Depression or recovery?

James Rickards, author of ‘Currency Wars,’ sees the U.S. suffering from years of subpar growth interspersed with recessions as necessary structural reforms remain unaddressed. The Federal Reserve’s tinkering with the money supply will result in a monetary collapse, he forecasts. He spoke at the recent Cayman Investment Forum. 


James Rickards, senior managing director at the U.S. firm Tangent Capital and author of the best-seller “Currency Wars: The Making of the Next Global Crisis,” says to understand what the economy is currently experiencing one would have to go back to the 1970s or the 1930s.

He argues that the economy is experiencing deflation and inflation at the same time, and while they are canceling each other out for the time being, the situation is highly unstable.

On the one side, Rickards notes, there is deflation because the U.S. economy is in the midst of a depression characterized by a long period of below trend growth. Under this definition, a country that is capable of 3 or 4 percent growth but only produces 1 or 2 percent is in a depression. The gap between actual and potential growth only widens as it is projected in the future and lost growth cannot be recovered.

Rickards argues that depressions are structural in nature and can only be addressed with structural solutions. Yet policymakers around the world are pursuing liquidity or cyclical solutions. “So we will never get out of it. We are going to have 1 or 2 percent growth unless we make some structural changes.”

The natural state of depression is deflation, he explains, referring to economist Irving Fisher’s debt-deflation theory of great depressions.

“When you are in a depression, you sell assets, you take the proceeds to pay down the liabilities and you are de-leveraging. Selling assets drives the price down and puts someone else in distress. They have to sell assets, too, to de-leverage.

“It feeds on itself.” 

On the other side, the Federal Reserve has printed almost $3 trillion of new money during the last three years, which is typically highly inflationary, he says. 

“And what you have is deflation coming from the depression and inflation coming from monetary policy, canceling each other out to some extent, producing what looks like a tame price series.”

Rickards likens the scenario to two tectonic plates pressing against each other with considerable force but calm on the surface. At some point the tension will break and result either in high inflation or an extreme case of deflation.


Currency wars 

Another scenario that is playing out, according to Rickards, is a currency war, where countries devaluate their currency as an instrument of policy to steal growth and trading opportunities from their trading partners.

While there can be valid reasons for currency fluctuations, such as changes in comparable advantage, technological breakthroughs, natural resource discoveries or productivity improvements, currency war type devaluations are intentional and malicious.

The intent is not so much to support the export of goods but rather the importation of inflation to solve the deflation problems posed by the depression, he says.


The Fed’s strategy 

The other reason the U.S. is not experiencing inflation as a result of three rounds of quantitative easing and a massively increasing money supply is that the velocity of money – how often each dollar changes hands in the economy – is collapsing at an unprecedented rate. 

Lower velocity reflects lower economic activity, and Rickards says the Fed believes it has to “explode money supply” to counter the effect of cautious consumer attitudes towards spending.

The worst possible situation the Fed could face is declining nominal growth – real GDP after inflation or deflation – and deflation at the same time, because it would collapse tax revenues and worsen debt-to-GDP ratios and other metrics.

In Rickards view, the Federal Reserve engages in nominal GDP targeting and its goal is to achieve roughly 4 percent nominal growth, because the debt it needs to pay down is a nominal amount. Ideally this nominal 4 percent target would consist of 3 percent real growth and 1 percent inflation. 

“If the Fed cannot achieve that because there is no 3 percent [real] growth they take 3 percent inflation and 1 percent growth,” he claims. “What the Fed is saying is if we cannot get the real growth, we take inflation.”

At the same time, the Fed has to bend the “velocity curve” to change spending behavior and get inflation to drive nominal growth. 

To achieve this, it uses negative real rates – higher inflation than nominal borrowing rates – which are a strong incentive to borrow, and a shock of inflationary expectation – higher inflation than expected by consumers – as an incentive to spend. 

“Negative real rates, an inducement to borrow, and an inflationary shock, an inducement to spend, are designed to get the money spending machine going again to drive GDP,” he says. Following this inflation can gradually be replaced with real growth to achieve the nominal GDP target.

But first the Fed has to get inflation and after several rounds of quantitative easing and “propaganda” to change spending behavior, it may soon resort to “helicopter money,” Rickards says. 

The idea is to take banks out of the equation as the middlemen, who are not doing their job because they don’t want to lend, and give it straight to the public through tax cuts to accelerate spending. Although currently unlikely, one scenario under which Democrats and the president could be convinced to agree to tax cuts would be a recession in an election year, he claims.


Monetary collapse 

The problem with the Federal Reserve’s approach, says Rickards, is that it is relying on equilibrium models for its forecasting, but the economy is a complex system and not an equilibrium system. As a result the “Fed’s forecasting record is terrible” with potential devastating consequences.

“The Fed is fiddling with a thermostat trying to adjust the economy, but in fact they are dealing with a nuclear reactor, a dynamic, complex, critical state system capable of becoming supercritical with a catastrophic result and meltdown. You better get it right.”

Applying complexity theory to today’s state of the capital markets would indicate that the system is about to collapse, he says.

This leads Rickards to conclude that the collapse of the international monetary system is imminent within the next three to five years. But this is not intended as a provocative statement, he notes. “It actually has collapsed three times in the past 100 years: 1914, 1939 and again in 1971. These things happen and they are not extremely rare events.”

Rather than the end of the world, he says, it means that the major trade and financial powers have sit down and reform the system to replace the U.S. dollar as a the world’s reserve currency.


“What you have is deflation coming from the depression and inflation coming from monetary policy, canceling each other out to some extent.” 

James Rickards

M2 Money Stock

Velocity of M2 Money Stock
Federal Reserve bank of St Louis