Fallout from the Currency Wars - Fund Evaluation Group, LLC

Fund Evaluation Group
2013 Investment Forum – Cincinnati, Ohio
March 19, 2013
Currency Wars and the
Future of the International
Monetary System
James Rickards
Partner, JAC Capital Advisors, New York, NY USA

International Monetary
System Today Dominated by
Currency Wars. Definition of a
Currency War:
Devaluation of one country’s currency against
that of another in order to increase exports and
economic growth
Important to place in historical and economic
context in order to understand today’s trends

Currency War I (1921-1936)
Began with massive war reparations and war debts
Weimar hyperinflation – 1921-1922
French devaluation and gold exchange standard – 1925
Fed policy blunders: Too loose 1927-28; too tight 1929-1931
English devalue in 1931 / U.S. devalues in1933
Tripartite Accord - 1936

Currency War II (1967-1987)
Bretton Woods prevails beginning in 1944
UK has massive overhang of Sterling claims from WWII
U.S. Policy of “Guns and Butter” begins in 1965
Bretton Woods begins to break down in 1967
London Gold Pool 1961-1968
Nixon Shock – 1971; Smithsonian Agreements
Inflation, recession, oil shocks 1973 - 1979
Volcker, Reagan and the return of “King Dollar” 1980-1984
Plaza Accord 1985 and Louvre Accord 1987

Currency War III (2010 - )
The Warning: Japan’s Lost Decade and LTCM
The Prelude: Glass-Steagall, Swaps Repeal, VaR, Basel III
Chinese export model meets U.S. consumption model
Greenspan and Bernanke “puts”
The Depression of 2007 and the Panic of 2008
Aftermath: Debt, Depression and Deleveraging.....Again

Dynamics of Currency Wars
Attractions of Currency Wars
Stimulates net exports when there are no other growth engines
Generates inflation when banks won’t lend
Steals growth from neighbors
Requires no legislation or taxes
Permanent rebalancing of terms of trade
Downside of Currency Wars
Invites retaliation in beggar-thy-neighbor fashion
Invites capital controls, withholding taxes, other tools
Supply chains are complicated and diverse
Increases prices for your imported components
Inflation hurts growth in the long-run
All advantage is temporary

Origins of a Currency War
Examining Growth – Fiscal Policy
Roots of Currency Wars are in debt, deleveraging, deflation
The debt overhang impedes growth for a decade or more
Fiscal Analysis
GDP = C + I + G + (X – M)

Origins of a Currency War
Monetary Drivers of Fed Policy
Monetary Analysis
PQ = Nominal GDP
Q = Real GDP
P = Inflation/Deflation
M = Money supply
V = Velocity of money
MV = PQ

Fed Expansion of U.S. Money Supply
QE1
QE2

Velocity of Money Both Volatile and
Declining Sharply
Velocity is collapsing

Fed Must Bend the Velocity Curve
Changing Velocity is a Socio-Psychological Task
Primary Tools are:
Negative Real Interest Rates
e.g. Nominal Rates of 2% and Inflation of 4% =
Real Interest Rate of -2%
Inflation Expectations Shock
e.g. Expectations of 2% inflation and actual inflation
of 4% causes an inflationary shock
Both Tools Require 4% Inflation

How Does Fed Achieve 4% Inflation?
✔ Cutting Interest Rates (2007)
✔ Quantitative Easing (2008)
✔ Communications Policy (2008)
✔ Currency Wars (2010)
✔ Operation Twist (2011)
✔ Nominal GDP Targets (2012)
✔ Try Harder (2013)

Monetary Math is Easy!
1 + 4 = 5
4 + 1 = 5
Nominal debt requires nominal GDP growth

The G4 Solution to Currency Wars –
U.S., UK, Japan, Europe Ease Together
Problems: Europe, Emerging Markets, Inflation

What Could Possibly Go
Wrong?

Fed Misapprehends the Statistical Properties
of Risk in Currency and Capital Markets
Fed and other central banks persist in using equilibrium models
Evidence for complexity and non-equilibrium states is convincing

Are Capital Markets Complex Systems?
Diversity
Connectedness
Interaction
Adaptability

Characteristics of Complex Systems
Emergent Properties
Phase Transitions
Critical State Dynamics
Power Law Distribution

Comparison of Normally Distributed Events to
Power Law Distribution,
Bell Curve and Power Curve –
Decay, Tails and Truncation
Bell Curve
Power Curve

Sub-Critical and Critical States
Assume 100 People repudiate the dollar in each case
in total population of approximately 310,000,000 people.
T = Critical Threshold for each cohort
Case 1
Sub-critical State
1,000 people / T= 500
1 million people / T = 10,000
10 million people / T = 100,000
100 million people / T= 10 mil.
200 million people / T = 50 mil.
Case 2
Critical State
1,000 people / T= 100
1 million people / T = 1,000
10 million people / T = 100,000
100 million people / T= 10 mil.
200 million people / T = 50 mil.

How Connected are we? How close to the Critical State?
Source: Professor Eve Mitleton-Kelly, London School of Economics. Used with permission.

FX Trading & Investment Implications
Bizarre Love Triangle – USD/CNY, USD/EUR, EUR/CNY
Key to understanding Euro strength
Key to understanding QE3 or NGDP Targeting
US provides liquidity
via swap lines
Germany vs. Periphery
€
$ ¥
Political fight about inflation & unemployment
China provides solvency
via bond purchases

Possible Solution to Euro Dilemma:
Convergence of Unit Labor Costs between
Germany and the Periphery
Periphery Labor Costs
German Labor Costs
Periphery Labor Costs
German Labor Costs
Case 1
Case 2
Extreme Deflation for Periphery
Mild Inflation for Germany
Look for ECB rate cuts, higher inflation in Germany. Whither the Euro?

Recent Developments in the Currency Wars
IMF Rescue of Europe Depends on SDR Debt, Global Participation
U.S. Launches Financial War or Iran – SWIFT – Iranian Response
Nigeria to Allocate 10% of Reserves (USD4 billion) to CNY
BRICS announce plan to launch new development bank
Rumors of a War – Iran, Israel, Russia, Turkey Syria and the U.S.

China: Between the Rock of Inflation and the
Hard Place of Unemployment
China can have any GDP it wants if it has debt capacity
SOES can “invest” their way to growth – but most is wasted
Rebalancing to consumer implies state sector must drop sharply
But if state sector declines sharply, how do you “pay off” cronies?
Currency wars a form of ease – China turns this on and off

Currency Wars Lessons for
Emerging Markets Currencies
Pegging to US Dollar imports inflation from US due to QE
Allowing currency to appreciate weakens export competitiveness
Either inflation or appreciation increases unit labor costs
Countries may choose to permit inflation to protect jobs, exports
The US will not relent in currency wars; expect global inflation

Australia: Watch for strength in AUD/USD and
AUD/EUR
Chinese flight capital will give AUD/CNY a boost
China may continue to import even with slower growth
Don’t underestimate U.S. desire to fight and win “currency wars”
Australia’s easing and currency deval may start to import inflation
Use of AUD as a reserve currency and trade currency will grow

Japan: An Exception that Proves the Rule
Japan is aggressively weakening JPY to promote exports
Given Japan’s demography & resources, it has few options
The U.S. will give Japan a “pass” in the currency wars – to a point
The U.S. has geopolitical motives to help Japan beyond trade
Japan has to work hard to overcome flight to quality

The Future of the International
Monetary System
Multiple Reserve Currencies
Gold
SDR’s
Chaos

A World of Multiple Reserve Currencies
Reprises 1920’s and 1930’s per Barry Eichengreen
U.S. Dollar Declined from 70% to 60% of Global
Reserves between 2000 and 2012
Future Reserve Mix could be 35% USD, 35% EUR,
10% JPY, 20% GBP, CNY, CHF, CAD, AUD, other
Dynamically unstable without an anchor
Solves no problems, creates new one

The SDR Solution
Introduced 1969. Issued in 1972, 1981, 2009
Obviated in 1980’s by commercial banks
Preferred path of the power elites
Ten-year plan includes issuers, buyers, dealers, repo,
derivatives and new allocations
SDR’s will not be local currency, but used for oil, global
corporations, balance of payments
Turns IMF into proto-world central bank with currency and
expanded balance sheet

A New Gold Standard
What is a Gold Standard?
What is the proper measure of Money?
What is the proper reserve ratio?
Which nations are included?

Metric Tonnes
9,000
8,000
7,000
6,000
5,000
4,000
3,000
2,000
1,000
0
8,133
United
States
Official Gold Holdings – Total 30,731 Metric Tonnes
3,406
2,966
2,451 2,435
1,054 1,040 937
Germany IMF Italy France China Switzerland Russia Japan All Others
765
7,544

Metric Tonnes
12,000
10,000
8,000
6,000
4,000
2,000
0
Holdings with Eurosystem – Total 30,731 Metric Tonnes
10,798
8,133
Eurosystem United
States
2,966
1,054
1,040 937
765
557 423
5,098
IMF China Switzerland Russia Japan India Taiwan All Others

USD per Ounce of Gold
50,000
45,000
40,000
35,000
30,000
25,000
20,000
15,000
10,000
5,000
0
Gold Prices Based on U.S. Monetary
Aggregates
$2,590
$6,475
$12,347
$30,868
M1 (.40) M1 M2 (.40) M2

USD per Ounce of Gold
50,000
45,000
40,000
35,000
30,000
25,000
20,000
15,000
10,000
5,000
0
Gold Prices Based on Global Monetary
Aggregates
(US, ECB, China)
$6,993
$17,482 $17,820
$44,552
GM1 (.40) GM1 GM2 (.40) GM2

What Happens When Gold is the Numeraire?
The S&P500 Index in Gold Ounces

Chaos

Thank you
James Rickards, Partner
JAC Capital Advisors LLC, New York, NY USA
james.rickards@gmail.com
@JamesGRickards