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By Lauren Foster

The United States is at war, but not in the conventional sense. There are no troops on the ground. There are no drone strikes. Instead, the weapon of choice is the U.S. dollar and the "enemy" is America's trading partners. Welcome to Currency War III.

That, at any rate, is James G. Rickards's view of the world. In a presentation at the recent Global Investment Risk Symposium, Rickards, a partner at JAC Capital Advisors and author of Currency Wars: The Making of the Next Global Crisis, outlined the case for why the international monetary system is dominated by currency wars. He also argued that capital markets are complex systems that are bordering on a "critical state" and are "potentially prone to collapse" - and that the U.S. Federal Reserve risks "melting down the system."

As Rickards sees it, we are well into the third currency war of the past 100 years. President Obama fired the first salvo during his 2010 State of the Union address, when he announced the launch of the National Export Initiative and said the goal was to double exports over the next five years. The easiest way to do that, of course, is to cheapen the U.S. dollar. But that is only part of the explanation, Rickards said.

To really understand what is going on, you have to start with the quantity theory of money, or MV = PQ. (Quick refresher: PQ = nominal GDP, Q = real GDP, P = inflation/deflation, M = money supply, and V = velocity of money.) The issue here is that the theory doesn't hold up in the real world because velocity - the number of times money changes hands, or turns over - is not constant. "Velocity is collapsing," Rickards said. "You can think of monetary policy as a desperate race between increasing money supply and decreasing velocity, and the Fed is printing money to offset the decline in velocity. . . . So the Fed's problem is best understood as one of trying to bend this velocity curve."

How exactly does Fed do this? Through "propaganda" and a mix of "carrots and sticks," according to Rickards.

The carrot is negative real rates, and the stick "is to shock you with inflation." Here is how it plays out: the negative real rates incent you to borrow, an inflation shock makes you want to spend, the "lending and spending machine" gets going again, and nominal GDP starts increasing. Then, real GDP gets back to trend and becomes self-sustaining, and "we all live happily ever after."

Except for one problem. The Fed, Rickards contends, is "going to fail."

He said negative real rates and inflation shock "both require 4% inflation - 2% won't cut it." So you have to think about 4% inflation as the Fed's real target. And to get to the 4% hurdle, the U.S. central bank will cheapen the dollar, which raises import prices and drives up inflation.

Plenty could go wrong, however. "The Fed thinks they are playing with a thermostat," Rickards said. "They think, 'If the economy is too cool, you dial it up a little bit. If the economy is too hot, you dial it back down. It's linear, it's reversible, it's all good. Everything is under control.'"

But in reality, he continued, "capital markets and financial markets are complex systems, which respond and correspond to complex dynamics, including critical state dynamics." The metaphor is not in fact a thermostat, Rickards said. It is a nuclear power plant: "You can dial a nuclear power plant up and down," he said, "but you had better get it right. Because if you get it wrong, you will cause a catastrophic meltdown, and it is an irreversible process. There's no such thing as a melt-up; if you destroy it, it stays destroyed."

Rickards believes the Fed, its staff, and its economists "misapprehend the statistical probabilities of risk" because they don't understand how risk works in complex systems. "They are using Keynesianism, they are using monetarism, they are using modern financial economics," he said. "Most of this stuff is deeply flawed, if not completely junk science." He believes the right way to think about risk is by using complexity theory. "When you start looking at things that way, you will see that this is a system that is bordering on the critical state and potentially prone to collapse."

Rickards said capital markets are "not only complex systems," but also "complex systems nonpareil. They are the quintessence of complexity." And all complex systems have various features, including "phase transitions," which is just a change in the state (think of water and steam), and "critical state dynamics," which Rickards explained "is just an extreme version of the change in the state."

In critical state dynamics, Rickards said, "minute changes in initial conditions can result in catastrophically different outcomes."

So are we in the critical state right now? "It's impossible to know," Rickards said. "But I am certain that we are closer to the critical state than we ever have been before. This is why I say the Fed is playing with a nuclear reactor. They think they are not. They think they are playing with a thermostat. But they risk melting down the system."

Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

Source: Currency Wars: 'The Fed Is Playing With A Nuclear Reactor'