Volume XII, No. IV

War drums continue beating around the world. Even as we wonder whether Israel will attack Iran, Iran’s close ally Syria descends further into civil war. With the U.S. and its Western allies supplying one side as Russia and China supply the other, it doesn’t take a PhD in history or military science to see that an Israeli attack on Iran may not only ignite a greater Middle East war, but may also find the U.S. and its Western allies staring across that battlefield at Russia and China.

But while the mass media focuses on this unfolding drama, an extremely dangerous war has already started and continues to spread – one that threatens both the financial and physical well-being of people in virtually every country on earth. It’s time we started paying attention.

So today we begin our investigation of:

• When and How It Started
• Who’s Fighting and Why
• How Long Can This War Keep Going – and What Happens Next

The first time we came across the idea of a currency war was June 2010. (What, you don’t remember?!!) That’s when we began to view our current crisis through the lens of the research and analysis presented by Ken Rogoff and Carmen Reihhardt in their book This Time Is Different. The authors provide a basic outline of our crisis, broken into five key stages:

• Banking crises
• Domestic sovereign debt defaults
• Foreign debt defaults
• Currency crashes
• Inflation outbursts

(In case you want to refresh your memory, you can click HERE for a summary of their thesis.)

The banking crises of 2008 – 2009 started the ball rolling. Massive government bailouts of “too-big-to-fail” banks were supposed to put an end to the danger. They didn’t. Even as trillions poured into banks, the headlines turned to the unsupportable liabilities, i.e. debts, of U.S. and European governments. And so defaults and the threat of defaults of government debts began. (That’s what the European debt crisis and the recent downgrading of U.S. treasury debt is all about.) And now we find ourselves facing what Rogoff and Reinhardt term "currency crashes."

Let’s keep in mind that we’re not talking about the occasional collapse of a particular currency - something that happens from time to time. For example, over the last 15 years or so, we’ve seen the currencies of Argentina, Russia and Zimbabwe collapse. But that’s small potatoes compared to what we’re now facing. Instead of an occasional crash, we’re in the midst of a massive currency war involving almost every country on earth.

You’re probably aware of the economic sanctions the U.S. government and some of its allies imposed on Iran, sanctions justified by the belief that Iran is developing nuclear weapons. And you may be aware of the the U.S. military’s contingency plans for war with Iran. Dozens of ships from the U.S. and its allies have entered the Persian Gulf to conduct mine-sweeping operations and naval exercises.

What you may not be aware of is the fact that the first shots were already fired this past spring. But rather than using bullets, bombs or missiles, the battle commenced when the U.S. government unilaterally blocked Iranian banks’ access to what is known as the SWIFT system, a network that facilitates the wiring of money between banks. The SWIFT system exists to support international commerce. Without access to it, Iranian banks could no longer transact with banks of other countries. The goal was to prevent Iran from trading oil for dollars. This action received virtually no press coverage.

While an argument can be made that this action was not only an act of aggression, but could be construed as an act of war, that was only the beginning of this particular battle in our current currency war. Here’s what happened next.

The U.S. followed up its action by threatening any nation that attempted to do business with Iran with denial of access to the SWIFT system. Most of the European countries have already complied with the U.S. on this. Asian countries have been slower to respond with the exception of the second biggest economic power in the world: China.

When we mentioned the U.S could find itself staring at China across an Iranian and Middle Eastern battlefield, this could be the beginning of that the staring contest. The Chinese government has told the U.S. that they intend to buy Iranian oil and don't care if the U.S. prevents them from using the SWIFT system to transact the business. The Chinese will simply transact their oil business without the use of U.S. dollars.

To understand why this news - though hardly reported - profoundly changes an economic order that has existed since the beginning of the 20th century, you must know that ever since oil became the indispensable energy source powering the growth of the world’s economy - going all the way back to the beginning of the 20th century - the U.S. dollar has served as the one medium of exchange for all transactions involving oil. But all that is about to change. Rather than comply with the U.S. government’s demands, the Chinese turned to gold as the medium of exchange for their oil transactions with Iran.

India indicated they may do the same, but China is the bigger story. And that story revolves around the fact that while China cannot produce enough oil to meet its needs, China does produce more gold than any other country in the world. The importance of this story cannot be overstated. For one thing, we're witnessing a major new chapter in the history of gold as money. And if China successfully executes this plan, it will lead the way to other countries doing business without the U.S. dollar.

The dollar has been the reserve currency of the world since World War II. Before the outbreak of today’s currency war, any international business transactions used dollars. Oil is big, BIG international business - the biggest of them all. The dollar’s reign as the one and only reserve currency may be coming to an end.

In a further development, The Chinese government just completed an agreement with the Russian government that calls for the Russians to provide oil to China - as much as China wants - again without using the U.S. dollar. And, in case it wasn’t clear what their ultimate intention might be, Chinese leaders announced that their currency, the Yuan, could now be used by any other countries who wished to circumvent the use of U.S. dollars in their international commerce - all this in the space of less than six months.

(For more on the implications of this latest battle in today’s currency war, click HERE.)

The U.S. government’s decision to use the SWIFT system to threaten other countries was not the first time a government used money as a weapon. But how and when did modern governments come to use money as a weapon in the first place? We’ll find our answer by taking a look at the development of modern weapons - specifically weapons of mass destruction - in the 20th century.

Men fought each other with sword and arrow for centuries until they figured out that gunpowder would project a solid object a lot farther and faster than an arm or a bow. As weapons increased in range and power, so would the size of wars grow into the beginning of the 19th century culminating with the massive armies of the Napoleonic Wars.

After Napoleon’s defeat in 1815 at the battle of Waterloo, the victors and vanquished agreed, at the Congress of Vienna, to a “balance of power” in Europe. For the rest of the 19th century, no one government would find itself in the position to revive Napoleon’s dream of complete domination of Europe. And this political stability proved to be the perfect climate for the Industrial Revolution.

Freed from the demands of war, money could now be directed to industry and trade rather than murder and mayhem. Indeed, international trade grew to such an extent that the century would witness a dramatic rise in the standard of living, fostering a belief in “progress” that promised of a new world of ever-growing prosperity.

If political stability provided the perfect climate, it would be the monetary stability of the “gold standard” that would supercharge the unprecedented economic growth of the 19th century. People of one nation offered goods and services at which they excelled to people of other nations for a fair price - a process economists call “specialization.” The gold standard provided a simple and stable framework for the historic growth of international trade. You would have to go back to the Roman Empire to find such a large geographical area engaging in relatively free trade.

As a special bonus, the gold standard of the 19th century, while not a perfect system, prevented governments from meddling with the value of money as the Roman Emperors once did, and as today’s governments do. Trade flourished as never before – until the outbreak of hostilities in World War I.

The bullets fired by Serbian nationalist Gavrilo Princip in June 1914 resulted in the death of Archduke Ferdinand, heir to the throne of the Austro-Hungarian Empire. They did not necessarily have to start a world war, but they did. While the causes of World War I are beyond the scope of this letter, I hope you can appreciate the enormous tragedy of this war. A world that had believed in progress through peace and prosperity was turned on its head.

The men who rushed into battle believed they would be back home in a matter of months, if not weeks. But this dream’s glory would quickly be dashed against the harsh reality of modern warfare. When Germany’s initial advance into France was stopped just miles from Paris, visions of a swift victory quickly dissipated, to be replaced by the hellish slaughter of trench warfare that now swallowed Europe’s armies.

Rather than find a way out of this nightmare, Europe’s leaders fashioned a new plan: fighting men would alternate between rotting in filthy, disease-riddled trenches and charging over open ground to be senselessly ripped to shreds in what was appropriately named “no-man’s land.” Incredibly, Europe remained in the grip of this madness for four years.

With the collapse of political stability and the end of economic growth, it was only a matter of time before the “Great War” would kill the gold standard. Government would turn to borrowing and ultimately to printing the money they needed to keep the war going. The dark nightmare of trench warfare would continue for four years until November 11, 1918.

When we get back together, we’ll see how the act of printing money to keep the war going did not end with the armistice of 1918, but took on a life of its own. Instead of a return to economic growth nourished by political and monetary stability, the physical destruction of a shooting war would give way to the modern era’s first currency war, the granddaddy, so to speak, of our own currency war.

But before we part company, imagine for a moment what our world might have been like had governments somehow come to their senses and simply withdrawn from the battlefield once they had run out of money and could no longer borrow what they needed. Couldn’t each side have preserved its honor by admitting to the gross error they had made, once the armies became bogged down?

Many have speculated about this. Perhaps the most well-known “might-have-been” is that without four years of relentless slaughter, the English and French would not have imposed draconian “war reparations” on Germany. And without the disastrous effects of those war reparations, perhaps Hitler’s Nazi Party would not have found the fertile ground to plant the seeds of hatred and aggression that resulted in World War II.

An even more striking “might-have-been” is the fact that, if not for World War I, the Bolsheviks might never have gained the upper hand in Russia. They were, after all, a small minority party that had neither power and nor prospects until the economic and political collapse of Russia caused by it’s entry into the war. We sometimes forget that by the outbreak of World War I, the Czar had already abdicated his absolute power to a modern elected parliament. Russia may have been on the road to a more just and prosperous future had it expanded its relationship with its Western allies in a time of peace and prosperity. Instead, the ultimate victory of a band of radical, godless, Bolshevik misfits resulted in the descent into hell that would mark the totalitarian Communist state of the Soviet Union for the better part of 70 years.

You have to wonder what evil gripped the souls of European leaders who persisted in fighting what became known as the “Great War” even in the face of incontrovertible evidence that the result would be the slaughter of an entire generation of their young men.

A Time for Caution?

Okay, I realize I’ve strayed a bit from our discussion of currency wars. But in researching and thinking about the ideas for this letter, it struck me that with the loss of political and monetary stability, the world took a terrible turn for the worse in the 20th century – a century that brought two World Wars, the Great Depression, the Cold War and, as we will see next time, two currency wars. And in this light, I would ask you to consider this.

Imagine growing up during those years before 1914 when the West developed in an atmosphere of relative peace, progress and prosperity. What must it have been like to witness that peace, progress and prosperity disappear into four years of death and destruction in World War I? Now imagine growing up being born after 1914, watching the world struggle to recover its bearing, only to be waylaid by the Great Depression and eventually World War II.

I bring this up because most of us have lived, until recently, in the era of relative peace, stability, and prosperity that has characterized the Western world after World War II. Even those who lived under the shadow of the Cold War with its threat of nuclear war between the United States and the Soviet Union never had to face the cataclysmic collapse of civilization that marked the first half of the 20th century. For most of us, I suspect that such a possibility is inconceivable. While I hope and pray it stays that way, you may want to consider how fortunate our lives have been compared to those of our immediate forbears.

Taking this one step further, you may want to also consider this. Did the economic and financial storm that hit us with such force in 2008 mark the worst that will happen to us during our current crisis? If you believe that it has, your plans for the future should factor in a world headed back to peace, progress and prosperity, albeit with some difficult years to be faced along the way.

On the other hand, 2008 may have been a first shock signaling the end of the post-World War II order whose peace, progress and prosperity lies behind us with an uncertain future directly ahead. Will that future find us descending into harder times than any of us have experienced? It’s certainly happened before.

Yes, I realize it’s hard to conceive. And I’m not saying the world is coming to an end by any means. On the other hand, we Americans, spared true hard times for so long, might consider the possibility that things may not get better before they get worse and prepare ourselves for all that may entail.

P.S. – The Chinese government may be tangling with the American government, but the Chinese people recently put their leaders on notice. To find out how, click HERE. Also check out the best comment we’ve found about the ongoing European debt crisis.

Richard S. Esposito, ChFC
Lighthouse Wealth Management LLC
405 Lexington Avenue, 26th Floor
New York, NY 10174
Tel: 212-907-6583/Fax: 866-924-1952

Email: resposito@lighthousewm.com