Economic Shifts, Financial Shocks and Currency Wars

"Currencies of Power and the Power of Currencies: The Geopolitics of Currencies, Reserves and the Global Financial System"

IISS Seminar

30 September – 2 October, 2012

FIRST SESSION: Economic Shifts, Financial Shocks and Currency Wars

James Rickards
Author, "Currency Wars: The Making of the Next Global Crisis"; Partner, JAC Capital Advisors 2

About fifty yards off the Southern coast of Turkey near a place called Uluburun lies one of the most important archeological discoveries ever made. Two hundred feet underwater is the wreck of a vessel reliably dated to 1300 BC with its full cargo scattered around the site. It was discovered accidentally by a local sponge diver named Mehmed Çakir who reported the find.

The authorities arranged for archeology teams to explore the wreck in several diving expeditions between 1984 and 1994. What they found was a composite of trade, culture and economy derived from the interconnectedness of multiple civilizations in the Late Bronze Age. They found a degree of financial complexity over 3,000 years ago that would be familiar to bankers in London and New York today.

The cargo included tons of copper and tin, which could be alloyed to make bronze ornaments and weapons. Divers also found precious materials such as ebony, ivory, gold, cobalt blue glass ingots and amber. Among the weapons found were spears, daggers, and swords. Foodstuffs in the cargo included figs, olives and grapes. The most spectacular find was a gold scarab inscribed with the name of Egyptian Queen Nefertiti.

What has impressed students of the find ever since was the diversity of the cargo’s sources. The copper came from Cyprus and the tin from Turkey. The amber came from the Baltic Sea coast, over 2,000 miles away. The cobalt blue glass ingots were bound for Egypt where they were highly prized. The foodstuffs originated in the lands of present-day Israel and Syria. What emerges is an ancient version of today’s globalized trading system.

The Bronze Age trading network stretched from the Baltic Sea in the north to Sudan in the south and from the Indus River in the east to Spain in the westover sixteen million square miles. The wealth, sophistication and interconnectedness of this trading network are difficult to comprehend, even today. Then suddenly it collapsed.

The collapse of Bronze Age civilization in about 1200 BC, just one century after the Uluburun wreck, happened with surprising swiftness. Within fifty years, multiple kingdoms and empires crumbled.

The collapse did not affect just one culture, but many – the Hittites, Mycenaeans, Mesopotamians, Egyptians and many others fell into chaos. Cities and palaces were destroyed, trade dried up, invaders attacked and enormous wealth was lost. City dwellers moved out to villages and adopted a more agrarian lifestyle compared to the complexity of city life. It was the beginning of a Dark Age that lasted until the rise of what became Ancient Greece and Rome several centuries later.

This Bronze Age collapse and subsequent Dark Age around 3,000 years ago bears some resemblance to the better-known collapse of the Roman Empire and another Dark Age about 1,500 years ago. What the two collapses teach us is that civilization is not linear, it is cyclical. We do not continually get richer, smarter, more sophisticated and more complex. Occasionally things come apart. It is not the end of the world, yet it is the end of an age. The Bronze Age and Roman Empire civilizational collapses took place 1,500 years apart. It has been about 1,500 years since the last collapse. Is another civilizational collapse in the making?

It is impossible to know. However, it is possible to say that civilizational complexity is the cause of civilizational collapse. This is because of the demands of elites for more inputs to maintain their privileged position in a stratified society. These inputs in ancient societies took the form of tribute, taxes, forced labor, slavery and the spoils of war. In post-industrial societies, these inputs take the form of energy and money. The result is an increase in the size, or scale, of society and financial markets. Complexity requires increased complexity.

When one increases the scale of a complex system the risk of collapse rises even faster. This is not speculation, it is sound theoretical science. Unless society takes immediate steps to reduce the scale of today’s complex capital markets by breaking up banks and banning derivatives it faces a catastrophic collapse on a par with the Bronze Age or Ancient Rome.

Unknown to most observers is that the financial dangers of 2008 have not gone away, in fact, the situation is worse. The biggest banks are even bigger with a larger share of total bank assets. The taxpayers bailed out the system in 2008 and got nothing in return except the prospect of having to do it again. If the system is riskier and more dangerous than it was in 2008, where will the next collapse begin? What domino will cause the other dominoes to fall? A survey of the big three currency areasEurope, China and the United Statesprovides a foundation for understanding why real risks remain and a new catastrophe is looming.


The economic situation in Europe today is paradoxical because it is the most worrying to the global financial community and yet Europe has the soundest economic plan and the best chance for a successful exit from the vast burden of debt afflicting all economies.

The litany of problems confronting Europe is well known. Greece has already defaulted on some of its debt. Spain and Italy are paying high borrowing costs compared to Germany. Ireland’s banks are insolvent and are being propped up by the government. Ratios of debt-to-GDP in Portugal and other euro currency countries are non-sustainable. Youth unemployment exceeds 25% in many countries. The list goes on.

Lost in this barrage of bad news is an equally long list of strengths. The population of the EU is larger than that of the United States and it has a higher gross domestic product (GDP). The combined debt-to-GDP ratio of the EU is lower than that of the U.S.

The seventeen members of the euro currency bloc have a combined gold hoard of over 10,000 tons versus just over 8,000 for the U.S. Europe is well positioned from a global trading perspective and is an inviting destination for foreign investment from China. Even the much-maligned euro is trading in late 2012 at about $1.26, which is comfortably inside its ten-year trading range of $1.10 to $1.60.

Europe has broadly based economic strengths that are being overshadowed by some highly specific weaknesses. Mainstream economists have called for Greece, Spain and Portugal to abandon the euro for local currencies that could be devalued to increase exports and tourism.

Devaluation is a recipe for disaster as it merely invites retaliation from other countries that soon cheapen their currencies as well. The other toxic byproduct from devaluation is imported inflation as prices of foreign goods increase due to the cheap local currency. Given the experience of the United States in the 1970’s, when a cheap dollar policy led to a six-fold increase in oil prices and borderline hyperinflation, it is surprising that economists and policymakers perceive devaluation as a remedy.

A more effective approach for euro system members is to remain in the currency union and maintain a sound euro while lowering costs internally. This can be done through reduced government spending, reduced regulation, more well-trained labor markets, increased savings and lower wages. This combination of policies is painful in the short run but leads to higher productivity in the end.

Skeptics say that 50-year old government workers in Greece will protest in the streets before accepting pay cuts. The skeptics may be right about the 50-year old, but they ignore the 25-year old who has never had a job. Youth labor does not have anchored expectations about how much they should be making and will prove eager to take entry level positions at foreign-financed assembly plants with the offer of benefits, training and advancement over time. This is the key to getting Europe growing again; world competitive labor costs combined with Europe’s advanced technology and Chinese capital can make Greece or Spain a kind of Singapore-on-the-Mediterranean with high value-added exports at world prices.

This adjustment process has been boosted by some good news recently. Germany is the largest economy in Europe and well known for its fear of inflation dating back to the hyperinflation of the Weimar Republic in 1921. Their insistence on no inflation meant that the entire burden of labor cost convergence had to fall on Greece, Spain and Italy.

However, Germany recently concluded that the success of a European-wide monetary policy should be judged by European metrics. This meant that European inflation, not German inflation, was the proper measure. With Spain and others in deflation, there was room for Germany to have higher inflation and still keep the European-wide price index at an acceptable level. This means that they will share the burden of adjustment in the form of higher labor costs and meet the periphery partway.

Calling this policy one of austerity is a misnomer. In fact, it is a policy of prudence, investment, deferred gratification and living within one’s means. The result will be lower output in the short-run and much greater export competitiveness in the long-run.

A virtuous cycle combining higher savings and investment, lower labor costs, indigenous technology and foreign capital has been set in motion. The German growth model is being imposed on the rest of Europe. This trend will be bolstered by unified budgets and fiscal policy and ultimately a European Treasury that will issue Euro Bonds backed by the entire euro area. Now fiscal and monetary policy will be unified.

This will not happen overnight. It will take three to five years to implement the announced plans and even longer to see the results. In the end, Europe will have a highly productive economy, highly competitive prices with a sound currency potentially backed by a huge hoard of gold. One major flaw is that much of the gold is physically located in the United States where it is subject to seizure in the event the U.S. dollar comes under attack. This problem can be easily remedied by European countries requesting that their gold be physically relocated to Berlin, Paris, Rome or other national centers. This would echo similar efforts by Charles DeGaulle to demand the shipment of gold to France in exchange for dollars before Richard Nixon closed the U.S. gold window in 1971.

Europe is on a path to a stronger euro with export and investment led growth after it passes through the current period of adjustment and declining output. While Europe’s challenges are large, its prospects are bright especially when compared to the looming disasters in China and the United States.


If things are not as bad as they appear in Europe, the opposite is true in China. The world perceives China to be a growth juggernaut that will soon overtake the United States in total output while dominating its trading partners and neighbors. There is no doubt that China has made world historic economic strides. Yet, much of this progress has been achieved at the cost of hidden weakness through banks, state-owned enterprises, provincial governments, corruption, malinvestment and overreliance on U.S. dollar reserves. As these weaknesses emerge, a Chinese hard landing will shake the world economy at its core.

The widely accepted definition of economic growth consists of increases in consumption, investment, government spending and net exports. Any economy can grow based on some combination of these factors. The U.S. economy relies heavily on consumption, which constitutes almost seventy percent of total activity. Unfortunately for the U.S. much recent consumption has been fueled by debt and is now stagnating because debt levels are too high. Consumers are saving more instead of spending.

In contrast, China’s economy is driven largely by investment, government spending and net exports rather than consumption. Investment is a sound way to grow an economy because the economy gets a boost when the investment is made, and gets a further boost in later years as the original investment increases productivity. However, China’s investment is grotesquely distorted by government intervention. Much of the investment is wasted on excess capacity in favored industries or white elephant infrastructure projects.

Economists are beguiled by China’s recent annual growth rates of ten percent or more. Even with a cooling off in 2012, China’s growth rates still exceed seven percent. Yet, China’s growth can be whatever policymakers want it to be simply by forcing infrastructure investment either through government spending or bank lending to state-owned enterprises.

Much of China’s growth is being driven by massive infrastructure projects financed with debt that can never be repaid. This debt comes not only from banks but also from provincial governments and other forms of shadow banking that are rampant in China. This type of debt and infrastructure driven growth is not limited by economic efficiency, it is only limited by debt capacity. As long as Chinese banks and enterprises can keep borrowing, they can continue to invest in projects that temporarily create jobs and growth however wasteful in the end.

China is trying to finesse a hand-off from an investment driven economy to a consumption driven economy as an expanding middle-class acquires a taste for household amenities, luxury goods, travel and other things that Americans take for granted. This seems unlikely to succeed for two reasons.

The first is that China’s savings rate remains quite high and incomes are not rising fast enough to support both this level of savings and expanding consumption. High savings and relatively low interest rates will be needed in China for years to come in order to prop up the banking system, especially as bad debts from poor investments begin to pile up.

The second reason is that China has entered into a new warlord period, similar to that of the 1920’s. Except that now the warlords are financial rather than military. A huge cadre of corrupt government officials and so-called princelings, the progeny of Communist Party heroes, have emerged to dominate the financial landscape in China. Their interests are aimed at maximizing personal wealth regardless of the impact on China as a whole. As a result, they insist that their steel companies continue producing steel even when it is not needed. This leads to unnecessary construction projects to use the excess steel. Other princelings own construction companies that are engaged to build entire cities from the ground up at a time when existing vacant "ghost cities" already litter the landscape.

For the time being, this gives the appearance that all is well. Factories are humming, construction is booming, jobs are plentiful and GDP is growing nicely. Ultimately this model is non-sustainable because the investments will not pay for themselves and borrowing capacity will become constrained as bad debts overwhelm the banking system. At that point, China will have to use a significant portion of its reserves to bail out its banking system and can only hope that the reserves are still valuable because they are denominated largely in dollars that the U.S. Treasury is determined to devalue.

China’s growth will continue to appear strong through 2012 and into 2013. These are important years for the Communist Party of China because it marks a transition to a new generation of leaders. The Communists do not want to rock the boat. They want things to go smoothly and will rely on the debt-and-investment growth model to continue. Yet, by 2014 this model will approach the limits of debt capacity and strains will begin to appear in measures such as Chinese borrowing costs and credit default swap spreads. China will once again try to cheapen its currency to prop up its export sector and a new round in the currency wars will have begun.

Chinese elites see this coming and are not waiting around for the inevitable hard landing. Flight capital outflows have already begun and will continue as the elites and their cronies try to get their wealth into safe havens such as Australia, Canada and the United States.

The overall Chinese growth story from 1979 to 2012 is indeed admirable and has involved an unprecedented amount of wealth creation. Hundreds of millions have been lifted from poverty and a huge Chinese middle-class has emerged. This is all to the good.

Yet, like any trend, it can be carried too far, too fast and move into bubble territory. This has now happened in China. In order to continue to create growth and jobs, China has moved past the low-hanging fruit of highly productive infrastructure into the zone of zombie projects financed with unpayable debt. This will end in a hard landing for China in ways that will put downward pressure on global commodity prices and upward pressure on foreign currencies. The combination of the two is highly deflationary. This Chinese bubble will end badly – but not quite yet.

United States

Of the three leading global economic zonesEurope, China and the United States – the United States is the most difficult to forecast because it embodies the greatest contradictions.

On the one hand, the U.S. has a huge, well-educated work force, abundant natural resources, agricultural surpluses, the world’s most advanced technology and greatest universities, creative entrepreneurs and nimble capital markets capable of directing financial resources fairly efficiently to the best ideas and brightest minds.

On the other hand, the U.S. seems determined to throw away its many advantages with disastrous public policies including wasteful government spending and excessive taxation. In short, the future of the United States’ economy is a struggle between inherent strengths and self-inflicted damage.

The key to understanding the U.S. economy is to realize that the U.S. is in a Second Great Depression that began in 2007 and will continue indefinitely depending on policy choices. Depression dynamics are different from recession dynamics, which confuses many analysts.

Recessions are products of credit and business cycles. When inflation becomes too high, the Federal Reserve raises interest rates to cool down the price increases. Businesses respond by cutting back inventories and reducing investment in new plant and equipment. Layoffs increase and sales decline.

For a brief time, GDP may decline slightly, meeting the widely accepted definition of a recession. Eventually inflation cools and the Fed cuts interest rates giving a boost to the economy by encouraging credit purchases such as autos and new homes. Next hiring expands, incomes grow and retail purchases increase. This story of expansion, contraction and a new expansion has been repeated many times. It is the familiar lens through which most economists and analysts see the data.

Depressions are completely different. They are not driven by income and interest rates. They are driven by debt and deleveraging. In a depression, many borrowers cannot get loans because they are insolvent. Other borrowers do not want loans because they are more interested in selling assets and deleveraging. Citizens would rather save than spend. The result is a classic liquidity trap in which fearful consumers put money in banks or hard assets. This reduces sales further, which leads to more layoffs, more business failures and more fear.

Mainstream economists and officials including those at the Fed never use the word "depression." This is partly for propaganda reasons. It is considered bad form to mention the word depression because a depressionary psychology can feed on itselfthat’s what a liquidity trap is. The other reason is that depression is not a precisely defined term in economic literature. Economists prefer precision to indefiniteness and will talk about recessions and "double-dip recessions" without ever once mentioning the word depression. That is unfortunate because depression dynamics are unique and the failure to look a depression in the face and see it for what it is blinds policymakers to the right remedies.

Depressions are not necessarily characterized by uninterrupted declines in output. In fact, depressions can feature periods of growth and declining unemployment. What distinguishes a depression is that the periods of growth are intermittent and non-sustained and the gravitational force of debt and deflation soon brings the growth spurt back down to earth.

In a depression, the economy may get better for brief periods but it never heals permanently until the root cause of the depressiontoo much debt – is expunged.

The United States has had two depressions in the past 100 years prior to the current depression. The first depression was relatively brief, 1920-1921. The second was much longer, 1929-1946.

In the depression of 1920, the U.S. government balanced its budget and did almost nothing else. The private sector was left to deal with the problem. Asset prices plunged, bankruptcies were widespread and unemployment soared. Then, after a mere eighteen months, it was over. The U.S. began a period of robust growth known as the "Roaring ‘20’s" characterized by rising incomes, stable prices, consumer amenities and technological innovation.

In the depression of 1929, the U.S. government, in both the Hoover and Roosevelt administrations, was hyperactive. New agencies were created to pursue public works and to create public jobs. Price supports on agricultural and other goods were implemented then revoked. Gold was confiscated from private citizens after which the government increased the price almost 75% with the gold in government hands. Monetary and fiscal policy veered from loose to tight and then loose again.

The 1930’s were characterized by what economists call "regime uncertainty," in which investors and business leaders refrain from new productive activities because they have no clarity on critical tax, monetary and regulatory policies and no sound basis for assessing the risk and reward of new investment. In these conditions, it is safer to wait for some visibility.

Why was the depression of 2007 not over by 2009? Technically the recession was over by 2009 but the depression was not. Anemic growth and high unemployment have continued at depression levels for five years notwithstanding a small amount of growth in the interim.

The reason is that the policy response to the onset of the Second Great Depression in 2007 was more akin to the 1929 depression than the 1920 depression. Government has once again become hyperactive with major experiments in health care, tax policy, quantitative easing and fiscal stimulus that create the kind of regime uncertainty that causes investors and business people to move to the sidelines.

The primary fiscal and monetary policy responses of the U.S. government to the new depression have been exactly the opposite of what is required to ameliorate the problem. On the fiscal side, the U.S. had incurred more than five trillion dollars in new debt in the past four years. Some of this money was spent on valuable infrastructure, but most of it was wasted on non-productive government jobs and crony investments in so-called green technology such as the Solyndra solar panel company that went bankrupt after receiving $500 million from U.S. taxpayers.

The idea that there is some kind of Keynesian multiplier, which produces more than a dollar of growth for each dollar spent by the government, has been widely discredited in numerous empirical studies. These studies show that government spending actually destroys private wealth once all effects are taken into account. On the contrary, a concerted effort to reduce government spending in order to move closer to a balanced budget would have instilled confidence in U.S. economic management

On the monetary side, there was some justification for cutting interest rates in 2008 to deal with liquidity problems after the failure of Lehman Brothers. However, the Fed should have begun a slow, steady process of raising interest rates by late 2009. The effect would have been to stabilize the exchange value of the dollar and make the U.S. a magnet for private direct investment from around the world. Instead, the Fed’s actual policy of zero interest rates and quantitative easing is designed to undermine the value of the dollar and import inflation from abroad in the form of higher import prices.

The Fed’s inflationary policies are intended to cause negative real interest rates where the rate of inflation is higher than the cost of borrowing, an inducement to borrow. Inflation itself is intended to get people to spend more for fear that prices will go much higher in the near future. It is hoped that the combination of increased borrowing and spending will return the U.S. economy to its prior debt and consumption driven growth pattern.

This policy is having the opposite effect of its intended impact. The Fed’s zero interest rate policy tells people that the Fed is more concerned with deflation than with inflation. As long as deflation is the fear, people will save and not spend and the liquidity trap will grow stronger.

Will the Fed and the Treasury reverse course in time? Will they allow interest rates to rise and let asset values fall clearing the way for future economic growth? This seems unlikely. No administration, Republican or Democrat, seems willing to pay the price needed to break the depressionary dynamic and return to robust growth.

A pro-growth policy involves breaking up large banks, banning derivatives and reining in Wall Street abuses. A pro-growth policy also involves raising interest rates, promoting a stable dollar, cutting government spending and lowering taxes. Implementation of these policies seems extremely unlikely due to a lack of understanding of economic dynamics and the cronyism of Washington and Wall Street.

Instead the Fed and Treasury are likely to double-down with more money printing and deficit spending. This strategy will barely keep the economy afloat as the inflationary effects of government policy struggle against the deflationary effects of depression. In the end there are limits to confidence in the Fed’s balance sheet and the amount of debt the U.S. can incur. When those limits are reached, there will be a near-instantaneous collapse of confidence in the U.S. dollar. This collapse can lead to hyperinflation as holders dump dollars quickly in exchange for whatever goods can be had.

This type of collapse is what risk managers call "jump risk" because conditions jump from one phase to another without going through intermediate phases. The Fed expects that inflation will increase gradually so they will be able to stop it when they see it. Yet, with jump risk or phase transition, inflation can leap from five percent to twenty percent in a matter of months based on lost confidence and changed behavior. The Fed will see it happen but will be powerless to stop it.

Dynamics of Wealth Destruction

Central bankers have now taken the world to a place from which there is no exit. By cutting interest rates to zero, or close to it, and by expanding balance sheets with unprecedented amounts of money printing, they have for now forestalled a more severe contraction, something that might have resembled the depression of 1920 in its intensity. Yet, in doing so, they have destroyed markets and merely delayed the reckoning.

In desperation, policy makers then turn to currency wars, trying to cheapen their currencies against those of their trading partners. The purpose of cheapening a currency is to cheapen exports and create economic growth and jobs through the export-producing sector. At best, this produces temporary relief, but the gains are soon reversed as trading partners retaliate.

A good case in point is the United States. In 2010 and 2011, the U.S. did succeed in weakening the dollar against the Chinese yuan and the European euro and some other currencies such as the Brazilian real, at least slightly. Yet, by mid-2012, China, Europe and Brazil had all cut interest rates and lowered their currencies against the dollar, undoing the cheap dollar policy of 2010. No doubt, the Fed will keep up the fight by printing more dollars and trying to lower the value of the dollar again in 2013. This is how the currency wars play out back-and-forth for years with no clear winners but a legacy of increasing inflation and dysfunctional capital flows.

If central banks continue on this destructive dead-end path they will eventually erode confidence in all paper currencies and cause the collapse of the international monetary system. This has happened several times in the past, most recently in 1914, 1939 and 1971. However, the international monetary system has shown the capability to reform itself as happened in 1925, 1944 and 1981.

The next collapse of the international monetary system will produce a replacement system based on one of two foundations. The first possible foundation is gold at much higher nominal prices, perhaps $5,000 to $7,000 per ounce. The second possible foundation is the use of a new world money called the "special drawing right" or SDR. These would be newly printed by the IMF and given out to members where they can be used to settle balance of payments deficits or exchanged for other currencies such as dollars to pay debts or bailout banks.

Both solutions are highly inflationary. A repricing of gold to $7,000 per ounce would cause the repricing of all commodities at the same time. This is the world of $150 per ounce silver, $400 per barrel oil and $100,000 per year college tuitions. At least it would provide a way to pay off existing nominal debts. The old debts, including sovereign bonds, could be paid in dollars worth far less in real terms than the lenders and investors ever imagined. The inflationary effect of printing SDR’s out of thin air would be very much the same as repricing gold.

Is there a way out that does not involve either a deflationary collapse from withdrawing policy support or a hyperinflationary burst from revaluing gold or printing SDR’s? The answer is yes, but the path is narrow and the odds of it being pursued are small.

Governments and central banks need to withdraw their artificial support from markets while at the same time providing an environment where entrepreneurs and markets can create the kind of real growth that will make the debt burdens manageable.

For example, raising interest rates in the U.S. would deflate certain asset values such as stocks, bonds and housing, but it would give a big lift to savers who would then make higher savings available for productive investment. The U.S. could eliminate the corporate income tax and individual capital gains taxes. The positive impact on stock and other asset prices would probably be greater than the negative impact of raising rates. The result would be that asset prices would rise based on fundamentals not inflation. These asset price rises would then encourage more capital formation, investment and job creation. This investment driven model would be closer to what Germany does today and it has proved highly successful there and in other northern European countries such as the Netherlands, Sweden and Finland.

Government spending could be reduced to finance the tax cuts. Private sector job creation could then be relied upon to replace the lost government jobs. Pension costs could be rationalized since private sector pensions are generally not as lavish as those in the public sector. Additional needed reforms should come through the break-up of all large banks and the prohibition of derivative products.

Other cost savings could be realized by removing the government from the health care sector. Health care costs could be reduced through a combination of vastly improved technology, consumer choice and private insurance competition with a modest amount of regulation to provide for the neediest.

This formula of tax cuts, spending cuts, private investment and sound money would soon return the U.S. economy to trend growth in excess of 3% per year after a brief above-trend burst of 5% per year. Unemployment would plunge, productivity would surge and the U.S. would be a magnet for savings from around the world.

What are the chances of this package of reforms actually being enacted into law? Practically zero. Private and public elites such as major bank CEO’s and the board of the New York Fed are heavily invested in the role of big banks that use derivative products to steal from customers. They are also invested in high taxes and high government spending to prop up their elite status at the expense of economic growth. These elites will also be the best positioned to profit when inflation emerges to rob the savings of everyday Americans. Democratic processes are unlikely to change the outcome because mainstream media are part of the elite themselves and because the dynamic processes behind inflation are not well understood by most citizens.

Currency War and Financial War


The forgoing describes the topography of the currency wars. These are understood as a struggle for growth in a world with inadequate sources of growth due to excess and unpayable debt. Major trading partners try to steal growth from each other through successive devaluations. The devaluations are attempted through monetary ease and capital controls. Successive devaluations go back and forth between adversaries like the ball in a ping-pong match. The dynamic plays out over years and even decades. In the end, no one wins. The results are always inflation, deflation and contracting world trade. Ultimately the international monetary system destabilizes, is reconfigured, and the game begins again on a more sound footing.

Yet, this is not the only dynamic in play. In addition to currency wars, the world is witnessing the advent of outright financial war. In financial warfare, economic damage is not the unintended consequence of bad policy, it is the intended consequence of malicious acts. It is war by other means.

There is little doubt that the U.S. military can suppress and defeat any military on earth in kinetic warfare. This does not mean it is easy or without cost, but U.S. weapons, technology and trained warriors can rapidly degrade the air and naval vessels of any opponent and disrupt command and communications for any land forces.

The U.S. rarely finds it in its interest to engage in major land-based invasions, Iraq being a notable exception. Yet, when it comes to control of air, sea and space, the defense of allies and occasional projection of force, the U.S. is in a league of its own.

It is for precisely this reason that rivals of the U.S. increasingly turn away from kinetic warfare toward what is called asymmetric warfare. This type of warfare has moved from the fringes to the center of war fighting doctrine in recent years. It includes strategic use of weapons of mass destruction such as chemical, biological, and nuclear devices and terrorism, cyber-warfare, attacks on critical infrastructure and financial warfare.

Of these, financial warfare is least familiar to military and political strategists due to its highly specialized nature and relatively recent arrival in the battlespace. Financial warfare involves malicious acts in markets for stocks, bonds, currencies, commodities and derivatives.

It is estimated that over $60 trillion in wealth in all forms was destroyed globally in the financial panic of 2008. There is no evidence that this panic was caused intentionally or maliciously by any foreign power. The panic was something countries did to themselves through overleverage, deregulation and a deficient understanding of the properties of risk.

Yet, what if something like the panic of 2008 could be caused intentionally? What if it could be targeted at certain markets and asset classes so as to inflict disproportionate economic harm on rivals while leaving the perpetrator unscathed? What if the cost of launching such an attack were only in the billions of dollars compared to the trillions of dollars of losses that would be inflicted?

For example, convention wisdom holds that China has enormous leverage over the United States because of the $3 trillion of U.S. debt owned by China. It is said that China could simply dump these securities on the markets causing a spike in dollar interest rates that would ruin the U.S. housing and stock markets and leave the U.S. mired in debt as it struggled to pay the new higher interest rates on its Treasury notes.

In fact, such a scenario is highly unlikely mainly because it wouldn’t work. If China tried to dump Treasury notes it would have to work through a web of electronic systems and primary dealers controlled by the Treasury and the Federal Reserve. Immediately upon commencing such a financial attack, the Treasury would become aware of the disorder in the markets. The White House has the authority to freeze all Chinese bond accounts if their trading activity poses any threat to U.S. national security. In short, the Chinese would be stopped in their tracks before inflicting any strategic financial harm on the U.S.

The Chinese well understand their position. This is why the development of financial war fighting doctrine involves the use of disguised channels and dispersed elements so that attacks are not easily traced to their source and not easily stopped. In effect, the Chinese and others will adopt techniques already in use by hedge funds that wish to hide their identities and intentions in the market place.

One approach would be for the attacker, be it China, Russia or Iran, to establish a network of hedge funds in obscure tax havens around the world such as Cyprus, Malta, Macao, the Cayman Islands and other lightly regulated jurisdictions. These hedge funds could be established using private Swiss bank middlemen so that the identities of the true parties were obscured. The hedge funds would be given anodyne names as is typical in the industry. Local lawyers, administrators and directors would all be unwitting accomplices in this charade.

Each hedge fund would be financed with $1 billion of disguised enemy capital. If five hedge funds were utilized, the total investment would be $5 billionless than the cost of a single aircraft carrier and potentially more destructive. While the funds would be legally based in the tax havens, they would be traded by separate management companies in more sophisticated locales such as Geneva, Zurich or London adding another layer of disguise to the structure. Again, this is totally in keeping with established hedge fund practice and would raise no eyebrows if done professionally and discretely.

These covert hedge funds would establish banking and brokerage accounts through legitimate channels and commence trading in the same stocks, bonds and derivatives as their peers. With good risk management, the funds could conduct trading in such a way that they neither gained not lost much money. The purpose of such trading would not be to make money but rather to become an established and trusted name in the marketplace and a good customer of the brokers who are happy collecting commissions on this desultory trading. In effect, the funds would tread water until the orders were given to commence the financial attack.

The attack would begin on a day when U.S. stock markets were already down significantly. This is what military planners call a force multiplier. Rather than push a rock uphill, it is much easier to roll it downhill. Once U.S. markets started to slide, the phalanx of enemy hedge funds would simultaneously flood their brokers with sell orders on all of the large cap stocks such as Apple, Exxon, General Electric and others. They would also buy put options, a kind of bet on falling markets, to gain further leverage. As the slide accelerated, agents in place would get on the phone to brokers to spread rumors about major banks running low on cash and other brokers planning to file for bankruptcy. In the wake of the Madoff, MF Global and the "London Whale" scandals of recent years, these rumors would gain more credence than usual.

Soon the attack would broaden to bond, currency and commodity markets. The attacker would have planned its own proprietary positions in advance so as to make enormous profits at the same time that its trading positions were sinking western capital markets. A successful attack would result in trillions of dollars of lost wealth, exchange closings and possible social unrest as Americans stared at decimated 401(k) accounts and evaporated home equity. This would be 2008 all over again except bigger and harder to recover. The most important difference would be that it was a malicious act of financial warfare and not an accident of overleverage.

This is just one of many scenarios that can be played out in the new arena of financial warfare. Such warfare not only has offensive components but also components of intelligence, defense and retaliation. Nations need to consider what they can do to detect and disrupt such attacks and how to develop offensive capabilities to create a kind of mutually assured financial destruction. Cold War doctrines are being dusted off and reapplied in this Brave New World of financial warfare.

For a contemporary real-world example of financial warfare, one need only consider the case of Iran. The U.S. has imposed sanctions of various kinds on Iran for over thirty years, but the tempo and scope has increased lately as Iran moves closer to mastering the uranium enrichment cycle and nuclear weaponization. The U.S. unleashed the ultimate financial weapon against Iran on February 5, 2012. Banks were told that they would be banned from the U.S. dollar payments system if they did business with the Central Bank of Iran.

This sanction caused dollars in Iran to immediately dry up. Merchants who needed dollars to purchase imports such as mobile phones and computers were suddenly unable to obtain dollars except through black market transactions. The scarcity of dollars caused the Iranian currency, the rial, to plummet in value against the dollar. The rial fell over forty percent against the dollar in a matter of days and this slide has continued. This meant that merchants had to double their rial prices in order to get the amount of dollars necessary to replenish their inventories of imported goods.

This increase injected hyperinflation into sectors of the Iranian economy and started a run on Iranian banks as depositors raced to withdraw their funds and convert them to hard assets for protection. Iranian banks dramatically increased interest rates on deposits in order to reassure depositors and stop the bank run. At the same time, the Iranian regime imposed harsh penalties for certain black market transactions in dollars, including capital punishment.

By unilaterally excluding Iran from the dollar payments system, the U.S. caused a currency collapse, hyperinflation and sky-high interest rates in a matter of days. These events were bound to be deeply unpopular with Iran’s cosmopolitan urban dwellers who enjoy imported mobile devices and pop music as much as their peers in Paris or Tokyo.

The U.S. sanctions contained one enormous loophole however. There are other payments systems in the world including those operated in Europe for clearance and settlement of transactions in Euros. At an even higher level, almost all payments in the world in any major currency are transmitted through the Brussels-based Society for Worldwide Interbank Financial Telecommunications, or S.W.I.F.T. Iran could continue to make payments in Euros, yen or Swiss francs via its correspondent banks and S.W.I.F.T. even if were excluded from dollar payments.

As of March 2012, the U.S. successfully pressured the S.W.I.F.T. governing board to exclude Iranian banks from its facilities as well. Iran now appeared to be truly isolated. The entire Iranian banking system including their Central Bank had no capacity to send or receive payments from its international trading partners. Iran could not receive payment for its oil shipments, so it could not pay counterparties for vital imports of refined products such as gasoline and critical food shipments of wheat and other staples.

By March 2012, Iran had reached out to its principal trading partnersChina, India and Russia among others—to develop trade financing mechanisms that did not involve dollars or settlement via S.W.I.F.T. Ideas under consideration included simple barter deals where Iran could trade oil for gold with India or gold for wheat with Russia. Iran could also engage in bilateral banking relations with particular countries that did not involve S.W.I.F.T. For example, an Indian importer of oil from Iran could simply make payment in rupees deposited to an Iranian account in an Indian bank. Iran may have been quite limited in terms of what it could do with those rupees, but still it was a form of payment the U.S. could not prevent.

An even bolder solution was to engage in covert action against S.W.I.F.T. by making large hard currency deposits in Chinese and Russian banks. Those banks would then act as agents for Iran without disclosing their association. The banks would then make and receive payments in various currencies, including dollars, via S.W.I.F.T. for Iran’s accounts without notifying the counterparties of the connection. These transactions would be in violation of S.W.I.F.T. rules requiring the identification of third-party beneficiaries, but S.W.I.F.T. has limited ability to discover and prove the violations. S.W.I.F.T may not have even wanted to attempt such discovery because it was not enthusiastic about the sanctions in the first place, and had only gone along to placate the United States.

The results of the U.S.-led financial war on Iran was a classic case of "be careful what you wish for." In the first instance, the U.S. sanctions had proved highly effective in bringing a currency collapse, inflation and high interest rates to Iran. Still Iran was too powerful and its oil too vital to global commerce for it to remain a complete pariah. Alternative payment channels including smuggling, barter, bilateral payments and covert action emerged almost immediately.

The implications of alternative arrangements had an unintended consequence that went far beyond Iran. For the first time, Asian countries and the BRICS were beginning to see a way out of the global dollar hegemony that has prevailed since 1944.

In late March 2012, the BRICS countriesBrazil, Russia, India, China and South Africaheld a summit conference at which they agreed to study the creation of a new multilateral bank that would facilitate lending and payments among emerging markets and create a currency other than the dollar as its medium of Exchange. BRICS members Russia, India and China were already deeply involved in arranging alternative payments facilities for Iran. These developments were a manifestation of their numerous complaints since 2009 about U.S. Treasury and Federal Reserve’s debasement of the dollar and abuse of the dollar’s preeminent reserve currency position. One could easily see this payments union expanded to include emerging economies such as Malaysia, Kazakhstan and Turkey.

Alternatives to the dollar such as the euro and its predecessors have existed for some decades, but their success was based in large part on issuers maintaining an open capital account and easy convertibility into dollars. What the BRICS were suggesting was something new—a payments system and a currency that would not necessarily be convertible into dollars but would make the dollar irrelevant, at least with regard to transactions among the participating nations.

What all of these recent developments have in common is dissatisfaction with the debasement of the dollar by the United States and a need to seek new sources of liquidity and stability.


What will cause the next collapse in capital markets? It could be the failure of Europe as a whole to make the transition to an investment and export driven economy. This could cause a default in European sovereign debt and the break-up of the euro currency itself spreading financial contagion around the world.

It could be the failure of China to make the transition from overreliance on infrastructure to consumption led growth. This will lead to a hard landing as unpayable debt overwhelms the banking system and depletes Chinese reserves in a massive rescue effort. This would deprive the developed world of a huge source of liquidity and potential investment.

It could be the failure of the United States to reduce government spending and entitlements. This will cause an explosion of U.S. debt that will eventually force the Fed to monetize it by massive money printing. The resulting inflation will destroy middle-class savings.

It could be all three. Any one failure in Europe, China or the U.S. is unlikely to leave the others unscathed. The world economy was globalized in its expansion phase and it will be globalized in the next downturn.

Or it could be an intentional, malicious act of financial warfare launched by an unseen enemy on an unsuspecting target country – the financial equivalent of the Pearl Harbor attack.

The Uluburun shipwreck at the end of the Bronze Age reminds us that great wealth and luxury can be destroyed almost overnight. The timing of a collapse may be uncertain, but the preconditions are plain to see.