Currency Wars: The Making of the Next Global Crisis

January 26, 2012


JOANNE MYERS: Good afternoon. I'm Joanne Myers, director of Public Affairs Programs, and on behalf of the Carnegie Council, I would like to thank you for joining us.

Our speaker is James Rickards. He will be discussing a topic that affects us all, the global finance. His presentation is based on his New York Times bestselling book Currency Wars: The Making of the Next Global Crisis, which will be available for you to purchase at the end of the program today.

I believe you all have a copy of his résumé. If you haven't read it yet, I encourage you to do so, because there are some very interesting twists and turns.

It was just a few years ago that the worst financial crisis since the 1930s gripped the global economy. While some countries have made a feeble recovery, those that haven't are shifting blame and faulting others for their sluggish growth. The debate has turned combative. The weapon of choice is financial, and it takes the form of one's currency.

While not the conventional military weapon, provocative manipulations of one's currency that range from printing money to buy government bonds, to currency devaluation and capital controls, are being used as a means to revive struggling economies worldwide. These tactics have the potential to ignite an economic war, a war that could destroy faith in the U.S. dollar, damage our economy, and threaten our national security.

In his book, our speaker exposes us to this new battleground of global finance and asks one of the most important economic questions today, which is whether our recent response for resuscitating a flagging economy is setting the stage for the next financial crisis. His reply is golden.

He begins by sharing a fascinating story about his involvement with the Pentagon in designing and participating in a war game that used currencies and capital markets to gain insight on potential attacks on the U.S. dollar. In the next section he provides a history of currency wars, of which there have been two, one in the 1920s and 1930s, the other in the 1960s and 1970s, and he writes that recent signs indicate that a third is quite possible.

He concludes by pointing a way toward a more informed course of action, one that will be more effective in meeting the challenges of a global economic slump. While expressing confidence in America's economic ability to defeat any nation-state in battle, still Mr. Rickards warns that if currency wars lead to rising inflation, eliciting more uncertainty, the United States could get dragged into asymmetrical warfare, and this would dramatically diminish America's role on the world stage.

The question is, what can currency wars of the past tell us about threats today so that we can ward off another crisis? For the answer, please join me in giving a very warm welcome to our guest today, Jim Rickards.

Thank you for joining us.


JAMES RICKARDS: Thank you, Joanne, for that introduction. It's indeed a pleasure to be here tonight.

I take it we have some viewers on the webcast from all over the world, but for those of us in the audience, we know the weather is not ideal, and I especially thank you for coming out on a rainy evening here in New York.

The weather may not be ideal, but I think our venue is. We have a very distinguished audience with us here tonight. I am very pleased to be a part of this.

We'll spend about 25 minutes or so in sort of straight presentation, and then we'll allow ample time for questions. We'll have a half-hour or so for questions and a little time to chat afterwards. Hopefully that's a good mix. I know I very much enjoy giving presentations like this, but personally my favorite part is the questions. I like to hopefully impart some learning, but I learn a lot as well from that part of the program, so I'm looking forward to that.

Let's jump in. Probably the obvious place to start is, what is a currency war? We're going to be talking about currency wars. I think we're living through one. But what is a currency war?

It's actually a fairly simple concept. It starts with insufficient growth. When the world economies are at a point where there is not enough growth to go around—when there's a lot of growth and economies are growing robustly, people don't care as much about the exchange rate. They always think about it. It's always an element of policy. But if there's enough growth to go around, you don't care as much. But when the growth is insufficient, the temptation to steal growth from your trading partners by devaluing your currency becomes overwhelming. That's really the origin of a currency war.

The way it works is very straightforward. The United States has a lot of great exports available to the world. Take Boeing aircraft as an example. They make a fine plane. But there are a couple of competitors around the world. We have Airbus in Europe. We have Embraer in Brazil. China is developing an aircraft industry.

Let's say you are a country like Indonesia. You need airplanes, but you don't have an indigenous aircraft industry, so you are going to go shopping around the world. I compare it to living in a small town. There are four stores. They all sort of sell the same thing. If one of those stores has a half-off sale, everyone is going to go to that store.

When you cheapen your currency, you make your stuff less expensive for foreign buyers, and in theory, they are going to buy your aircraft before they buy something from Airbus. That creates exports. That contributes to growth in the United States. It creates jobs. Given the fact that we have a serious unemployment problem and insufficient growth in this country, if a program can create jobs and create growth, it sounds great. What's wrong with that? That's the way a lot of politicians and policymakers look at it, and that's how this process of devaluing the currency begins.

The problem is that there are a lot of things wrong with it. They end very badly, very quickly, for a number of reasons.

First of all, there's the obvious fact that the United States imports more than we export.

Sure, our exports might be a little bit cheaper at the margin. We might sell a few more planes and Microsoft software and Hollywood films. But we import an enormous amount—all those iPads and iPods and flat-screen TVs and German cars and foreign vacations and a lot of other, more basic inputs to the supply chain as well. The price of those will go up. Since we import more than we export, that actually is a way of importing inflation and price increases into the United States. That then begins to feed through the supply chain.

We'll talk more about it, but this is exactly what happened in the 1970s. After President Nixon cheapened the dollar in 1971, we set out in one of the worst periods of inflation, bordering on hyperinflation, in U.S. history between 1977 and 1981. Cumulative inflation over the five years was 50 percent—five zero. It means the value of the dollar was cut in half. So that's one of the consequences of cheapening your currency and launching a currency war.

The other one, which was more illustrative, I think, in the 1930s, is retaliation. The United States could act in a vacuum, if we were the only country pursuing a policy. This might work for a short period of time. But sooner rather than later—and in today's world, almost instantaneously—other countries will begin to try to cheapen their currencies or, if they lack the sort of economic muscle to be able to do that—I think Brazil is a good example of this—they will do other things. They will put on capital controls. They come in a lot of different flavors.

You invest in the country. They say, "No more 30-day bank deposits. It's either six months or a year." We have even seen things like negative interest rates. We are seeing capital controls in Switzerland, Brazil, Thailand, South Korea, and some other countries around the world.

Then the third problem, in addition to importing inflation and inducing capital controls, is that currency wars quickly morph into trade wars. Countries will begin to put on import excise taxes, throw up other barriers to trade that actually reduce world trade and world economic output. Of course, that's what we saw in the 1930s.

So there is a whole host of bad economic consequences. We have seen this before. One of the reasons I spend so much time on history in the book, in addition to economic analysis, is to make this point, that we have set out on this road before and it has ended badly and, in my view, will end badly again.

So that's what a currency war is. It's a simple temptation to steal growth from your neighbors by cheapening your currency, lowering the cost of your exports. It has all these bad, negative consequences and feedback loops I described. That's kind of it in a nutshell.

Let's now, with that as a frame of reference, go to the outline of the book itself and talk about this in more detail.

As Joanne mentioned, the book has three parts. The first part is a little bit of a stand-alone. I think it's a good introduction and helps frame the issue globally. In the first two chapters we recount the first-ever financial war game. This was conducted by the Pentagon in 2009. It took place at a top-secret weapons laboratory outside of Washington called the Applied Physics Laboratory.

The Pentagon has been conducting war games for 50 years. Before that, nothing new about war games. That's their job. There are all kinds of scenarios they have to deal with, whether it's a potential Chinese invasion of Taiwan or an Iranian attack on Israel or Iran blocking the Strait of Hormuz. We all hope these things never happen, but we know that they might, it's a dangerous world, and the Pentagon needs to be prepared for that.

What was different about this war game was that the rules were that you could not use any what the military calls "kinetic weapons" or things that shoot or explode, no previous invasions, B-2 bombers, no flanking maneuvers. The only weapons were stocks, bonds, currencies, commodities, and derivatives.

I was invited in as a capital-markets expert. The Pentagon did not need any help from me conducting a war game, but they did need help on the capital-markets side. It's historically not a big part of the battle space, not a very important part of strategy during the Cold War. I worked side by side with the game's design team at the Applied Physics Laboratory, and we literally wrote the rules. It had never been done before. I call it playing "Risk" for adults. It had a very serious side to it, of course.

We did some straightforward things. The teams are the ones you might expect. It was the United States, Russia, China. We had a sort of conglomerate team. Our resources were limited, so we lumped in Europe and East Asia as group teams. We also allowed participation from non-state actors, such as hedge funds, banks, and other financial regulators. There was that component.

We played over two days. We had three moves. It's all described in the book. I don't have to go through it in detail. I hope you enjoy those chapters. I'm not going to give away the ending.

But, in addition to designing the game, I was invited to play on the China team. I had a close friend who was a Russian expert and actually had made his first visit to Russia in 1963, during the Khrushchev-Kennedy years. He is the epitome of the old Russia hand. They invited him to play on the Russian team. I had another friend on the Swiss team. We cooked up some surprises for the Pentagon and tried to give them their money's worth. I hope you enjoy those chapters.

It has a very serious side to it—clearly a learning experience. But when we look at the world today, events are actually unfolding faster than I would have thought a couple of years ago. We knew this was forward-leaning. We knew that the strategic community and the national security community had to get up the curve.

The reason for this is also straightforward. There is not a military in the world that can stand up to the United States toe-to-toe. Some are stronger than others. Some pose different challenges. But at the end of the day, there's not a navy we can't disable; there's not an air force we can't suppress; there's not a command-and-control structure that we can't disrupt at some level.

And other countries know this. Therefore, if you want to rival the United States, if you want to be an adversary of the United States, the trend is to think in terms of what we call unrestricted warfare or asymmetric warfare. Some of this is well known—chemical, biological, radiological weapons, weapons of mass destruction.

But the other equally powerful, maybe even more powerful, weapons are cyber warfare, and now the new kid on the block is financial warfare. These are all being incorporated into strategic doctrine, and not just in the United States. In the book we cite various Chinese documents and studies that explicitly make financial warfare part of Chinese strategic doctrine.

It's actually happening as we speak in Iran. The United States has been ratcheting up sanctions against Iran for years. Actually, these sanctions go back to the 1980s. But most recently, the president went for the jugular. He cut the Iranian central bank, Bank Markazi, out of the global financial system. The way we do this is we say to all the other banks, "If you do business with Bank Markazi, you may not do business in the United States."

Whether it's Deutsche Bank, UBS, Commerce Bank, Credit Suisse, they don't need to be told twice that the United States is dead serious about this. They have got enormous operations in the United States—actually larger than in their home countries in some instances. So they immediately cut Bank Markazi out of their list of counterparties.

This caused an instantaneous one-day drop in the value of the rial, the Iranian currency, of 40 percent. Their currency dropped 40 percent in a single day against our currency.

What happened next could also have been anticipated. A lot of what is sold in Iran is imported—maybe smuggled through Dubai, but it's imported—which means that if you are an Iranian merchant, you need dollars to pay the guys on the creek in Dubai to smuggle your stuff over. Some of it may be legitimately from Germany, et cetera. If your currency is down 40 percent, you need twice as many dollars. So what they did was, they doubled their prices in rials. So certain goods overnight went from 200,000 rials to 400,000 rials. Now we're injecting hyperinflation into the Iranian economy.

The fact that their election is in March is interesting. We're doing this ahead of their elections. Whether this is to stir the pot, get the Green Revolution going again, or to create some more dissent—inflation, by the way, is a very powerful motivator of popular discontent.

A lot of the Arab Spring—sure, it was their desire for democracy and to get rid of these dictators, absolutely, but there was an equally strong concern about inflation spreading around the world, thanks to our chairman of the Federal Reserve. Inflation was a big part of the Tiananmen Square demonstrations in 1989. We all remember the papier-mâché Statue of Liberty, but a lot of people in that square were urban workers and people coming in from the countryside who were concerned about inflation.

So it's a good way to destabilize a regime. Regime change is really the name of the game in Iran. Nobody wants a war, but if we can get a new group in there running the country, then there might be a way through this nuclear program.

This is financial warfare, clear as a bell. We gamed it in 2009. I certainly expected to see it sooner than later, but maybe not quite this soon.

Recent reports this week out of Jerusalem are that Iran may be striking a deal with India to sell Iranian oil to India for Indian gold—an oil-for-gold swap. Again, I don't think I'm giving away too much to tell you that using gold to displace the dollar payment system was a big part of what we did in the war game. This involved China and Russia more so than India, but the point is the same.

The United States does have a lot of power. We can push people around in the currency wars, but they push back. One of the ways to do it is to go outside the dollar system and as, "You've kicked me out of the club. Fine. I'll start my own club. It's a gold club, gold for natural resources. We'll proceed without the dollar payment mechanism."

This is unfolding, as I say, in real time. You'll be reading more about it. But you can see at least where it began, from a strategic point of view, in the first couple of chapters of the book.

The middle part of the book is about four chapters of history. It's really a history of the international monetary system from 1870 to 2010. This is very important. I enjoyed writing it, and a lot of the readers have said, "That was my favorite part of the book." People had different favorites. It was a very important part of the book, in my view, because at the end of the book we get into some more challenging economics—not that daunting; certainly written for a wide audience.

As much as I use models and believe in the value of quantitative modeling—and I do—it has limitations, and if you don't recognize the limitations, you will very quickly over-rely on the models. You'll go off course. This was a big contributor to the excesses in 2006-2007 and the financial panic of 2008, overreliance on these models. So I say, sure, use models, but do so with a lot of humility and understanding of the limitations.

That leaves some stuff fuzzy. You can fill in a lot of the fuzziness with a close reading of history. I thought that was an important part of the overall analysis, to show readers that we had been there before. Again, to anyone who loves and reads history, that rarely comes as much of a surprise.

I talk about two currency wars in the 20th century. Joanne said we may be going into Currency War III. I think we're there. I think we're in it. But that's a fair debate.

I talk about what I call Currency War I and Currency War II. Currency War I runs from 1921 to 1936. Currency War II runs from 1967 to 1987. You'll notice the dating of Currency War I. I'll talk about that for a minute. It overlaps, to a great extent, with the Great Depression, but it's not exactly the same. It's not coterminous. I actually start a lot earlier.

Conventional dating for the Great Depression is 1929 to 1940, starting with our stock market crash and ending with our mobilization for World War II, when government spending got the economy moving again. That's a very American-centric view of the Great Depression. Talk to anyone from England, and they will tell you that England was in a Great Depression throughout the 1920s, that their depression lasted much longer.

So I start in 1921 with the Weimar hyperinflation, a very well-known episode. At some point it gets silly to talk about what the value of a Reichsmark was. It got into the trillions to buy a loaf of bread. But the more interesting point is that at some point it went infinite, which is another way of saying zero. Janitors swept the currency down the sewers at the end of the day. There no longer was an exchange rate. It was litter. It was confetti. It wasn't even any form of money.

What's less well known is that, beginning in 1923, Germany had the strongest-growing major economy in the world. From 1923 to 1928, they had a very strong period of growth, based on a gold-backed currency that they went to. When your paper currency goes to zero, what are you going to do, issue more paper currency? The Bundesbank knew they had to do something.

Germany had a fair amount of gold. They had lost a lot in World War I, but they still had, I think, about 700 tons at the time. They were able to go back to a gold-backed currency, which stabilized prices immediately. It was very much in demand. As I said, their economy grew strongly off a low base throughout the 1920s.

That was Germany's bout with devaluing the currency or cheapening the currency to gain some advantage.

The advantage was interesting, by the way. The reparations from World War I were denominated in gold. So cheapening your currency by itself did not relieve you of the burden of reparations. But what it did do, it was so destructive of the German economy at the time that it engendered a lot of sympathy on the part of the United States and President Coolidge at the time, and the United States was instrumental in getting England and France to ease up a little bit on the reparations payment. So they got some sympathy, even if they didn't get a strict alleviation of the reparations.

The reparations were never repaid, by the way. Hitler came along in 1933 and just tore it up. Then we had World War II and we started over. Those debts were never repaid. Neither were the English and French war debts to the United States.

In 1925, it was France and Belgium's turn. At that point the world went back to the gold standard. I talk a lot in the book about the classical gold standard, from 1870 to 1914, right up to the eve of World War I, which worked very well. It was a period of growth, innovation, technological progress, low inflation throughout the world, on a strict gold-backed standard that was voluntary. You didn't have to do it, but the countries that joined the club, as they put it—and they called it a club—were able to share in this prosperity.

That was suspended in World War I, for obvious reasons. The governments were in an existential crisis. They printed as much as it took to fight the war. It was a kind of borrowing from their own people, if you think of it that way.

So in the 1920s, the countries said, "We want to go back to the gold standard." It was then that Winston Churchill made what he later called the greatest blunder of his life. Considering he planned the Gallipoli invasion, that's a major statement. But Churchill insisted, for what he thought were good reasons, that they should go back to the gold standard at the pre-World War I parity. It was about $20.67 an ounce, expressed in dollars. Churchill felt they were honor-bound, that there was a sacred obligation. They weren't going to deprive the note holders of the real value of that money.

The problem was, they had doubled the paper money supply in the course of World War I. Every gold standard is some relationship between paper money and gold. If you start out here and you double the paper money and you want to go back to the old parity, you have to cut the money supply in half. And that's what they did, which was tremendously deflationary. It severely impaired the UK economy. That's why they were in a depression in the 1920s and didn't catch up to the United States until the 1930s.

The right thing to do in 1925, when this was taking place, would have been to recognize the amount of paper money that had been created and to create a new parity. Perhaps $50 an ounce would have been mildly inflationary, and we might actually have avoided the Great Depression. But that's not what was done, at least not by England and the United States.

France and Belgium did devalue their currencies before they rejoined. They said, "Okay, we're going back into the gold club, but not at the old parity. We're going in at a new rate," where they were greatly devalued.

That devaluation of the French currency—many of you may have seen the Woody Allen movie Midnight in Paris. That golden age of U.S. expatriates—Hemingway and Fitzgerald and Gertrude Stein and others—living in Paris, being able to afford to do so, was because the French devalued their currency against the dollar, so if you had even a modest number of dollars, you could sort of live like a king in Paris.

So the French and Belgians got a discount getting back into the club. By 1931, it was too much for England. There was a global banking panic going on.

The period of the Great Depression—there are probably a thousand books written on it, but I think mine is the first book that discusses the Great Depression and the panic of 1931 through the lens of 2008. Because I had the benefit of writing the last book, with the most recent book on the subject, I can compare the failure of Lehman Brothers and the failure of AIG, and the parallels are striking.

Anyway, England broke with gold in 1931. By 1933, it was the United States' turn. President Roosevelt, on his first day in office in March 1933, issued an executive order seizing all the gold of the American people. You had to hand in your gold to the U.S. Treasury under pain of imprisonment and a fine, which, in today's dollars, would be over $100,000 in fines. If you know anything about criminal law, that's a very stiff fine.

People got paid for it. They got paid $20.67 an ounce. But Roosevelt knew that he was going to revalue it to a new level. So he bought it low. He bought it at $20.67 an ounce. He then proceeded to bid up the price through the Treasury to $35 an ounce, which is a 75 percent increase in the value of gold. Now, here we are in the worst period of sustained deflation in American history, and there's one thing that's going up 75 percent, which is gold.

There's a famous anecdote of FDR lying in bed in his PJs and he brings in Secretary Morgenthau, who was the secretary of the Treasury, and he says, "Henry, what do you think the price of gold should be today?"

He said, "I know. Bid it up 21 cents an ounce, because 7 is my lucky number and 21 is 3 times 7."

The secretary of the Treasury went out into the market and bid up the price of gold 21 cents an ounce that day. They did that in stages, until they got to $35. By this point, England was screaming, because, in effect, when gold goes up, that means the dollar is going down. We were also devaluating against sterling. Once they felt enough pain, Roosevelt called a time out and it stayed at $35 an ounce until 1971.

Finally, in 1936, England and France devalued a second time each. That was the end of that currency war. It led into World War II, which really made all these financial arrangements, the international monetary system, and the debts moot, until the subject was taken up again at Bretton Woods in 1944.

So you had Germany cheapening its currency in 1921, France and Belgium in 1925, England in 1931, the United States in 1933, England and France again in 1936. It's a truism of currency wars that not everybody can devalue against everybody at once, but you can take turns. It's kind of what happened there.

An awful period of growth, and not just growth, but true depression and collapse of industrial production, 20 percent-plus unemployment, as we know.

Currency War II begins in 1967. You will notice that I skipped over Bretton Woods, the Bretton Woods period from 1944 to 1971. There's a reason for that. That was a period of currency peace, and I was writing a book on currency wars. I had no shortage of books on the Bretton Woods period, except that I will add that again we were on the gold standard and again it was a period of low inflation, prosperity, high growth, and expanding trade among nations. It says something, I think, for the power of an anchor, let's say, whether it's gold or something else, in the international monetary system.

But again, we ran into the problem of debt. Here it really started before President Nixon and President Johnson. The roots go back to 1965. It was the combination of the vast expansion of the Vietnam War —the United States had been involved in Vietnam since the 1950s, but it was in 1965 that President Johnson sent massive troop deployments to Vietnam, finally reaching 500,000 troops. War spending caused budget deficits.

But in addition, at the same time in the State of the Union address in January 1965, President Johnson announced the Great Society program of benefits and entitlements of various kinds. This was the famous "guns and butter," guns for Vietnam, butter for the entitlements. It generated the twin deficits, the federal fiscal deficit, as well as a trade deficit with the rest of the world.

Now, in those days, if you ran a trade deficit with, say, the Netherlands or France—because we bought a lot of wine or whatever it might be, German industrial goods, et cetera—they got dollars for those exports to the United States. They could take the dollars and cash them in for gold, and we would have to send them the gold. And we did.

In 1950, the United States had 20,000 tons of gold. By 1970, we had 9,000 tons. Those 11,000 tons—where did it go? It's in Europe. It's actually downtown, at the Federal Reserve Bank of New York. But the title went to Europe. Germany has over 3,000 tons, the Netherlands, about 700 tons, Italy and France, over 2,000 tons each. That's where the gold went—and our trading partners, Japan and the UK.

President Nixon could see it was just a matter of time before Fort Knox would be empty. A lot of people say that's true today. I don't believe it. But we were heading in that direction in 1971. So he closed the gold window. He said, "From now on, you'll take your dollars. You can buy Treasury bills or buy stock, but no more gold for you."

And that was it. There was a series of monetary conferences. We went in stages—first devalued the dollar at a continuing fixed rate and then threw in the towel on fixed rates, went to a world of floating rates. We have been there ever since, with no anchor, no gold standard, no fixed rates, just a world of exchange rates bobbing up and down relative to each other like corks on the sea.

But we did stabilize it again with Paul Volcker and Ronald Reagan. They did not reintroduce the gold standard, although President Reagan did study it. He had a commission to do that. They did not introduce the gold standard, but they solidified the dollar standard.

Their policy was "King Dollar." When Volcker took interest rates to 21 percent, it actually made it worth investing in the United States, because you could get good yields on your investment. President Reagan's tax cuts got the economy moving between 1983 and 1986. In that three-year period, the cumulative growth rate in the United States was 16 percent in real terms. We grew 16 percent in those three years.

I don't know if anyone knows off the top of their head the cumulative growth in the last three and a half years. It's 1.5 percent. It's not zero. It's not negative. We're not shrinking, but our growth is anemic compared to what we got in those days.

So Reagan and Volcker put us on a dollar standard. That worked out fine for a long period of time. It made good growth in the 1980s and 1990s, under Republican and Democratic administrations, until now. The problem now is that we have probably not just used the dollar standard, but abused the dollar standard. In particular, this brings us to Currency War III, which I'll outline briefly and then wrap up and go to questions.

Currency War III began in 2010, with the easy money policies of Ben Bernanke, so-called quantitative easing [QE], quantitative easing 2. They had a second round. I think in the chairman's press conference yesterday, they more or less told us that we're going to have QE3 or something like it, probably later this year. At least that's my expectation.

Quantitative easing sounds complicated. It's not. It's just printing money. The way the Fed does this is, they buy bonds from the market. You sell me the bonds and I give you the money. But the money just comes out of thin air. I just credit your account with an electronic credit entry, and then that's it; you've got the money.

The Fed has increased its balance sheet—i.e., increased the money supply—from $800 billion to $3 trillion in the past three years. So we have printed over $2 trillion of new money.

A lot of critics have said, "You know, that's going to be inflationary. You can't print that much money without inflation getting out of control in the United States." The truth is, we haven't had that much inflation in the United States. We have had some—it seems to be picking up a little bit lately—but not that much. So the defenders of the Fed—Paul Krugman prominent among them—have said, "See? Told you. The dollar is a great tool. You can print money to generate some growth, and you don't have to worry about inflation."

I think Krugman is wrong about that. He should know better. He got his Nobel Prize for some of his work on international monetary economics. There was inflation, but not here. It went to China.

The reason is that China wanted to maintain a peg to the dollar. They actually wanted to go back to something like the old Bretton Woods system. They said here you have the two largest economies in the world. The trade is enormous. The foreign direct investment is enormous. The portfolio investment is enormous. They are the future, whether the United States is losing to China on a relative basis. So what? These are the two giants of the world economy. They don't have a fixed rate, and that gives businesspeople and investors some certainty in terms of the conduct of their business affairs.

But the United States was desperate to cheapen the dollar. The United States wants inflation. You will never hear a Fed chairman say, "I want inflation." You will never hear a secretary of the Treasury say, "I want a cheap dollar." I promise you, they do. They are desperate for that because the dominant economic force in the world today is deflation.

We're in a depression, by the way. A lot of people talk today about the double-dip recession. My view is that we're in a depression. It started in 2007. It will run until 2014, perhaps longer, depending on policy, perhaps a lot longer if the 1930s are a model or Japan over the last 20 years is a model. It is a central bank's worst nightmare.

So the Fed is determined to get inflation. They begin by cutting interest rates, but when you get to zero and you can't cut anymore, you are not out of ammunition. You can create monetary ease and import inflation by cheapening your currency. That's what the Fed is about.

So they set out to break the People's Bank of China. What they did was, they printed the money. How do you maintain the peg? If you are China and these dollars are coming over to China, you have to buy them up by printing your own currency. If you were a Chinese exporter to the United States and you got some dollars, the People's Bank of China said, "You have to give the dollars to us. We'll give you our currency in return so you can meet your payroll and pay your taxes and all that good stuff," which meant that the faster we printed, the faster they printed, and the inflation broke out in China.

Finally, that got to the point where it was possibly destabilizing. I like to say the Chinese are like a—it's like they are driving a Maserati on a country road and there are two guardrails. One guardrail says "Inflation." The other guardrail says "Unemployment." These are their two worst nightmares. I always remind audiences, they are a communist dictatorship. They are not exactly there by the will of the people. China just hit the inflation guardrail and bounced off. The danger today is that they are actually going to go over and hit the unemployment guardrail. But that's a story for another time.

So they panicked because of the inflation. They did allow their currency to go up. But what that means is that these inflationary chickens are now going to come home to roost, come back to the United States.

Interestingly—just to bring the story up to date—once China did that, their trade surplus, their growth, and their inflation cooled off really quickly. I would have said that this might play out over 18 months or two years. It took about six months.

So China is now going to go back to a soft re-peg. They are not going to issue a press release or anything, but they are going to re-peg to the dollar, because they are now not as worried about inflation as they are about growth. That's the unemployment guardrail. Once that happens, that's the green light for QE3—or they are actually going to dress it up and call it "nominal GDP targeting." That just means that we're going to go for nominal growth. We don't really care how much is real, how much is inflation. That will be how the Fed gets to QE3.

But basically it's round three of the currency wars. The Fed won round one. The yuan did go up. But once they re-peg, that's round two, and round three is more money printing by the Fed. This is going to go back and forth.

If that's all there were to it, I'd say, okay, let the bullies push each other around the playground. But I don't think that is all there is to it. I think this is a dynamically unstable process. The Fed likes to think they are playing with the thermostat. If the house is too cold, you dial up the heat. If the house is too warm, you dial it down.

My analysis says that capital markets are a complex, critical-state system, and what they are actually playing with is more like a nuclear reactor. They are moving fuel rods and control rods and neutron generators. They think they are playing with a thermostat. They are playing with something far more dangerous. You can dial up or dial down a nuclear reactor, but if you get it a little bit wrong, you will have a catastrophe. And in my view, what the Fed is doing with the dollar, abusing their privilege, is risking a catastrophe.

Finally, in the last chapter of the book, I talk about these possible outcomes. I want to leave plenty of time for questions, so I don't have time to go into them in a lot of detail, but I'll list them. I call them the "four horsemen of the dollar apocalypse."

The first is fairly benign. This is a world of multiple reserve currencies. In 2000, 70 percent of global reserves were held in U.S. dollars. Today that number is about 60 percent. We have come down 10 percent. Imagine that number continuing to drop until it's maybe 45 or 40. The euro comes up from 25 to 35. The yuan comes in for 5 percent or so. We sort of have this world where nobody's the boss. We all just take each other's currencies and there are plenty of assets and they are all good reserve currencies—sort of a "kumbaya" solution.

I think that the problem with this—and Barry Eichengreen, who is a leading scholar on this point—advocate—points out that this did happen in the 1920s, where the dollar and there sterling shared center stage. The problem is, then we were on the gold standard; today we're not. There's no anchor. I think, instead of one central bank behaving badly, you would have five or six. So I don't see that as a stable solution at all.

The second solution, the one favored by elites—and when I use the word "elites," I'm not talking about deep, dark conspiracies; I'm talking about finance ministers, central bankers, the folks you would bump into if you were on the street in Davos tonight, and a lot of intellectuals—is the SDR, the special drawing right.

Everyone knows that the Fed has a printing press. They can print dollars. The IMF [International Monetary Fund] has a printing press, too. They can print SDRs, hand them out to their members. They are not backed by anything. The next time there's a financial panic—and I expect one sooner than later, sometime in the next few years, at the rate we're going—it will be bigger than the Fed. The Fed will not be able to reliquefy the world, as it did do in 2008. What you will see instead is that the IMF will reliquefy the world with SDRs.

That's coming. It's not guesswork. There's a paper on the IMF website that spells out a ten-year plan to issue SDRs, right down to names of potential buyers, potential sellers of investable assets, dealers, a calendar of issuance per year, and a clearing settlement mechanism. It's not my blueprint; it's the IMF's. You can go look it up. It's mentioned in the book.

The third solution is the gold standard, which is highly stabilizing. I recommend that it be studied. The euro was studied for ten years before the euro actually was issued. Obviously, that probably wasn't long enough. But the point is, you don't go to a gold standard overnight. There are some key issues you have to wrestle with.

One is, if every gold standard is the ratio of paper to gold, how much paper do we count? Is it M0, M1, M2? Is it very different numbers?

The second thing is, what's the gold backing? You talk to the gold bugs, they will say it's 100 percent or nothing, because we can't trust the government. But historically that's not true. England ran a gold standard very successfully in the 19th century, with about 20 percent gold backing for the currency. In the United States historically, when we ran the gold standard, we had about 40 percent gold backing. So if you have enough to stand up to the market, you don't need 100 percent.

Third issue: Who's in the club? Is it just the United States? I think that's unlikely, because we would have the only currency anybody wanted. When you include China and Europe, you get different results. China has four times our money supply, but only one-eighth the gold. We have 8,000 tons; they have 1,000 tons. So you dilute the gold pool when you bring them in.

The point is, depending on how you pick those variables—money supply, backing, and membership—you get very different results for the implied price of gold. They are all in the book. At the low end of the range, $3,000 an ounce; at the high end of the range, if you take M2 with ECB [European Central Bank], China, and the United States, with 100 percent backing—which I don't recommend—if you do that, it comes to $44,000 an ounce. My estimate is $7,000 an ounce. I see that.

To me, that's not some wild guess to get a headline or whatever. It's eighth-grade math. Just look at the amount of paper money and the amount of gold and make some reasonable assumptions, and that's what you get to.

My fourth scenario—I'll finish up in one minute, I promise—is chaos. I actually think this is the most likely because of human nature. I think a combination of denial, wishful thinking, political expediency, short-termism, and a failure to understand the statistical properties of risk in complex systems may lead to this, in which case it's not the end of the world.

You'll see the president—maybe this president or another—on TV using dictatorial powers, which are the law. The International Emergency Economic Powers Act of 1977 gives the president, I think rightly so, dictatorial powers in an economic emergency. He would be able to do a host of things.

I suggest seizing the European gold that's downtown, sending it up the Taconic Parkway to West Point—most of our gold is in West Point, not Fort Knox—freezing the Chinese treasury bonds—not stealing them, but just saying, "Sorry, we'll pay as agreed, but you can't trade them or cash them in"—and closing exchanges until further notice, and then studying the gold standard.

That's how a president would react in the face of a widespread loss of confidence in the dollar.

I don't think any of this is inevitable. I think there are positive paths. I always like to end on a positive note. I give a series of recommendations in the book.

I get accused of—I say, let's get rid of the corporate income tax, let's have a zero capital gains tax, a flat personal tax, less regulation for business, more regulation for banks. Break up the big banks. When I started as a banker, J.P. Morgan was four banks. It was Manny Hanny, Chemical, Chase, and J.P. Morgan. I would like to see it be four banks again. If one of them fails, who cares? And ban derivatives.

I realize I went through that list quickly. I come at that, not from an ideological or political perspective, but from a scientific perspective. If you understand that risk is an exponential function of scale, the easiest way to de-risk a system is to de scale a system, break it into bite-size pieces.

I'll stop there and look forward to your questions. 

Questions and Answers

QUESTION: James Starkman. Thank you for a very interesting discussion.

The WTO, the World Trade Organization, has rules. I would assume that there are rules against currency manipulation. There is a law attempted to be passed in the U.S. Congress branding China as a currency manipulator. Aren't we also a currency manipulator in terms of QE1, 2, and QE18 that seems to be on the way?

JAMES RICKARDS: It's a very good question. I would like to say you took the words right out of my mouth. Look, China does manipulate its currency. I think all major countries do. The greatest currency manipulator in the world is the United States. China actually thought they were doing the right thing.

China made an enormous blunder—what will be seen as a blunder in the future. They actually trusted the United States to pay them back in value. That was a huge mistake. Look at the history of the United States of America. Whether it's Revolutionary War continentals, Civil War greenbacks, the Nixon-Carter inflation, we're very good at inflating our problems away. So what we're going to do to the Chinese is say, "Here's your trillion dollars back. Good luck buying a loaf of bread."

They are far more vulnerable to us than we are to them. This notion that they could dump all their Treasuries and make our interest rates go up—it's just one phone call from the president to the Fed to freeze their accounts in place. They know that, so they won't try that. They're doing other things.

But the short answer is yes. And I've said this all along. Quantitative easing is best understood, not as a response to domestic economic conditions, but as a policy tool to cheapen the dollar. I think that's the simplest way to understand it.

So what I tell clients and investors is, if you want to know when QE3 is coming, watch the cross rates. Watch the U.S./euro cross rate and the U.S. dollar/Chinese currency cross rate. If you see a strong dollar, which is not what the Fed wants, that's the green light for QE3. If the dollar weakens on its own, you might not see more quantitative easing, because the Fed is getting what they want.

But actually, it's sort of a crazy thing, where the Fed wants a weak dollar, but they are not getting it. The dollar has actually been holding its own because of the fear factor in Europe and the flight to quality. That just means more printing.

So I understand quantitative easing as a way to cheapen the dollar when you're at the zero bound. Lars Svensson, who is the deputy governor of the central bank of Sweden, a former colleague of Chairman Bernanke at Princeton, has written a paper on this. It's cited in my book. There is actually very good academic literature on this. It's not just speculation.

QUESTION: Ann Phillips.

A short comment and a question. You spoke about Iran trying to fight back. I read today that what they did was—apparently the Iranians are trying to get rid of their currency, get foreign currency because of the value of the rial—they have doubled their interest rate today to 20-some percent, so that people will put them in savings accounts so that they will earn more money and keep the rial in Iran. Not that I understand all of this.

The libertarian, Ron Paul, is advocating abolishing the Fed, going on a gold standard, and stopping the printing of money. I'm curious, because I don't really understand this terribly well, what you feel the impact of that action would be.

JAMES RICKARDS: Your first point is well-taken. Somewhere in Tehran there is an Iranian Paul Volcker, who kind of gets it.

But you're exactly right. When there's a flight out of Iranian rials and out of the Iranian banking system into the black market, one way to get that money back into the banking system is to raise interest rates—again, very similar to what Paul Volcker did. So it's a good policy response, but it's also proof of what I'm describing—that this has had a very potentially inflationary and destabilizing impact on the Iranian regime.

On your second point about Ron Paul—by the way, a few weeks ago, Ron Paul gave an interview to Time magazine, and the reporter asked him a number of questions. The last question was, "Congressman Paul, what are you reading on the campaign trail?"

He said, "Currency Wars by Jim Rickards."

It was a very kind endorsement from Congressman Paul.

But I think a lot of people bang the table about a gold standard. Then you say, "What do you mean by that?" and they actually don't have a good answer.

The truth is, there is no one, single gold standard. It's a catchall for a lot of different things. It could be simple. It could actually be walking around with gold coins. I don't recommend that. I think that's extremely unlikely. That's a form of barter. I say, "I'll give you a gold coin and"—it's probably a year's worth of groceries instead of a week's worth of groceries. I don't think that's—although Utah and some states are trying to move in that direction.

But what Ron Paul wants to do is get rid of the central bank and let private banks issue their own notes. That's the way it was in this country. If you were a citizen in 1880—the United States did not have a central bank from 1835 to 1913. During the period, post-Civil War, of great prosperity, there was no central bank. If you wanted paper money, you might have had a note from Citibank. It was called the National Bank of New York. You walked around with their note. They had gold downstairs and you could take it in and get gold.

So what Ron Paul is advocating is a return to private banking, not government-sponsored banking, and a gold standard where the banks literally have gold in their vaults, and if you want to cash in for gold, you can do that.

I don't necessarily agree with that. I don't mind the idea of a U.S. dollar. But I would like the gold standard to be studied.

That's not my first choice. My first choice is King Dollar. I kind of like the Volcker-Reagan policy.

But I do think the gold standard should be studied. The issues are the ones I mentioned: What's the ratio? What's the definition of money? Who's in the club and who's not in the club? Perhaps that's something we can get—I think if we keep going the way we're going, we'll end up on a gold standard, not by choice, but by necessity, because there will be a loss of confidence in the paper dollar and there will be a gold standard as a last resort.

The other thing to bear in mind is that the biggest economic problem in the world today—actually, it's debt, but debt leads to deflation. When governments run out of ways to fight deflation—they cut rates to zero, then they try to cheapen against the euro and they cheapen against the Chinese yuan, and everybody fights back. That's what the currency wars are. But when that gets you nowhere, there's one form of money that everyone can cheapen against at once, and that's gold. The best-performing stock on the New York Stock Exchange in the 1930s was Homestake Mining, which is a gold company.

A lot of people think the Fed tries to suppress the price of gold. The Fed might be the one that actually takes gold up to $5,000 an ounce, because then what you would have is inflation across the board. The world of $5,000 gold is the world of $300 oil and $100 silver and all the other commodity prices. It sounds bad, when you're in a liquidity/deflation trap, governments think a little inflation is a good thing, and that's how they get it.

So I don't recommend necessarily abolishing the Fed, but I would like to take away their discretionary monetary policy, go back to some kind of anchor, maybe use gold as a reference rather than a hard and fast conversion mechanism. What I would actually like to see is the next president or President Obama, if he's reelected, appoint a bipartisan commission of members of Congress and scholars to study this and make some recommendations.

QUESTION: I'm Randy Smith, from Capital Counsel.

Your statement that the Fed and the Treasury are interested in a lower dollar is—what would you take as the context of the expanded swap line that the Fed has opened up with the ECB in the midst of their travails right now, giving them access to as much as $600 billion worth of dollars?

JAMES RICKARDS: I happen to be a lawyer, in addition to an economist. I would say that would be exhibit A for my point, in the following sense.

I've been saying since last summer that the euro is strong and getting stronger. I think I was a party of one on that. I like to say that everyone is on one side of the boat and I'm on the other side, and the boat is tipping like this. Little by little, people have been coming over to my side of the boat.

Hedge funds have lost a lot of money shorting the euro. If I had taken you back to January 2011 and said, "Okay, I'm going to give you a year's worth of headlines"—euro falling apart, Greece will be kicked out of the euro. They printed up the drachmas. They are sitting in a warehouse near Piraeus. They're ready to come back.

If you asked, where do you think the euro will be in January 2012? I think a lot of people would have said $1.20, maybe parity. In fact, it's right where it was. It's about $1.30. There has been some volatility between $1.25 and $1.40, but it's pretty much right where it was.

There's a reason for that. If the United States wants to cheapen its currency and China at least wants to keep a lid on its currency, even if it can't cheapen—the problem with currency is, where somebody has to get stronger, you can't all cheapen at once. If the United States is cheapening and China is holding its own, the euro must get stronger or maintain its strength, which is what the United States wants.

Therefore, when the euro was in the greatest jeopardy a few months ago, the purpose of the swap lines was to prop up the euro. The euro came very close to a complete financial collapse a few months ago. We stopped that. Part of the motivation, apart from contagion, was to maintain a strong euro, and therefore a weak dollar.

QUESTIONER: But the market for the yuan, the forex [foreign exchange] market for the yuan, is too thin, and the Chinese, like the Japanese, have an obsession in retaining control over the cross rates for their currency.


QUESTIONER: So isn't it fair to say that the currency union that's really working is the U.S.-China currency union?

JAMES RICKARDS: No, I disagree with that. I think the U.S.-China currency union is actually pretty dysfunctional right now.

You're right, China has a closed capital account. They maintain very strict control of the relationship with the dollar. But, as I described, the Fed made them cry "uncle." The Fed forced them to revalue the yuan upward by printing so many dollars that inflation began to break out in China. I think the Chinese will now re-peg, and that will be round two or round three.

By the way, the Chinese—you're right, they don't want an open capital account, and the pool of investable assets in yuan is very thin. That's the difference, I'm sure you know, between a trade currency and a reserve currency. For a trade currency, I can use bottle caps or baseball cards. It just means we keep a bilateral score and we settle up once a year. But for a reserve currency, you need stuff to invest in, because it's a form of savings. You need a deep liquid bond market, which the Chinese don't have.

QUESTIONER: [Not at microphone]

JAMES RICKARDS: Correct, an art market, where they are neither deep nor liquid, but they're interesting. It's a way for the Chinese to invest.

By the way, one of the untold stories, not well-advertised stories—there's a lot of flight capital coming out of China right now. I was down in Melbourne, Australia, as part of the book tour. One of my colleagues came to me and said there was a Shanghai beer billionaire, the Busch family of Shanghai.

This person flew to Sydney, got a driver, went out and looked at a vineyard, snapped his fingers, bought it just like that for $30 million, and flew back to Shanghai. The richest people in China are getting the money out one way or the other, because they understand the vulnerabilities over there.

But China will seek reserve currency status without opening their capital account through the back door by becoming part of the SDR basket. Right now they are zero percentage of the SDR. But the IMF executive board has the ability to change the components from time to time, and they will.

Part of the way we're going to diminish and devalue the dollar in world economic affairs is to reduce the dollar component of the SDR, and increase the Chinese yuan component. Multinational corporations, oil pricing, settlement of balance of payments, the things that really matter in the international monetary system, in this vision, will be conducted in SDRs, and it would be a liquid deep market in SDR-denominated bonds, led by the IMF, which is leveraging its balance sheet for the first time in history. But you would dial up the yuan component, so the yuan would play a bigger role, without an open capital account.

By the way, the United States has committed a $100 billion line of credit to the IMF. This was slipped in by Barney Frank in the Defense appropriation bill in 2009. If the executive committee of the IMF calls up the Treasury and says, "We'd like to take down $100 billion," the Treasury is committed to that. That loan facility is already in place.

What's interesting about that—when the IMF takes $100 billion from the Treasury, they give them a note. The note is not denominated in dollars. It's denominated in SDRs. It has maturity, but there's no fixed rate for the maturity.

So at the end, when the note matures, the IMF pays back the amount of dollars based on the dollar-SDR exchange rate at the time, not a fixed rate, which means that the Treasury is shorting the dollar, because since the dollar is not 100 percent of the SDR, the weaker the dollar gets, the more dollars you are going to get back to make up a fixed amount of SDR. So we have the spectacle of the United States Treasury shorting its own currency.

QUESTION: I'm Brian Cohen.

I'm interested to hear your perspective on the theory that China has a different focus as far as, where the West and the United States is focused on currency wars, China is using it as part of their strategy to focus on a resource war and accumulate as many resources as they can right now under the status quo, with the long-term perspective that, to keep their people under control, it's not unemployment; it's more having the resources for their population, and under the status quo, they can accumulate half of the world's resources in steel and coal, et cetera, as well as increase their gold holdings.

Then eventually, when the dollar weakens, when the dollar loses its reserve status, China's currency will be that much stronger to buy resources more cheaply in the future.

JAMES RICKARDS: The natural resource play and the dollar play are very closely linked. I'm going to answer the question without addressing the expanded strategic version that you laid out. I will say it's absolutely the case that China is trying to get out of dollars, into hard assets of various kinds.

This actually does not involve dumping the Treasury bills that they have. Remember, they are still running trade surpluses. They can keep what they have, but when the incremental money comes in, when the new money comes in, instead of buying more Treasury bills, they can diversify their portfolio.

By the way, another reason I expect the euro to get stronger—I mentioned the fact that the United States wants a cheap dollar. We have ways of getting what we want. The swap lines are our leverage on Europe to make sure that they maintain a strong currency.

But beyond that, China will come in and engage in an enormous amount of direct foreign investment in Europe and buy the European sovereign bonds. They don't want to be the suckers. They don't want to do that at the first sign of trouble. But once they see Europe get its act together, which they are—I have a lot of confidence in this new European treaty. By the way, I think Angela Merkel is the only head of state who really understands all this. I think it's because she's a scientist, not an economist. I'm serious. I think she understands the scientific foundations for what we're talking about.

But as that progresses, the Chinese will be more and more willing to invest in Europe. They are going to get a lot of stuff they have wanted for a long time, but were denied—critical infrastructure, ports, airports, roads, railroads, other forms of infrastructure, defense technology, computer technology—because the Europeans need the money. So this is a way for Europe to refloat its economy, for China to diversify away from dollars, into euros.

But beyond that, the hard-asset play is absolutely critical. China has gone from back in the pack to being the number-one gold-producing country in the world in the last four years. They produce over 300 tons a year, all of which stays in China, some of which goes on sale to satisfy domestic demand. But the rest of it goes in the central bank, very nontransparently. You can infer some of this, but it's kind of hard to know exactly what they have.

The other thing the Chinese did was, they acquired 500 tons of gold covertly using their military and intelligence assets. Prior to 2009, they officially had 500 tons of gold. In 2009, they announced that they had acquired over 500 tons of gold. The new number is 1,054 tons. They didn't buy the 500 tons overnight. They bought it over four years. They just didn't tell anybody and they kind of kept it off the books and then booked it in the central bank.

So they are proceeding to buy more gold, mine more gold, get all the gold they can, buy gold assets in Africa.

One of the things they do, by the way, is, they buy mines and they do royalty agreements, where your return on your investment is the actual output, not a check. So they'll ship the dorés, 90 percent gold, or even forms of ore to China for refinement and conversion to .9999 pure gold. But what that does is, it bypasses the London market. So it's not only nontransparent but mitigates the price impact.

So they're going for gold and natural resources in a big way. You don't have to speculate that there's an endgame to defeat the United States. It's sufficient to say that they are doing everything they can to diversify into hard assets.

JOANNE MYERS: I want to thank you for enriching us about currency wars. Thank you very much.

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