In my last article ‘The Crisis Heats Up’, I wrote about a best-selling book by Strauss and Howe; ‘The Fourth Turning’… and how the authors studied history and drew some interesting conclusions. Namely, they drew the conclusion that we are in a Fourth Turning, a Crisis.
As a total readaholic, I confess that I just finished another ‘interesting’ book; this one by James Rickards, ‘The Road to Ruin’. Even though Rickards is hip to history, he does not take a traditional historian’s role.
Instead, he writes as an insider, a witness to the fatal errors and misconceptions held by the PTB; the trillionaire hedge funds, the ’too big to fail’ banks, the FED, the Treasury; in other words the controllers of the Fiat economy.
His thesis is that the tools used by funds, by the fed, and the treasury to ‘manage’ the economy are not only obsolete, but are fatally flawed. These tools are based on false assumptions; assumptions such as the ‘efficient market’ hypothesis, the ‘random walk’, ‘Monte Carlo’ analysis, etc. Rickards believes that the assumptions underlying the most sophisticated computer programs the Fed uses to ‘fine tune’ the economy are wrong from the get go.
Now this is not a great new insight; New Austrian economists have been pounding the table on these gross errors seemingly forever. We have insisted that the economy is highly non-linear, whereas the conclusions of traditional mainstream economics… projections and policy… are based on the assumption that the economy is linear… and that markets are random; unpredictable with no memory. Nonsense; markets are results of action taken by people, and people do have memory.
Today these flaws are becoming blatantly obvious; the failure of monetary policy, of demand/supply curves, of Keynesian intervention can no longer be papered over. Rickards draws similar conclusions, while coming from a different point of view.
To understand the economy, we have to let go of linear assumptions… and also of assumptions that markets are random. Markets and economies are neither random, nor deterministic. Markets are complex. But be careful; complex is NOT the same as complicated. For example, a Swiss watch is highly complicated, but is fully deterministic. Indeed, it is built for that specific purpose; wind it up, and it will run as predictably (deterministically) as technology can make it.
The opposite of deterministic is random; like a series of coin tosses is random. The odds of a coin toss coming up heads or tails is 50/50. It is quite impossible to predict the outcome of the next toss, and the next toss does not depend on the previous… coins have no memory. However, the more tosses, the more closely the mean approaches a 50/50 distribution.
By definition, complex phenomena lie somewhere between deterministic and random; and any hypotheses based on the assumption that markets and economies are random or deterministic are bound to be wrong.
Furthermore, a deductive study of economic data is also wrong; statistics (data mining) cannot predict the behavior of complex systems… and the Fed clearly states that its decisions are ‘data driven’. Data is ‘mined’ to determine trends, trends that are then extrapolated into the future… but this methodology leads to huge problems.
False extrapolation and the unanticipated breaking of trends are why we hear about ‘black swan’ events, why CEO’s complain about being ‘blindsided’ by ‘unexpected’ market changes. Markets are complex in the sense of being subject to periods of relative stability interrupted by moments of wild, trend breaking, causality breaking crises.
Complex systems behave like the proverbial ‘flutter of a butterfly wing in Tokyo causes a hurricane in Miami’. The question is which butterfly; there are thousands, and they all flutter their wings; so which butterfly starts the hurricane… and when?
Earthquakes are another example of complex systems; we all know that the stress in the Saint Andreas fault is rising, and one day the ‘Big One’ will hit… but when, and exactly how big? Conventional studies are helpless in predicting these non-linear effects.
Although the stress builds steadily enough, and is studied extensively, no one knows when the trend will end, the built-up stress released, and a new trend started. At least, no one using traditional methods knows…
Interestingly, some (fringe) scientists do make earthquake predictions that are significant. They use out of the mainstream methods and data… like electrical effects, releases of various gases, and even the unusual behavior of animals! Plus, the proliferation of fore shocks.
Rickards also uses out of the mainstream methods; his methods are based on complexity theory. His methods use inductive logic, rather than deductive. Methods like Bayesian probability; a method used by the intelligence community to predict behavior when there is no extensive data set to analyze; there was only one Great Depression (so far) so there is no data base of why depressions occur.
Rather, the Bayesian method looks closely at the single occurrence, hypothesizes the most likely cause, and makes predictions based on the hypothesis… then studies the aftermath, and if the predictions turn out correct, the hypothesis is strengthened.
To make a long story short, Rickards considers the 1998 failure of Long Term Capital Management to be a foreshock, predicting greater shocks… and the Big One… to come. He was intimately involved in the LTCM debacle, and reports clearly how the underlying assumptions of the quants and Nobel Prize winners running LTCM were wrong; and how their fundamental error led to the loss of hundreds of billions of dollars.
In broad terms, LTCM made bets on the ‘return to the mean’ hypothesis; a belief in economic linearity, a belief based on projections of trends into the future. LTCM found distortions in the markets, and bet heavily that the distortions would be corrected in time; that the markets would ‘return to the mean’. Then they leveraged the heck out of their bets, using 100 and even 200 to one leverage.
This worked rather well… for a while… as long as the current period of relative stability held. Indeed, they made hundreds of billions of Dollars for themselves. Unfortunately, greed overcame common sense; a few hundred billion seemingly was not enough. They kept on pushing their method… perhaps aiming for a trillion?
But guess what; the butterfly started to ‘flutter its wings’… but this butterfly was in Moscow, not Tokyo. The USSR economy collapsed, and Russian bonds defaulted. Instead of a return to the mean, the mean also started to collapse… quickly.
Within a matter of days, as highly leveraged bets went sour, the hundreds of billions disappeared like snowflakes in hades.
Due to the interconnectedness of the markets, these losses would have brought down other players… like the Italian Government, for one example. The net exposure of the (hedged, therefore supposedly risk free) bets no longer counted; what suddenly counted was the notional exposure. The counterparty supporting the hedge disappeared. The insurance was gone; the leveraged bet was left naked.
The problem was so serious that the Fed had to take immediate action; they called in several Wall Street players, knocked some head together, and bailed out LTCM… to preserve the financial system. For the story of LTCM, I suggest you read;
When Genius Failed: The Rise and Fall of Long-Term Capital Management’
by Roger Lowenstein
So, there was a lesson here; reversion to the mean can fail… and leveraged bets placed on reversion to the mean can fail big time. Was the lesson learned? Clearly not at all… in ten years, we had another, even heavier ‘foreshock’; this time not just a hedge fund in trouble, but sovereign debt in trouble; the Great Financial Crisis of 2008.
This time, bail outs were not enough; so called bail-ins as well as bail-outs were instigated by TPTB; that is, the money of innocent bystanders was grabbed, to once again paper over the gambling losses. The GFC was the second foreshock, much stronger than the first one; but the lessons still have not been learned.
The ‘too big to fail’ banks are bigger than ever, the quantity of Fiat borrowed into existence (the total Global debt) is larger than ever, leverage is greater, interconnectedness is tighter. The ‘Big One’ is getting closer.
In the last Fourth Turning crisis, Gray Champion Franklin Delano Roosevelt shut down the bank system (bank ‘holidays’) and confiscated American’s gold… to ‘save the system’.
This time around, the problem is much bigger, so it will command much larger, much more drastic measures. Rickards predicts that the whole (digital) financial system will be frozen. Banks closed for sure, along with ATM’s, but also money market funds, stock markets, futures markets, the whole enchilada.
I cannot disagree with his prognosis; what governments are able to do, they are likely to actually do, in a desperate effort to save the system. Look at the situation; war on cash, promotion of digital ‘money’, and full coverage of every financial transaction… when the tsunami hits, all trends will break; no ‘reversion to the mean’ will be possible.
Now Rickards does give some advice on how to ameliorate the coming crisis; his suggestion for the system is to reinstate the Glass-Steagall act. This law was passed by the US Congress in 1933, during the Great Depression. It was a law prohibiting commercial banks from ‘speculative’ (gambling) activities.
It separated commercial banking from ‘investment banking’… it kept the banks from gambling with depositor’s (our) money. The Clinton administration repealed this law in 1999… Just after the LTCM debacle… and the system has run wild ever since.
If the law is reinstated… and Trump has suggested he is in favor of this, and several states as well as congressmen have been pushing the law… then the derivative bomb will be constrained. By Rickard’s reckoning, the separation would reduce risk (instability) by reducing the size… or ‘scale’… of the system. Less at risk, less connectivity leads to more stability of complex systems.
While Glass-Steagall would not reduce the debt problem, it may at least give us more time before the ‘Big One’ hits. Time to change direction, one hopes.
For the individual, Rickards’s advice is to invest your wealth in a ‘1/3, 1/3, 1/3’ pattern; one third non digital money (Gold, Silver and cash under the mattress… assets that cannot be frozen), one third land, and one third art. I certainly agree with part one; own Gold, Silver, and small denomination cash notes… I have been making this very same suggestion for years.
Land is a hedge against financial destruction; but it must be owned free and clear, and preferably offshore; extreme taxation/confiscation are not impossible. Owning farm land in particular is brilliant; farm land, as valued in Fiat, has been appreciating for decades, and I suggest this trend will not only continue but will pick up speed.
Art is also a hedge against inflation and monetary collapse, but there is a learning curve. Unlike bullion or cash, art is subjective and thus a neophyte is at a disadvantage. Nevertheless, 22 carat Gold jewelry (art?) is a great idea, as it is not as likely to be subject to confiscation as bullion coins or bars.
To sum it all up, The Road to Ruin is a very interesting book, and I do recommend it. The only negative is that it is not really complete; it does not come to any final conclusions… indeed, Rickards himself intends to write a sequel. Hopefully the sequel will bring closure. I am looking forward to reading it.
R. J. Fritsch