Currency Wars_ The Making of the Next Global Crisis - James Rickards [110]
Under complexity analysis, the view is completely different. In complex systems analysis, shorts are not subtracted from longs—they are added together. Every dollar of notional value represents some linkage between agents in the system. Every dollar of notional value creates some interdependence. If a counterparty fails, what started out as a net position for a particular bank instantaneously becomes a gross position, because the “hedge” has disappeared. Fundamentally, the risk is in the gross position, not the net. When gross positions increase by 500 percent, the theoretical risk increases by 5,000 percent or more because of the exponential relationship between scale and catastrophic event size.
This is why the financial system crashed so spectacularly in 2008. Subprime mortgages were like the snowflakes that start an avalanche. Actual subprime mortgage losses are still less than $300 billion, a small amount compared to the total losses in the panic. However, when the avalanche began, everything else was swept up in it and the entire banking system was put at risk. When derivatives and other instruments are included, total losses reached over $6 trillion, an order of magnitude greater than actual losses on real mortgages. Failure to consider critical state dynamics and scaling metrics explains why regulators “did not see it coming” and why bankers were constantly “surprised” at the magnitude of the problem. Regulators and bankers were using the wrong tools and the wrong metrics. Unfortunately, they still are.
When a natural system reaches the point of criticality and collapses through a phase transition, it goes through a simplification process that results in greatly reduced systemic scale, which also reduces the risk of another megaevent. This is not true in all man-made complex systems. Government intervention in the form of bailouts and money printing can temporarily arrest the cascade of failures. Yet it cannot make the risk go away. The risk is latent in the system, waiting for the next destabilizing event.
One solution to the problem of risk that comes from allowing a system to grow to a megascale is to make the system smaller, which is called descaling. This is why a mountain ski patrol throws dynamite on unstable slopes before skiing starts for the day. It is reducing avalanche danger by descaling, or simplifying, the snow mass. In global finance today, the opposite is happening. The financial ski patrol of central bankers is shoveling more snow onto the mountain. The financial system is now larger and more concentrated than immediately prior to the beginning of the market collapse in 2007.
In addition to global financial descaling, another solution to complexity risk is to maintain the system size but make it more robust by not letting any one component grow too large. The equivalent in banking would be to have more banks, but smaller ones with the same total system assets. It was not that many years ago that the current JPMorgan Chase existed as four separate banks: J. P. Morgan, Chase Manhattan, Manufacturers Hanover and Chemical. A breakup today would make the financial system more robust. Instead U.S. banks are bigger and their derivatives books are larger today than in 2008. This makes a new collapse, larger than the one in 2008, not just a possibility but a certainty. Next time, however, it really will be different. Based on theoretical scaling metrics, the next collapse will not be stopped by governments, because it will be larger than governments. The five-meter seawall will face the ten-meter tsunami and the wall will fall.
Complexity, Energy and Money
Using behavioral and complexity theory tools in tandem provides great insight into how the currency wars will evolve if money printing and debt expansion are not arrested soon. The course of the currency war will consist of a series of victories for the dollar followed by a decisive dollar defeat. The victories, at least as the Fed defines them, will arise as monetary ease creates inflation that forces other countries to revalue their currencies.