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The Book in a Nutshell
Written in 2011 after the Great Financial Crisis, Currency Wars argues that the competitive devaluation of currencies is not just an economic issue but a grave national security issue. By embarking on quantitative easing from 2008, the Federal Reserve started a currency war and now risks exposing the dollar to a serious collapse. Rickards argues that this error of judgement has been driven by a reliance on outdated economic schools of thought that fail to acknowledge the complexity of our capital and currency markets. Without a rethink and a return to sound principles of money, the result may be a serious financial collapse.
Book Summary: The Key Ideas
#1: The Anatomy of Currency Wars. Currency wars can be defined as a process of competitive devaluation between currencies. Since 2008, Rickards argues that the US initiated a third major currency war of the last century. The stakes, he argues, are now the monetary system itself.
#2: Globalisation, State Capitalism and the Geopolitical Playing Field. The current economic model of the modern world is not true capitalism, but state capitalism, with corporations being an extension of state power. Between the US and other major powers such as China and Russia, there is fine geopolitical and economic balance posing a future threat to the dollar.
#3: The Misuse of Economics. Through their focus on Keynesianism and monetarism, economists and central bankers have underestimated the complexity of financial markets and the consequences of their actions.
#4: The Nature of Complex Systems. Policymakers would benefit instead by adopting a complexity theory economic lens, recognising that complex systems arise spontaneously, behave unpredictably, exhaust resources and tend to collapse catastrophically.
#5: The Possible End Games. The US dollar will likely lose its status as world reserve currency, sooner rather than later. In its place, we might end up with a multi-reserve currency system of regional currencies, a system based on Special Drawing Rights (SDRs), a gold standard reserve currency, or most likely in Rickard’s view, chaos.
Book Notes: The Key Ideas in Detail
The below are more detailed notes on the key ideas from Currency Wars by James Rickards, along with some quotations that caught my eye. These notes do not by any means cover the full breadth of the book. They are instead intended to serve as an introduction to some of the key ideas, from which to decide whether the book is worth further attention.
Key Idea #1: The Anatomy of Currency Wars
A currency war can be described as a process of competitive devaluation of one side’s currency against others. The results of currency wars can be devastating for economies and societies.
Rickards suggests that the process of currency devaluation has a number of problems and understated consequences:
- Higher input costs: Production usually comes with international input costs. It is rare that all components of production are sourced domestically.
- Tit-for-tat devaluation: A major international competitor may devalue its currency in response via lower interest rates or QE.
- Protectionist responses: Tariffs may be imposed, or even sanctions.
- Global recession: Even if the devaluation successfully drives up exports, it may dry up manufacturing and jobs in a purchasing country, which then paradoxically impacts their ability to afford goods at cheaper prices.
With the launch of quantitative easing (QE) in 2008, Rickards argues that the US started “Currency War III”. The implications of this currency war will be born out in the coming years.
According to Rickards, the 20th century was marked by two major currency wars: Currency War I, from 1921-1936, and Currency War II, from 1967-1987.
Currency War I had several antecedents. Rickards points to the end of the classical gold standard, the creation of the Federal Reserve and the Treaty of Versailles as key triggers. Following World War I, Currency War I began in Weimar Germany, where the central bank embarked on a policy of aggressive money printing, which eventually led to devastating hyperinflation. This was followed by a wave of international currency devaluations.
Currency War II started in the late 1960s with significant sterling devaluation, followed by the end of Bretton Woods and the inflation of the 1970s and 80s.
As we head into the consequences of Currency War III, Rickards believes the stakes are even bigger:
“Today the risk is not just of devaluation of one currency against another or a rise in the price of gold. Today the risk is the collapse of the monetary system itself – a loss of confidence in paper currencies and a massive flight to hard assets.”
Key Idea #2: Globalisation, State Capitalism and the Geopolitical Playing Field
Rickards believes that our current economic model is not true capitalism, it is “state capitalism”. This is a model where corporations are extensions of state power. In conjunction with globalisation, Rickards argues that is had led to a form of neo-mercantilism, with state-sponsored enterprises competing on global stage.
In order to illustrate how this model plays a role in the ongoing currency war, Rickards discusses this concept by exploring the role of three countries (UAE, Russia and China) and their relationship with the US dollar.
“If you destroy the currency, you destroy all markets and the nation. This is why the currency itself is the ultimate target in any financial war.”
UAE is the neutral venue in the currency wars, a financial centre for converting wealth into untraceable wealth and facilitating payments.
Russia, on the other hand, is far from neutral in this war. Importantly, it supplies 20% of the world’s gas, with Europe largely dependent on its gas. This gas is supplied via Gazprom, an organization that could scarcely be more connected with state. Rickards argues that while the Russian ruble will not replace the dollar, their gas position could lead to a regional reserve and trade currency for gas to its main customers.
Finally, China has a critical position in the currency war. It holds most of its dollar FX reserves in US Treasury bonds, bills and notes (or did at the time of the book’s writing). But China’s concern is that the US will devalue its currency through inflation and destroy the value of these holdings. Rickards argues that China could dump these holdings and cause US interest rates to rocket and USD to collapse. That would of course have devastating effects for households. Indeed, China is already diversifying its FX reserves and moving into commodities, which spells problems for the USD in future.
Key Idea #3: The Misuse of Economics
It is important to understand the flaws in the economic schools of thought that underpin much of the logic of today’s currency war, not least the schools of Keynesianism, monetarism and financial economics.
The monetarist economic school believes that national output should be influenced by adjusting money supply. The flaw in this idea, Rickards suggests, is that the Federal Reserve is conceptually limited to controlling the money supply but not money velocity. Rickards argues that this means the Federal Reserve relies on its ability to play on human psychology to influence velocity. For example, to increase inflation it must create a fear of inflation or euphoria from the “wealth effect”. The former has been achieved through sustained negative interest rates in the early 21st century.
“Monetarism is insufficient as a policy tool not because it gets the variables wrong but because the variables are too hard to control.”
What’s more, as expansionary monetary policy devalues the currency, the truth of the deception is eventually exposed and trust is broken.
Key Concept: The Wealth Effect. The wealth effect describes the idea that as the nominal value of our household assets (e.g. real estate and stocks) increases, people tend to spend more and stimulate the broader economy.
Keynesianism, on the other hand, argues that government spending can produce a multiplier effect in the real economy, increasing aggregate demand and driving growth.
The problem with Keynesianism, Rickards argues, is that governments have no money of their own. Governments have to print, tax or borrow the money. Printing can cause inflation and leave real growth unaffected, while taxing and borrowing can crowd out public sector investment.
Financial economics has also done significant damage to global economies, not least the concepts of efficient markets and normal distribution of risk.
The efficient market hypothesis claims that information is immediately reflected in prices so beating the markets is luck. But behavioural economists have increasingly shown this is not true. Investors are full of irrationalities.
The idea of normal distribution of risk assumes that since future price movements are random, the severity and frequency of price swings will also be random. Again, the evidence suggests differently.
Key Idea #4: The Nature of Complex Systems
“Complex systems arise spontaneously, behave unpredictably, exhaust resources and collapse catastrophically.”
The impacts of Keynesian and monetarist policy are everywhere. Fortunately, new theories are emerging. Rickards points to “complexity theory” as a promising new school of thought.
According to complexity theory, there are four principles of complex systems:
- Spontaneous formation. Complex systems design themselves through evolution of many small and autonomous parts.
- Emergent properties. The entire system behaves in ways that can’t be predicted simply by looking at its component parts.
- Exponential energy use. In other words, when you increase the scale by 10, the energy requirements increase by more than 10.
- Prone to catastrophic collapse. As the systems exhaust more energy exponentially, propensity to fail catastrophically increases.
The application of this theory to finance can easily inform where currency wars might take us. But as Rickards argues, applying complexity theory in capital and currency markets has the added challenge of human psychology:
“The complexity of human nature sits like a turbocharger on top of the complexity of markets.”
Complex systems form out of individual autonomous parts, or “autonomous agents”. To become complex, these agents exhibit four characteristics:
- Diversity: The agents are all different.
- Connectedness: The agents are connected through some channel.
- Independence: The agents can influence one another.
- Adaptation: The agents learn from experience.
These characteristics of complex systems magnify the risks in capital and currency markets. As scale and interconnectedness increase, the damage of “phase transitions” increases exponentially. One solution, Rickards argues, is descaling of these complex systems, but the current trajectory is quite the opposite.
Key Idea #5: The Possible End Games
Rickards believes that there are four possible outcomes in prospect for the dollar:
- Multiple Reserve Currencies. As the dollar’s proportion of global reserves continues its decline, it is possible that a multi-reserve currency system might emerge. One version of this might take the form of regional reserve currencies, where trade within that region is confined to a designated regional currency. Rickards points to the example of Russia, whose control of the gas market might put it in a position of strength in the formation of such a regional reserve currency.
- Special Drawing Rights (SDRs). SDRs are essentially “world money” controlled by the IMF. SDRs are pegged to nothing and can be printed at will, but might provide a “neutral” reserve currency for trade. With SDRs as a new world reserve currency, countries would continue to use their own currencies locally but SDRs would be used for significant international transactions such as trade invoicing and international loan syndicates.
- Return to the Gold Standard. Rickards suggests that the IMF could run a “bancor” style currency backed by gold as a global trade currency. This would restore trust and credibility to the global reserve currency, and be fixed in supply and protected from manipulations of regular government fiat currency.
- Rickards suggests that the most likely outcome, due to the geopolitical and economic balance we face, is a severe financial collapse. This would likely be characterized by panic in financial markets which would likely lead to significant government intervention. Paradoxically, this intervention would likely exacerbate the economic conditions that caused this chaos in the first place.