In my 2011 book, Currency Wars, I gave a detailed description of the first-ever financial war game sponsored by the Department of Defense.
This financial war game took place in 2009 at the top-secret Applied Physics Laboratory located about twenty miles north of Washington, D.C. in the Maryland countryside.
Unlike typical war games, the “rules of engagement” for this financial exercise did not permit the use of any kinetic weapons such as bombs, missiles or drones.
The only weapons allowed were financial instrument including stocks, bonds, currencies, commodities and derivatives.
The contestants included about 40 players on the six teams and another 60 participants including uniformed military, civilian defense officials and observers from the Treasury, Federal Reserve, CIA and other government agencies as well as think tanks, universities and financial industry professionals.
In that original financial war game, a scenario involving Russia, China, gold and the destruction of the U.S. dollar was played out against a backdrop of geopolitical events including the collapse of North Korea and a threatened Chinese invasion of Taiwan.
On May 8, 2015, the Pentagon sponsored a new financial warfare session, which I was also invited to attend. This time the financial war took place inside a secure meeting facility at the Pentagon itself.
This new financial war game exercise was smaller and more focused than the one in 2009. I was one of three individuals from the investment management community. Our scenario this time was not global, but was limited to a confrontation between China and the U.S. in the South China Sea.
Our role was not to contemplate the use of aircraft carriers, submarines or missiles in such a confrontation. We were there to consider the use of financial weapons such as disruption of payments systems, cyber-attacks on banks and stock exchanges, and trade sanctions that could cut off supply chains and dry up energy imports.
One of the main topics of discussion was the use of sanctions involving access to the Society of Worldwide Interbank Financial Telecommunication, known as SWIFT.
Contrary to the assumptions of many, SWIFT is not a bank or a financial institution itself. It is more like a phone company or internet service provider that facilitates communication among its members.
SWIFT has over 10,500 banks and asset managers as members and handles over 5 billion messages each year amounting to trillions of dollars of payments from one member to another.
SWIFT message traffic is literally the oxygen supply that keeps the global financial system alive.
In 2012, the U.S. and its allies were successful in kicking Iranian banks out of the SWIFT system.
This was extremely damaging to the Iranian economy and led to hyperinflation, bank runs, instability and social unrest until President Obama eased these sanctions in late 2013.
The U.S. Senate has more recently called for the use of SWIFT-related sanctions against Russia. In response, Russia has said that it would regard an effort to ban access to SWIFT as an act of war.
In our new financial war game, we asked; what would happen if the roles were reversed?
What if financial weapons developed by the U.S. were adopted by China and turned against the U.S. and its allies?
These and other interesting scenarios made for a long and lively day of discussions among our team of experts convened for this exercise in twenty-first century warfare.
I learned two lessons that day.
The first is that when nations engage in financial warfare, individual investors can be collateral damage. If China tries to attack the U.S. by closing the New York Stock Exchange, it will be tens of millions of Americans who will suffer an immediate loss of wealth as prices plunge and accounts are locked-down or frozen.
The second lesson was that the future wars will be fought in cyber-space using digital technology applied to payments systems such as SWIFT, FedWire, MasterCard, Visa and Europe’s Target2 system.
The answer to both threats — collateral damage and digital warfare — is to have some hard assets in physical form that cannot be attacked digitally. Such assets include cash and physical gold and silver, among others. These are the things that cannot be erased in a digital attack or frozen when payments systems are disrupted.
That’s why I recommend you keep some cash in a safe place outside the banking system. I’m talking paper money now. Having some cash is like having a battery and flashlights. I live in a place that occasionally gets hurricanes and nasty storms, so the power goes out on occasion. You want to keep some flashlight batteries around. And that means cash.
Remember, when the power’s out, nothing works. The ATMs don’t work. The gas stations don’t work, etc. It’s good to have some what we used to call in Philadelphia “walking around money.” But you can’t withdraw too much from your bank because the government won’t let you.
Try withdrawing $20,000 in cash from your bank and you’ll be reported to the government on a currency transaction report. That report will be put in a file right next to Al-Qaeda and the drug cartels, with the Financial Crimes Enforcement Network.
The point is, you might think you can get your cash, but you can’t. When you go down to the bank and actually try to, you’ll be treated like a criminal. This is of course part of the war on cash. The American people are being led like sheep to the slaughter. They’re being herded into digital pens, which are the banks.
Most people think we have a cash system. But we really don’t. How much cash do you carry in your purse and wallet? Probably not that much. You use your debit card. You use autopay. You use your online banking account. You use your iPhone if you have Apple Pay. You use your credit card. It’s all digital.
You don’t actually have that much cash, and if you try to get it, you won’t be able to get it.
That’s why I also recommend you put some money into physical gold or silver, in a monster box. A monster box has 500 ounces of American silver eagles, one ounce each. They cost about $10,000 on the market. You should find a good dealer that doesn’t charge too much commission.
But it’ll preserve your wealth. In an emergency situation, people will take it. Many people will gladly give you some groceries for a solid ounce of silver because no one trusts any other money.
I also recommend real estate as part of your portfolio. It’ll still be there if there’s a storm or a power outage or your bank’s shut down.
These are some of the things I recommend before the next great crisis strikes. They are important ways to preserve your wealth in the years ahead.
One of the most famous passages in American literature occurs in Chapter 13 of Ernest Hemingway’s The Sun Also Rises. It takes place in a café in Pamplona, Spain during the running of the bulls.
Bill Gorton, a friend of the protagonist, Jake Barnes, has just arrived from New York. Bill is in the café talking with Mike Campbell, an upper-crust Englishman, now fallen on hard times but keeping up appearances.
In the course of telling a story about his tailor, Mike casually mentions his bankruptcy. Here’s the dialogue:
“How did you go bankrupt?” Bill asked.
“Two ways,” Mike said. “Gradually and then suddenly.”
“What brought it on?”
“Friends,” said Mike. “I had a lot of friends. False friends. Then I had creditors, too. Probably had more creditors than anybody in England.”
Mike admits to his own helplessness; his descent into bankruptcy was apparently totally beyond his control. This reflects upon his lack of control with regards not only to his business matters, but to his life in general.
You’ve probably seen variations of the part of the passage that says, “Gradually and then suddenly.” It’s often paraphrased or misquoted as, “slowly at first, and then quickly.”
The short version of the quote is offered as a warning that a slow, steady accumulation of debt with no particular plan for repayment can continue longer than expected, and then suddenly descend into a full-blown financial distress scenario and a rapid end-state of collapse.
Ernest Hemingway was not only a Nobel-Prize winning author, but was an astute observer of human nature and a fine armchair economist. His description of going bankrupt in Chapter 13 of The Sun Also Rises is a pitch-perfect narrative of how the United States is now barreling toward a crisis of confidence in the dollar.
I selected the longer version to give the short quote some context. The debtor, Mike, didn’t just go bankrupt. He had a lot of “friends” who relied on him for his generosity and support, with no willingness to pay him back or help him in distress.
He also had a general “lack of control” with regard to his financial situation. Most debtors can see problems coming and either cut back spending or take other steps to deal with the debt. Either course will bring the situation to a head sooner than later.
It’s the lack of control that allows the debtor to reach the point of non-sustainable debt, the “gradually” part, and then have a crisis thrust on him all at once, the “suddenly” part. This is how the inevitable becomes a surprise.
Sound familiar? It should. This is exactly the situation in which the U.S. now finds itself. The U.S. national debt has been accumulating slowly for decades. There is no plan to make it sustainable; just a vague wish that the creditors will keep expanding the debt or rolling it over.
The U.S. has a lot of “friends,” both at home and abroad, who expect benefits whether in the form of entitlements, foreign aid, government contracts, or tax breaks. Clearly the U.S. Congress and White House each exhibit a complete lack of control. The café scene is complete.
The question is whether the U.S. is now at the point of “suddenly” going bankrupt. Of course, the U.S. won’t actually go bankrupt. It can print all the money it needs to pay off its debts in nominal terms. The issue then is a matter of when that kind of money printing becomes necessary, and under what conditions.
The dynamic of “gradually, and then suddenly” is well-known to physicists and applied mathematicians. In physics, it is known as a phase transition. A good example is a pot of water being boiled and then turning to steam. The flame can be applied to the pot for quite a while and absolutely nothing happens to the naked eye. Of course, the temperature is rising, but hot water looks just like cold water.
Suddenly the surface of the water becomes turbulent and quickly after that the bubbly surface bursts into steam. The water has been transformed. If nothing is done, the entire pot will evaporate.
In mathematics, the same dynamics are known as hypersynchronicity. That’s a fancy word for a lot of people suddenly all doing the same thing at the same time. A run on the bank is a perfect example...
All financial crises are the same and different at the same time.
They are the same when it comes to the dynamics of contagion, illiquidity, bank failures and the high-panic state in which everyone in the world wants his money back at the same time.
Yet each crisis is different in its specific causes.
The 1994 Tequila Crisis was caused by Mexico’s inability to roll over short-term unsecured debts. The 1998 Russia-LTCM crisis started in 1997 with Thailand devaluing its currency. That panic spread around the world through Indonesia, South Korea, Malaysia and Russia before finally landing in Greenwich, Connecticut, home of Long-Term Capital Management.
Wall Street, and Lehman Brothers in particular, would have been the next victims if LTCM had not been rescued by the same banks with the most to lose. Of course, the 2008 panic had its roots in subprime mortgages, but quickly spread to debt obligations of all kinds, especially money market funds and European bank commercial paper.
But what about the next crisis?
According to one recent Bloomberg article, the next crisis will begin in the private bank debt market.
The specific culprit is a kind of debt called “contingent convertible” debt, or “CoCos.” These bonds start out like ordinary debt, but a bank in distress could convert them to equity to improve its capital ratios.
The problem is that bondholders know this and start dumping the bonds before the bank can pull the trigger on the conversion clause. This can cause a run on the bank and trigger cross default clauses in other bonds. Far from adding safety to bank capital structures, CoCos can make banks more unstable by igniting panics.
This is just one more example of capital market complexity, and it signals the fact that the next crisis will be worse than the last.
The bottom line is that today, systemic risk is more dangerous than ever. Each crisis is bigger than the one before. Too-big-to-fail banks are bigger than ever, have a larger percentage of the total assets of the banking system and have much larger derivatives books.
New automated trading algorithms like high-frequency trading techniques used in stock markets could add to liquidity in normal times, but the liquidity could disappear instantly in times of market stress. And when the catalyst is triggered and panic commences, impersonal dynamics take on a life of their own.
These kinds of sudden, unexpected crashes that seem to emerge from nowhere are entirely consistent with the predictions of complexity theory.
In complex dynamic systems such as capital markets, risk is an exponential function of system scale. Increasing market scale correlates with exponentially larger market collapses. This means that the larger size of the system implies a future global liquidity crisis and market panic far larger than the Panic of 2008.
The ability of central banks to deal with a new crisis is highly constrained by low interest rates and bloated balance sheets, which despite some movement in that direction still have not been normalized since the last crisis.
For now, it’s not clear which way things will break next. Markets are still in a precarious position and volatility is high. Regardless of which direction markets go from here, we cannot escape the risks hidden linkages pose to modern capital markets.
We’ve already had a correction this year. But the next correction could turn into a 30% or 40% crash.
The conditions are in place. But you can’t wait for the shock to occur because by then it will be too late. You won’t be able to get your money out of the market in time because it’ll be a mad rush to the exits.
I recommend you reduce your exposure to the stock market and move into cash, gold, Treasuries, land and fine art.
You might possibly miss out on some stock market gains, but you won’t have to worry about losing everything when the crash comes.
There are four major factors driving the market. The factors are growth, trade wars, geopolitics and regulation of technology.
Each of the four factors has its own internal contradictions, in effect a binary outcome for each. This means there are 16 possible paths the market might follow (24 = 16). No wonder the market acts confused.
With regard to growth, the bulls expect a boost from the Trump tax cuts. They are also anticipating inflation due to strong job creation, rising labor force participation and a low unemployment rate. They expect interest rates to rise but consider this more a sign of economic strength than a cause for concern.
Strong growth is good for corporate earnings, and a little inflation is usually good for nominal stock prices, at least in the early stages. The bull case for growth is a curious mixture of the Phillips curve and the Laffer curve.
Bears point to an economic slowdown in the first quarter (most projections are around 2% or less). This is consistent with the dismal average of 2.1% growth since the end of the last recession in June 2009.
Stronger growth is impeded by demographic and debt head winds and the impact of Chinese labor and technology on global pricing power. Tax cuts are not expected to help, because the drag on growth caused by increased debt will outweigh any stimulus from lower taxes.
The Fed is giving a weak economy a double dose of tightening in the form of rate hikes and the unprecedented destruction of base money as they unwind QE. The Fed will probably push the economy to the brink of recession before they get the message and pause on rate hikes.
This bearish view combines the Reinhart-Rogoff thesis on debt death spirals with a return visit to Fed policy blunders in 1929 and 1937.
To some, the trade wars are another conundrum. There is little doubt that a true trade war will reduce global growth. But many are wondering if we’re facing a trade war or just a series of head fakes by Donald Trump as he pursues the art of the deal?
For example, Trump imposed Section 232 tariffs on steel and aluminum imports and then almost immediately carved out exemptions for Canada and Mexico pending progress on NAFTA. Then the president trumpeted a trade deal with South Korea that imposed quotas on steel imports but almost immediately said that deal was conditional upon South Korean help in dealing with North Korea.
Trump threatened over $50 billion of Section 301 penalties on China for theft of U.S. intellectual property, but within days China and the U.S. calmed market fears by announcing plans for bilateral trade negotiations.
So is it really a trade war, or just a set of negotiating tactics?
I believe the trade war scenario is more likely.
Yes, Trump offered relief to Canada and Mexico on the steel tariffs. But that was only so he could gain negotiating leverage on the NAFTA talks that are ongoing. If Canada and Mexico fail to give Trump the concessions he wants on NAFTA, those steel tariffs can bounce back to hit Canada and Mexico as they already hit China and Brazil.
Meanwhile, Trump will wait to see if China is willing to make concessions in the intellectual property area. If not, he can easily double or triple that $60 billion figure.
My take is that this trade war is not going away anytime soon. It will last for years, get much worse and be a major headwind for stock prices (click here for an urgent trade war update).
But I admit that Trump has left enough wiggle room to indicate he could back off the trade wars if he can exact enough concessions from China and the NAFTA countries.
Geopolitics are another on-again, off-again market driver. A strong case can be made for a coming war with North Korea.
Decades of North Korean development of nuclear weapons and ballistic missiles and a rapid increase in the operational tempo of tests in the past year reveal that North Korea is determined to build an arsenal of nuclear-armed ICBMs that pose an existential threat to the U.S.
For its part, the U.S. has made it clear that North Korea will not be allowed to acquire or possess these weapons. These two views are irreconcilable and point toward war.
President Trump has ratcheted up his war of words against Amazon.
Late last week, Trump tweeted that Amazon is having a negative impact on competing retailers, as well as the federal and local governments:
I have stated my concerns with Amazon long before the Election. Unlike others, they pay little or no taxes to state & local governments, use our Postal System as their Delivery Boy (causing tremendous loss to the U.S.) and are putting many thousands of retailers out of business!… This Post Office scam must stop. Amazon must pay real costs (and taxes) now!
Then there was this morning’s tweet:
Only fools, or worse, are saying that our money losing Post Office makes money with Amazon. THEY LOSE A FORTUNE, and this will be changed. Also, our fully tax paying retailers are closing stores all over the country… not a level playing field!
Trump’s campaign against Amazon is nothing new.
He sent out a string of tweets last summer raging against Amazon’s monopolistic business practices. Here’s one from last August, for example, that sounds a lot like last week’s tweets:
Amazon is doing great damage to tax paying retailers. Towns, cities and states throughout the U.S. are being hurt — many jobs being lost!
But Trump’s attacks against Amazon are not just economic — they’re also personal.
Amazon CEO Jeff Bezos also owns The Washington Post, which is strongly anti-Trump. Trump sees The Washington Post as the unofficial leader of the resistance to his administration. The president has even referred to the newspaper as the “Amazon Washington Post.” And he knows it’s been out to get him.
What does all this mean?
It means there’s an excellent chance that Trump could pursue antitrust legislation against Amazon.
Trump’s logic is simple. Most of Bezos’ net worth is tied up in Amazon stock. In the world of billionaires and powerful politicians, the way to hit someone hard is in the pocketbook.
Trump will attack Amazon and clip Bezos’ wings by $10–20 billion as payback for what he considers Bezos’ attacks on him via the Post.
Antitrust law enforcement in the United States is a bit like the weather — unpredictable in the long run and highly changeable.
The Justice Department can go years or even decades without bringing a major antitrust case and then suddenly decide the time has come to send a message to big business, with emphasis on the word “big.”
When that happens, there is always one company that stands out from the crowd as a kind of sitting duck for ambitious prosecutors. Today, the sitting duck is Amazon.
When the case against Amazon begins, the stock will tumble. Amazon’s stock price is vulnerable under the best of circumstances because it ran up so far so fast. The bad news of an antitrust case will be the catalyst that causes investors to dump the stock in a desperate race to get out ahead of the crowd. Selling will feed on itself.
The selling contagion will spread to the rest of the FAANG stocks (Facebook, Apple, Netflix and Google) and to the Nasdaq as a whole.
Amazon stock was down as much as 6% today, based on Trump’s latest attacks. And the Dow is down almost 500 points at writing. The S&P and Nasdaq are also getting hammered.
But this could just be the beginning.
These companies are already vulnerable because China has threatened sanctions against U.S. technology companies. Technology stocks, led by Apple, dragged the broader market lower last week when the news broke. These threats of course come in retaliation against Trump’s latest promise to crack down on Chinese theft of U.S. intellectual property.
Any antitrust action Trump pursues against Amazon will trigger another correction or worse in U.S. stocks.
But investors who can read the antitrust tea leaves correctly stand to make huge profits when the Justice Department strikes.
What we have seen so far are just the opening shots of the coming trade war. Think of it as the Battles of Lexington and Concord that opened the Revolutionary War. Much larger tariffs and penalties are waiting in the wings.
Trump will soon receive a report under Section 301 of the Trade Act of 1974. That report has been almost a year in preparation and will reveal that China has stolen over $1 trillion in U.S. intellectual property.
Section 301 of the Trade Act of 1974 is the “nuclear option” when it comes to trade wars.
I don’t want to get too deeply in the weeds here, but Section 301 gives the president broad authority to impose sanctions and penalties. The president will have a completely free hand to impose billions of dollars of damages if not more on China.
Trump could receive this report within days or weeks. Regardless, it is coming soon.
Once the president receives it, the law gives him 90 days to react. But he will likely act within days or weeks upon receiving it.
Importantly, Trump does not require Congressional approval to act. Again, the law gives the president enormous flexibility. So he doesn’t need Congressional backing as he did for, say, the tax cuts.
Initial reports indicated that these penalties will be about $60 billion. In fact, Trump used that figure in today’s press conference on tariffs. But that’s just for starters.
Trump will wait to see if China is willing to make concessions in other areas. If not, he can easily double or triple that $60 billion figure.
The penalties Trump seeks to impose are not limited to specific sectors but may apply across a wide range of goods and services from China that benefitted in any way from the theft of intellectual property (IP).
IP is a very tricky subject with a lot of gray area.
Trade restrictions on steel, for example, are much easier to implement. Steel is tangible. You can weigh it, track it, etc.
Intellectual property, on the other hand, is much more vague, much more amorphous. It exists inside human brains, or on the internet or a computer thumb drive. It can be everywhere at once in a sense.
So it’s much more difficult to identify, quantify, and throw tariffs on than traded products like steel, autos, solar panels or washing machines. Yet intellectual property is more important than ever.
We live in a world of technology, a world of the internet, of smart devices, and even cryptocurrencies for that matter. These are all forms of intellectual property.
Now, China has been stealing U.S. intellectual property for decades in various ways. Sometimes it happens when a Chinese scientist comes to the United States and takes what he learns back to China.
But a lot of the theft has been done through malicious hacking of U.S. technology companies. These could be big defense contractors like Lockheed Martin or Northrop Grumman. But they could also be small firms with one great innovation or idea. These smaller firms may actually be more vulnerable because they don’t have the defenses against hacking or cyber warfare that the big guys do.
With this stolen intellectual property, China has been able to build up companies like Huawei, a large technology and telecommunications firm. And its defense industry has made enormous strides because of stolen intellectual property.
Because intellectual property is so amorphous, the president could look at a wide variety of Chinese industries and say:
“You know those electronic products you’re assembling, like smart phones? They wouldn’t be so smart if you hadn’t stolen some of our intellectual properties. So we’re going to throw a tariff on them.”
These penalties will have a much broader and deeper impact than the steel and aluminum tariffs, or those on washing machines or solar panels.
This is the most aggressive tempo of rate hikes of any major central bank and puts U.S. policy rates significantly higher than those in the U.K., Japan or eurozone.
The issue for investors is whether the Fed is raising rates too aggressively considering the strength of the U.S. economy. Higher rates imply a stronger dollar, imported deflation and head winds to growth.
If the U.S. economy is on a firm footing, then the rate hikes may be appropriate, even necessary to head off inflation.
But if the U.S. economy is vulnerable, then the Fed’s actions could trigger a recession and stock market sell-off unless the Fed reverses course quickly. My view is that the latter is more likely. The Fed is tightening into weakness and will reverse course by pausing rate hikes later this year.
When that happens, important trends in stocks, bonds, currencies and gold will be thrown into reverse. Investors who position now for a coming course correction by the Fed can reap huge gains when that Fed flip-flop occurs.
Outwardly, the Fed is sanguine about the prospects for monetary normalization. Both Janet Yellen and new Fed chair Jay Powell have said that interest rate hikes will be steady and gradual. In practice, this means four rate hikes per year, 0.25% each, every March, June, September and December, with occasional pauses prompted by strong signs of disinflation, disorderly markets or diminution in job creation.
Balance sheet normalization is even more on autopilot than rate hikes. The Fed will not dump its securities holdings. Instead, it refrains from rolling over maturing securities. When the Treasury pays the Fed upon the maturity of a Treasury note, the money simply disappears.
This is the opposite of money printing — it’s money destruction. Instead of QE, we now have QT, or quantitative tightening.
The Fed has been transparent about the rate at which they will run off their balance sheet this way, although transparency should not lead investors to complacency. The balance sheet reduction tempo as of late 2018 is $600 billion per year, equal in impact to four 0.25% rate hikes per year.
The annual combined impact of the Fed’s rate policy and QT is a 2% increase in interest rates. For an economy addicted to cheap money, this is like going cold turkey.
The Fed would have investors believe that the rate hikes are already priced into capital markets, and QT is a nonevent, running on “background” in the Fed’s words, like an Excel spreadsheet on your laptop while you watch a film from Netflix.
Neither assumption is correct.
The view that balance sheet normalization can run on background without disruptive effects is unwarranted. The Fed printed almost $4 trillion of new money over six years from 2008–2014 to inflate the value of risky assets.
Yet somehow, the Fed would have investors believe that destroying $2 trillion in even less time will have no negative impact on the value of those same risky assets.
The next financial crisis will hit us in the next six to eight months and will be triggered by war between the US and North Korea, best-selling author Jim Rickards predicts on the Big Money Questions show.
Jim Rickards examines what the next financial crisis will look like and how it will be different from previous panics, gives us his outlook for gold and the key drivers for the yellow metal in part one of a tremendous two-part interview. Don’t miss my conversation with Jim Rickards, coming up after this week’s market update.
