The scientific version of what I am saying… (James Rickards)

Here is a PDF I have come across on Jesse’s Cafe American‘s  site: James Rickards

I’ll try to attach the PDF below but am unsure as to how to go about it. If I fail, you can always get it from Jesse’s site.

Rickards

Below are select excerpts in guise of summary of a fairly lengthy but interesting document that gives food for thought. Whilst Rickards is concerned with the possibility of a hostile attack on the West via the financial system, what I wish to highlight in this report are the echoes of some of my views and reasons that Western politicians may be plunging us into a world war even before such a foreign attack may materialize.

Begin excerpts (emphasis added):

They [our leaders] have a concept of the system of money and bank- ing (and the institutions that conduct those operations that create money and extend credit) that connects directly to macroeco- nomic theories expressed variously as Keynesian or Monetarist. This understanding translates into misnamed stimulus packages, which are, in fact, redistributionist inflation packages to be car- ried out by Treasury borrowing and Federal Reserve monetization of the resulting debt (Cogan et al., 2009 [2]). The circularity of this superficial understanding of system and the ineffectuality of macroeconomics in a systemic crisis is thus complete.

The field of nonlinear dynamical systems has recently been enriched by the concept of self-organized criticality as described in Bak (1996) [4]. The idea is that actions propagate throughout systems in a critical chain reaction. In the critical state, the prob- ability that an action will propagate is roughly balanced by the probability that the original action will dissipate. In the subcritical state, the probability of extensive effects from the initial action is low. In the supercritical state, a single minor action can lead to a catastrophic collapse. Such states have long been observed in physical systems, e.g., nuclear chain reactions in uranium piles, where a small amount of uranium is relatively harmless (sub- critical) and larger amounts can either be carefully controlled to produce desired energy (critical), or can be shaped to produce atomic explosions (supercritical). (Supercritical systems are just larger, more complex versions of critical systems; both are poised on the edge of an unpredictable but potentially catastrophic out- come.) Informed by this new paradigm of the self-organized, scale invariant, nonlinear dynamical system in the critical state (i.e., the Nonlinear Paradigm), we return to the field of finance to consider the implications from the perspective of systemic risk and threats to national security.

Similarly, experts have queried why in 1998 the hedge fund LTCM lost $4 billion in four weeks and nearly caused a systemic collapse, while in 2006 another hedge fund, Amaranth, lost $6 billion in one week and barely caused a ripple in financial markets. The answer in both cases is that there is no linear relationship between cause and effect and the search for differentiating proximate causes is futile. What does matter is that in all three cases, the system was in a critical state, but only in two (1987 and 1998) did initial conditions cause market losses to propagate into a full-scale panic whereas in the other case (2006) such propagation did not occur; it died out. This is exactly the kind of unpredictable but potentially catastrophic behavior that the Nonlinear Paradigm predicts.

Globalization in this context is the integration of capital mar- kets across national boundaries. Until recently there were specific laws and practices that had the effect of fragmenting capital mar- kets into local or national venues with little interaction. Factors included withholding taxes; capital controls; protectionism; nonconvertible currencies; and licensing, regulatory, and other restrictions that tilted the playing field in favor of local champi- ons and elites. All of these impediments have been removed over the past 20 years to the point that the largest stock exchanges in Europe and the U.S. (NYSE and Euronext) now operate as a single entity.

Derivative products have exhibited even faster growth than the growth in underlying financial assets. This is due to improved technology in the structuring, pricing, and trading of such instru- ments and the fact that the size of the derivatives market is not limited by the physical supply of any stock or commodity but may theoretically achieve any size because the underlying instru- ment is notional rather than actual. The total notional value of all swaps increased from $106 trillion to $531 trillion between 2002 and 2006 (New York Times, 2008 [9]). The notional value of equity derivatives increased from $2.5 trillion to $11.9 trillion86 Unrestricted Warfare Symposium Proceedings 2009

over the same period while the notional value of credit default swaps increased from $2.2 trillion to $54.6 trillion (New York Times, 2008 [9]).

Leverage is the third element supporting the massive scaling of financial markets, i.e., margin debt of U.S. brokerage firms has more than doubled from $134.58 billion to $293.2 billion from 2002 to 2007 while the amount of total assets per dollar of equity at major U.S. brokerage firms has increased from approximately $20 to $26 in the same period. In addition, leveraged investors invest in other entities, which themselves use leverage to make still further investments, etc. This type of layered leverage is impossible to unwind in a panic.

Recalling that sys- tems described by a power law allow events of all sizes and that such events can occur at any time, particularly when the system is supercritical, the conclusion is inescapable that the greatest financial catastrophe in history is not only inevitable but could well be what we are experiencing today.

If the U.S. power grid east of the Mississippi River were at no point connected to the power grid west of the Mississippi River, then a nationwide power failure would be an extremely low probability event. Either the “east system” or the “west system” could fail catastrophically in a cascading manner but both systems could not fail simultaneously except for entirely independent reasons because there are no nodes in common to facilitate propagation from critical state to catastrophic failure across systems. In a financial context, governments should give consideration to preventing mergers that lead to globalized stock and bond exchanges and universal banks. The first order efficien- cies of such mergers are outweighed by the risks of large-scale failure especially if those risks are not properly understood and taken into account.

Guido here: The above is valid not only for mergers but also for bailouts.

In summary, Wall Street’s reigning risk management paradigm consisting of a combination of stochastic methods in a normally distributed model combined with stress testing to account for out- liers is a manifest failure. It should be replaced with the empiri- cally robust model based on nonlinear complexity and critical state dynamics. Applying such a paradigm leads to the conclu- sion that the current financial crisis is likely to get far worse and threaten national security because the system has been scaled to unprecedented size prior to the onset of the catastrophe.

Based on this vulnerability analysis, the question arises whether an enemy of the U.S. could insinuate itself in financial markets in such a way that it became a trusted counterparty with access to credit and transactional venues and then use that access to create imbalances that would branch and cascade through crit- ical nodes in such a way to cause panic, failure, and collapse? If so, how would this be done?

Guido here: In light of all that has happened in the past 24 months, we really don’t need a foreign enemy to do anything. We’ve done all of the above to ourselves. We have met the enemy and it is us.

The ideal commercial cover for an enemy assault on financial markets would be an institution large enough to deploy massive amounts of capital and obtain large lines of credit but unregu- lated enough not to pose significant barriers to entry or be subject to oversight. This could be done using a variety of intermediaries including hedge funds, trust accounts and derivative products or all of these in combination. If an enemy fails they have a modest cost and some deniability; if they succeed, they could destroy Western capital markets. This is an excellent risk–reward ratio.

Guido here: again – the above reminds me of the Federal Reserve and the ECB

the evidence from bubble behavior shows that once we hit bottom (and we may still be a year or more away depending on the particular asset class or index considered), we should expect a prolonged and pernicious period at the bottom itself without any appreciable gains for years. The implications of this for tax revenues, fiscal stability, U.S. economic power, and the ability of the U.S. to project hard or soft political power are daunting.

Guido here: bingo!

What the U.S. has just experienced is the breaking of numer- ous bubbles in residential housing, credit card debt, consumption versus savings, growth in derivative products, growth in struc- tured products, and the willingness of investors to use leverage and sell volatility in order to chase illusory gains. These breaks are not characteristic of normal cyclical downturns of the type which occurred in 1990–1991 and 2001 or even the more severe down- turn of 1973–1975. We expect that the U.S. economy has entered a prolonged and steep decline that could reduce real GDP by 20 percent or more over the next several years with no immediate prospects for recovery.

The defense, intelligence, and diplomatic communities should expect a potent mixture of increased missions due to failed states, civil unrest, and enemy adventurism induced by our economic weakness, and a world of diminished resources due to fiscal con- straints and rising demands for bailouts and the social safety net. The combination of increased missions and reduced resources

will stress readiness, analytic and collections capability, and pri- orities across the board. In the LUV trio, the L-shaped recovery is the one most dangerous for national security and the one most likely to occur.

Guido here: granted but not only due to exogenous forces. Instability could very well stoke social unrest and eventually revolution. Considering the amount of social expenditure reduction Western government must effect in coming months, a revolution is no longer in the realm of the impossible.

ConCLUSIon

Notwithstanding an earlier period of globalization during 1880–1914, there can be little doubt that the current period of glo- balization from 1989–2009, beginning with the fall of the Soviet Union and the end of the Cold War, represents the highest degree of interconnectedness of the global system of finance, capital, and banking the world has ever seen. Despite obvious advantages in terms of global capital mobility facilitating productivity and the utilization of labor on an unprecedented scale, there are hidden dangers and second-order costs embedded in the sheer scale and complexity of the system. These costs have begun to be realized in the financial crisis that began in late 2007 and have continued until this writing and will continue beyond.

Among the emergent properties of this complexity are expo- nentially greater risks of catastrophic collapse leading to the com- plete insolvency of the global financial system. This dynamic has already begun to play out and will continue without the imple- mentation of appropriate public policies, which, so far, are not in evidence. More to the point, this ongoing instability lends itself to amplification through the actions of adversaries who can accel- erate destabilizing trends through market manipulation and the conduct of marginal transactions in critical securities and com- modities such as U.S. Treasury debt, oil, and gold.

The U.S. response should include three components:

• Improved public policy to stabilize the system including temporary nationalization of banks to remove bad assets, preemptive study and consideration of a return to the gold standard, higher interest rates to support the value of the U.S. dollar, increased tolerance of failure in financial institutions to reduce moral hazard, and mandatory use of central counterparty clearing in order to mitigate the impact of institutional failure and descale the system to make it more robust to attack.

• An expert market watch function and all source fusion with improved financial counterintelligence and clandestineChapter 1 Featured Papers 117

action to detect and disrupt attempted malicious acts in global capital markets by adversaries.

• An offensive capability in global capital markets including asset freezes, asset seizures, and preemptive market manipulations.

Finally, the vulnerability of companies and technologies to control and diversion by adversaries must not be overlooked. This requires improved interagency coordination of the various legal and forensic tools at the disposal of the U.S. in the areas of securities, antitrust, tax, banking, export restrictions, direct foreign investment restrictions, sanctions, and emergency eco- nomic powers. These tools should be supplemented by improved financial counterintelligence and new automated tools focused on supply-chain linkages, nonobvious relationship awareness (NORA), and market price anomalies.

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