervene and that just means more intervention and more distortion and then the whole thing just gets worse.
Q: You criticize the widespread use of derivatives by banks that are too big to fail.
Rickards: I would ban most derivatives, not all of them. I think exchange-traded futures, and a few tests having to do with transparency, good risk management and good collateral management [are OK]. The Chicago future exchanges have 150 plus years track record of doing things right. I think we can have some confidence in those. But, over-the-counter swaps and derivatives that are off the balance sheet of the books of the banks that don’t have good capital, I would ban most of those. So the combination of breaking up the big banks and banning most derivatives and increasing capital requirements – those three things taken together would be the equivalent of exploding some dynamite that isn’t dangerous now and preventing the avalanche danger. These are all ways of descaling the system. It’s not that there won’t be failure anywhere. It’s just that it won’t be systemic.
Q: I noticed that you also called for reinstating the Glass-Steagall Act, particularly provisions in the 1933 law that separates investment banking from commercial banking by deposit-taking institutions that was repealed in 1999 the Gramm-Leach-Bliley Act. Would separating those business into separate companies add another layer of protection for the financial system?
Rickards: Yes. Absolutely. When I say these [like bring back the Glass-Steagall Act,] I like to put some science, some data or analytics behind them so they don’t come off as political rants because I’m not that political and I try not to be a ranter. But take the whole history – the pre-history, the history and the post-history of Glass Steagall. What happened? Well, in the 1920s banks in the United States discovered they could create garbage products and sell them to their customers and essentially fleece the customers. And that collapsed in a pyramid and the stock market crashed and [we had] the aftermath of 1929.
So, in 1933 the Congress had hearings and said our job is to protect the public, so let’s find out what happened. And they had hearings and they reached a conclusion that there were inherent conflicts of interest[between taking deposits and lending, on one hand, and investment banking, on the other]. So, they said, OK, this is simple. From now on you can take deposits and make loans. That’s fine and you’ll be regulated. Or, you can underwrite and sell securities. And that’s fine. But you can’t do both. It’s a conflict of interest to take depositor money off the street of basically from people who trust you and then use that to speculate in the securities market and use your franchise or store window to sell garbage to customers. You can’t do that. Well, that was Glass-Steagall in a nutshell.
That was the law for 65 years until 1999 and in the entire 65-year period we did not have any systemic crises of the kind we saw in 2008. We’d have to go back to 1929 and before that to 1907 to find this type of crisis and then all the way forward to 2008 to find it – and in between we didn’t [systemic crises]. Now, we did have bank failures. Some of the were pretty big. We had Penn Square. We had Continental Illinois. We had problems in the banking system, the [savings and loan] crisis of the 1980s, which cost about $200 billion in real terms in today’s money to clean up. So, I’m not saying it was trouble free but we never had anything like the systemic risk or TARP. Now, come forward to 1999, Congress repealed Glass-Steagall. And then they repealed swaps regulation in 2000 [when they passed the Commodity Futures Modernization Act].
So what happens? Within years [of repealing Glass-Steagall] the banks originated garbage products and started selling them to their customers. So is that any surprise that eight years later we have a massive systemic crisis that almost destroyed the banking system? In other words, the minute you took the guard rails off the banks, they went right back to doing what they were doing in the 1920s, which should come as no surprise because they’re greedy and there are inherent conflicts of interest and once you take the guard rails off. And so, it’s almost as if the Congress in 1999 thought they were smarter than the Congress of 1933. But they weren’t. The Congress of 1933 had just lived through a disaster and they wanted to do something about it. And they did something that worked for 65 years. Why on earth would you repeal it? Why on earth would you think you’re smarter than the people who had first hand experience with it and came up with a solution? So, yeah, put Glass-Steagall back on as soon as possible.
That is also consistent with the idea of doing what I call de-scaling, which is what physicists would describe as what you are doing to the system. Break the system into smaller parts so that a failure of any part does not threaten the system as a whole. That’s the basic idea. Glass-Steagall does that. Breaking up the banks does that. Reducing derivatives does that. It all feeds in.