Mutually Assured Financial Destruction

By Navin Doshi, May 19th, 2010

Mutually assured destruction (MAD) is a doctrine of military strategy and national security policy in which a full-scale use of nuclear weapons by two opposing sides would effectively result in the destruction of both the attacker and the defender. The doctrine assumes that each side has enough nuclear weaponry to destroy the other side and that either side, if attacked for any reason by the other, would retaliate with equal or greater force. The expected result is an immediate escalation resulting in both combatants’ total and assured destruction. It is now generally hypothesized that the nuclear fallout or nuclear winter resulting from a large scale nuclear war would bring about worldwide devastation, though this was not a critical assumption to the theory of MAD. The primary application of this doctrine started during the Cold War (1940s to 1990s) in which MAD was seen as helping to prevent any direct full-scale conflicts between the United States and the Soviet Union while they engaged in smaller proxy wars around the world. It was also responsible for the arms race, as both nations struggled to keep nuclear parity, or at least retain second-strike capability. (From Wikipedia)

While we have overcome the Cold War, we are quickly descending into MAD in the financial markets among developed countries, with assured free market destruction as we know it, and with “Debt Bombs” countering with more printing paper money. However, there are differences in the two situations. First and foremost a nuclear holocaust did not happen, while today, in the views of many market analysts, we are on the path of eventual financial destruction. Unlike the bipolar world of MAD, our interactions are in a globalized world with multiple players making the situation much more complicated. First, the debt bomb went off in America in late 2008, causing tremors all over the world. So the Fed dropped the paper money bomb in a form of a trillion-dollar stimulus package, in essence creating the fiat money and degrading the value of the dollar. That was the beginning of state capitalism replacing the free market capitalism after its demise, taking over failed banks, automobile companies, and mortgage companies.

Capitalism takes many forms but all of them can be distinguished by their use of wealth to create more wealth, a broad enough definition to capture both free-market and state capitalism. In the free-market form of capitalism, the job of the state is to “enable” wealth generation by enforcing contracts and limiting the influence of moral bads such as greed—the latter can lead to market failures, which have occurred periodically since the Dutch tulip craze of 1637. Free-market governments attempt to ensure that the economic game is played fairly. In contrast to free-market capitalism, the economy in state-capitalist regimes, like in China and Russia, is dominated by the state agenda. If forced to choose between the protection of the rights of the individual, economic productivity, and the principle of consumer choice, on the one hand, and the achievement of political goals, on the other, state capitalists will choose the latter every time. Continuing the sports game analogy, state capitalists control the referees as well as the main players. (Refer to “The End of the Free Market” by Ian Bremmer)

A few weeks ago Jean-Claude Trichet, the head of the European Central Bank (ECB), was telling the world there was no way the ECB would go nuclear to resolve the Greek debt problem. Then, over the weekend, they went nuclear, creating a trillion dollars out of thin air. Rather than dropping an atomic bomb, however, Europe dropped a money bomb on the markets – a rescue package worth about a trillion dollars. The package included the authority for the ECB to wade into the markets and directly purchase debt. There is perhaps just one thing left to do: Destroy the euro. Jean-Claude Trichet, the head of the ECB, should swallow hard… admit his failure… and print like a madman, devaluing the currency in order to “monetize” the vulnerable eurozone countries’ debts. The euro was always a lousy idea – a hodge-podge of dissimilar cultures and economies, stitched together in a “Mad Doctor’s” dispensary. The same monetary policy for various and varied economies in the euro zone has created huge imbalances and stress. One medicine cannot cure all the ills.

While Germany has maintained discipline in its financial dealings since the inception of the European Monetary Union, Greece, Italy and Spain have partied. Enjoying the advantage of lower interest and inflation rates, Southern Europeans were caught up in a big credit-driven boom that has gone bust just as it had happened in the U.S.A. The big bailout, unprecedented in size for Europe, in truth is a bailout of the European banks which were on the hook as the main creditors. The ECB, by following the U.S.A. in matters of keeping a loose monetary policy, has demolished its own credibility. Apparently the outcome for the euro, dollar and the British pound should be an eventual self-destruction. In the words of Alan Abelson of Barron’s magazine, “all the central banks in Europe and U.S.A. are determinedly printing money like mad to save the world”. These actions of money printing are certainly bullish for gold and silver in long run. Please note that nothing goes up or down in straight line. Gold is over-bought and should correct itself downwards. There is a huge short position on the euro and could go up for a few months when the shorts are being covered.

The state capitalism is very much involved in market manipulation as we are experiencing in the U.S.A. Institutions, with the blessings of the government, use derivatives to artificially maintain a strong dollar so that the interest rate and therefore the cost of borrowing is maintained at a much lower level. In spite of this effort, the government seems to be losing control over the price of gold. During the September 2008 meltdown, the dollar and U.S. treasury went up over 10 % while the gold price was down by 20 %. However, gold has outperformed both the dollar and the S&P 500 in each and every time interval of 30 days, 3 months, 6 months, 12 months, 2 years, and 5 years. As a matter of fact, gold has gone up by about 170% while the S&P 500 is down by five % in the last five year time interval (As of May 19th, 2010).

Please note that 70 % of the trading volume comes from both foreign and domestic institutions employing their proprietary soft ware. The message here is that the foreign central banks are accumulating gold to strengthen their currencies because the confidence in western currencies is receding. The great games, played by world powers, are first played in the economic realm, before they consider going to war.

Looking at the state of the market, there were two melt downs in the last 25 days. One of them was an almost death experience. Only the dollar and the gold have been holding well. For graduating students, toughest test is getting a job. About 80 % of 2009 fresh graduates moved back home with their Parents, compared to 75 % in 2008, and 65 % in 2006. In the view of this writer, the most important responsibility of the executive branch of the government is to keep the job seekers, and certainly fresh graduates, employed.

(Mr. Doshi, a writer, trader, and a philanthropist, posts his articles at http://www.nalandainternational.org)

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