Chaos

Perhaps the most likely outcome of the currency wars and the debasement of the dollar is a chaotic, catastrophic collapse of investor confidence resulting in emergency measures by governments to maintain some semblance of a functioning system of money, trade and investment. This would not be anyone’s intention or plan; rather it would simply happen like an avalanche brought about by the layering of one last financial snowflake on an unstable mountainside of debt.

The instability of the financial system in recent years has been dialed up through the greatly increased diversity and interconnectedness of market participants. Embedded risk has been exponentially increased through the vastly expanded scale of notional derivatives contracts and leverage in the too-big-to-fail banks. The exact array of critical thresholds of all market participants is unknowable, but the overall system is certainly closer to criticality than ever before for reasons already discussed in detail. All that is required to initiate a collapse is a suitable catalyst relative to the lowest critical thresholds. This does not have to be a momentous event. Recall that both small and large fires are caused by the same-sized bolt of lightning, and what makes for conflagrations is not the lightning but the state of the world.

The catalyst might be noteworthy in its own right, yet the link between catalyst and collapse may not immediately be apparent. Following is one scenario for the catenation of collapse.

The triggering event happens at the start of the trading day in Europe. A Spanish government bond auction fails unexpectedly and Spain is briefly unable to roll over some maturing debt despite promises from the European Central Bank and China to support the Spanish bond market. A rescue package is quickly assembled by France and Germany, but the blow to confidence is severe. On the same day an obscure but systemically important French primary bond dealer files for bankruptcy. Normally trouble in Europe is good for the dollar, but now both the dollar and the euro come under siege.

The double-barreled bad news from Spain and France is enough to cause a few Dutch pension fund dollar stalwarts to change their minds in favor of gold. Although not usually active in the to-and-fro of dollar trading, the Dutch push the dollar “sell” button and some snowflakes start to slide. In Geneva, another dollar-critical threshold is crossed at a hedge fund, and that fund pushes the “sell” button too. Now the slide is noticeable; now the avalanche has begun.

The dollar quickly moves outside its previous trading range and begins to hit new lows relative to the leading indices. Traders with preassigned stop- loss limits are forced to sell as those limits are hit, and this stop-loss trading just adds to the general momentum forcing the dollar down. As losses accumulate, hedge funds caught on the wrong side of the market begin to sell

U.S. stocks to raise cash to cover margin calls. Gold, silver, platinum and oil all begin to surge upward. Brazilian, Australian and Chinese stocks start to look like safe havens.

As bank and hedge fund traders perceive that a generalized dollar collapse has begun, another thought occurs to them. If an underlying security is priced in dollars and the dollar is collapsing, then the value of that security is collapsing too. At this point, stress in the foreign exchange markets immediately transfers to the dollar-based stock, bond and derivatives markets in the same way that an earthquake morphs into a tsunami. The process is no longer rational, no longer considered. There is no more time. Shouts of “Sell everything!” are heard across trading floors. Markets in the dollar and dollar- based securities collapse indiscriminately while markets in commodities and non-U.S. stocks begin to spike. Dumping of dollar-denominated bonds is causing interest rates to surge as well. This has all happened before high noon in London.

New York traders, bankers and regulators are disturbed in their sleep by frantic calls from European colleagues and counterparts. They all awake to the same sea of red and rush to get to work. The usually sleepy 6:00 a.m. suburban commuter train is standing room only; the normal “no cell phone” etiquette is abandoned. The train looks like a trading floor on wheels, which it now is. By the time the bankers arrive in midtown Manhattan and Wall Street, the dollar index has dropped 20 percent and stock futures are down 1,000 points. Gold is up $200 per ounce as investors scramble to a safe haven to preserve wealth. The contrarians and bottom-feeders are nowhere in sight; they refuse to jump in front of a runaway train. Some securities have stopped trading because there are no bids at any price. The dollar panic is now in full swing.

Certain markets, notably stock exchanges, have automatic timeouts when losses exceed a certain amount. Other markets, such as futures exchanges, give officials extraordinary powers to deal with disorderly declines, including margin increases or position limits. These rules do not automatically apply in currencies or physical gold. In order to stop a panic, central banks and governments must intervene directly to fight back the waves of private selling. In the panic situation just described, massive coordinated buying of dollars and U.S. government bonds by central banks is the first line of defense.

The Fed, the ECB and the Bank of Japan quickly organize a conference call for 10:00 a.m. New York time to discuss coordinated buying of the U.S. dollar and U.S. Treasury debt. Before the call, the central bankers consult with their finance ministries and the U.S. Treasury to get the needed approvals and parameters. The official buying campaign begins at 2:00 p.m. New York time, at which point the Fed floods the major bank trading desks with “buy” orders on the dollar and U.S. Treasuries and “sell” orders on euros, yen, sterling, Canadian dollars and Swiss francs. Before the buying begins, Fed officials leak a story to their favorite reporters that the central banks will do “whatever it takes” to support the dollar and the Fed source specifically uses the phrase “no limits” in describing the central banks’ buying power. The leaks soon hit the newswires and are seen on every trading floor around the world.

Historically, private market players begin to back off when governments intervene against them. Private investors have fewer resources than governments and are informed by the timeless admonition “Don’t fight the Fed.” At this point in most panics, traders are happy to close out their winning positions, take profits and go home. The central banks can then mop up the mess at taxpayer expense while traders live to fight another day. The panic soon runs its course.

This time, however, it’s different. Bond buying by the Fed is seen as adding fuel to the fire because the Fed prints money when it buys bonds— exactly what the market was troubled by in the first place. Moreover, the Fed has printed so much money and bought so many bonds before the panic that, for the first time, the market questions the Fed’s staying power. For once, the selling power of the panic outweighs the buying power of the Fed. Sellers don’t fear the Fed and they “hit the bid,” leaving the Fed holding a larger and larger bag of bonds. The sellers immediately dump their dollar proceeds from the bond sales and buy Canadian, Australian, Swiss and Korean currencies in addition to Asian stocks. The dollar collapse continues and U.S. interest rates spike higher. By the end of day one, the Fed is no longer spraying water on the fire—it is spraying gasoline.

Day two begins in Asia and there is no relief in sight. Even stock markets in the countries with supposedly stronger currencies, such as Australia and China, start to crash, because investors need to sell winning positions to make up for losses, and because other investors have now lost confidence in all stocks, bonds and government debt. The scramble for gold, silver, oil and farmland becomes a buying panic to match the selling panic on the side of paper assets. The price of gold has now doubled overnight. One by one officials close the Asian and European stock exchanges to give markets a chance to cool down and to give investors time to reconsider valuations. But the effect is the opposite of the one intended. Investors conclude that exchanges may never reopen and that their stock holdings have effectively been converted into illiquid private equity. Certain banks close their doors and some large hedge funds suspend redemptions. Many accounts cannot meet margin calls and are closed out by their brokers, but this merely shifts the bad assets to the brokers’ accounts and some now face their own insolvencies. As the panic courses through Europe for the second day, all eyes slowly turn to the White House. A dollar collapse is tantamount to a loss of faith in the United States itself. The Fed and the Treasury have been overwhelmed and now only the president of the United States can restore confidence.

Military jargon is peppered with expressions like “nuclear option” and “doomsday machine” and other similar expressions used both literally and figuratively. In international finance, the president has a little-known nuclear option of immense power. This option is called the International Emergency Economic Powers Act of 1977, known as IEEPA, passed during the Carter administration as an updated version of the 1917 Trading with the Enemy Act. President Franklin Roosevelt had used the Trading with the Enemy Act to close banks and confiscate gold in 1933. Now a new president, faced with a crisis of comparable magnitude, would use the new version of that statute to take equally extreme measures.

The use of IEEPA is subject to two preconditions. There must be a threat to the national security or the economy of the United States, and the threat must originate from abroad. There is some after-the-fact notification to Congress, but in general the president possesses near dictatorial powers to respond to a national emergency. The circumstances now unfolding meet the conditions of IEEPA. The president meets with his economic and national security advisers and speechwriters to prepare the most dramatic economic address since the Nixon Shock of 1971. At 6:00 p.m. New York time on day two of the global dollar panic, the president gives a live address to an anxious world audience and issues an executive order consisting of the following actions, all effective immediately:

• The president will appoint a bipartisan commission consisting of seasoned veterans of capital markets and “eminent economists” to study the panic and make suitable recommendations for reform within thirty
• All private and foreign-owned gold held in custody at the Federal Reserve Bank of New York or depositories such as the HSBC and Scotiabank vaults in New York will be converted to the ownership of the U.S. Treasury and transferred to the U.S. gold depository at West Point. Former owners will receive suitable compensation, to be determined at a later
• All transfers of foreign holdings of U.S. Treasury obligations held in electronic book entry form in the system maintained by the Federal Reserve will be suspended immediately. Holders will receive interest and principal as agreed but no sales or transfers will be
• All financial institutions will record U.S. Treasury obligations on their books at par value and such securities will be held to
• Financial institutions and the Federal Reserve will coordinate efforts to purchase all new issuance of U.S. Treasury obligations in order to continue the smooth financing of U.S. deficits and the refinancing or redemption of any outstanding
• Stock exchanges will close immediately and remain closed until further
• All exports of gold from the United States are

This interim plan would stop the immediate crash in the Treasury bond market by freezing most holders in place and mandating future purchases by the banks. It would not offer a permanent solution and would at most buy a few weeks’ time within which to develop more lasting solutions.

At this point policy makers would recognize that the paper dollar as currently understood had outlived its usefulness. Its claim to be a store of value had collapsed due to a total lack of trust and confidence, and as a result its other functions as a medium of exchange and unit of account have evaporated. A new currency is now required. More of the same would be unacceptable; therefore, the new currency would certainly have to be gold backed.

Now the hidden strength of the U.S. financial position would be revealed. By confiscating foreign official and most private gold on U.S. soil, the Treasury would now possess over seventeen thousand tons of gold, equal to 57 percent of all official gold reserves in the world. This would put the United States in about the same relative position it held in 1945 just after Bretton Woods, when it controlled 63 percent of all official gold. Such a hoard would enable the United States to do what it did at Bretton Woods— dictate the shape of the new global financial system.

The United States could declare the issuance of a “New United States Dollar” equal to ten old dollars. The new dollar would be convertible into gold at the price of one thousand new dollars per ounce—equal to $10,000 per ounce under the old dollar system. This would represent an 85 percent devaluation of the dollar when measured against the market price of gold in April 2011, and would be slightly greater than the 70 percent devaluation against gold engineered by FDR in 1933, but not a different order of magnitude. It would be far less than the 95 percent dollar devaluation measured in gold that occurred under Nixon, Ford and Carter from 1971 to 1980.

Because of its gold backing, the New United States Dollar would be the only desirable currency in the world—the ultimate victor in the currency wars. The Fed would be ordered to conduct open market operations to maintain the new price of gold as described under the flexible gold exchange standard above. A windfall profits tax of 90 percent would be imposed on all private gains from the upward revaluation of gold. The United States would then pledge generous concessionary loans and grants to Europe and China to provide liquidity to facilitate world trade, much as it had done under the Marshall Plan. Gradually, those parties whose gold had been confiscated, mostly European countries, would be allowed to buy back their gold at the new, higher price. There is little doubt that they would choose to store it in Europe in the future.

Confidence would slowly be restored, markets would reopen, new prices for goods and services would be discovered and life would continue with a New King Dollar at the center of the financial universe.

Or not. This scenario of chaos followed swiftly by the ascent of a new gold-backed dollar emerging phoenixlike from the ashes is only one possibility. Other possible scenarios would include an unstoppable financial collapse followed by the widespread breakdown of civil order and eventually a collapse of the physical infrastructure. These scenarios are familiar from popular films and novels, like Cormac McCarthy’s The Road. The stories typically involve a post-apocalyptic survival tale in the wake of devastation caused by shooting wars, natural disasters or alien invaders. In principle, the destruction of wealth, savings, trust and confidence in the aftermath of a currency war and dollar collapse might be no less catastrophic than a hostile alien invasion. A person’s net worth would consist of those things she can carry on her back.

Another possible response to a dollar collapse would be government intervention of a type that is far more extreme and coercive than the executive action permitted by IEEPA and described above. Such coercion would more likely occur in Asia or Russia and may involve wholesale nationalization of capital stock and intellectual property, closed borders and redirection of productive capacity to domestic needs rather than export. The world would retreat into a set of semiautarkic zones and world trade would collapse. The result would be the opposite of globalization. It would be the Beijing Consensus without the free riding—there would be no one left to ride.

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