Punch #1, a left jab to the jaw, was a 5.8 Richter scale earthquake on Tuesday.

Punch #2, a right blow to the mid-section, was a Category 1 hurricane on Sunday.

Yep, within less than a week, we were shaken by an earthquake and deluged by a hurricane. I’m not sure what the chances were of that happening – ever – but to say that it was completely unexpected would be putting it mildly.

Hurricanes around here are rare (5 in the last 70 years), earthquakes even rarer. But they both just happened – WITHIN LESS THAN A WEEK! While some communities continue to suffer flooding from the hurricane, we can only hope that the experience encourages people to take more seriously the whole idea of being prepared.

Which is kind of what our exploration of the current dollar crisis has been about, isn’t it? For the last few months, we’ve continually asked: Are You Prepared? If you remember, starting last April and continuing through last month, we’ve tried to show:

• How We Know We Are Indeed in a Dollar Crisis Right Now
• Why This Dollar Crisis Could Wipe Out Your Wealth
• What Will Be Left When Our Dollar Crisis Ends

This month, we’re going to dig deeper into the details of the dramatic events of the late 1970’s and early 1980’s when things finally came to a head. Our mission will be to understand what happened then so that we can be better prepared for what’s happening right now. We’re going to see that 30 years ago the U.S. faced an almost disastrous run on the dollar. Will we be so lucky this time around?

To find out if we will, we’ll look at:

• What Nearly Drove the Dollar Off a Cliff

as well as

• Why the Crisis Came to Head and Almost Led to Calamity

But we begin our journey this month with:

Black Swans come in all sorts of shapes and sizes. In his second book, Taleb explained that all the statistical models that so many economists and investment professionals use to make “informed” decisions about economic policy and investing are fundamentally flawed because they don’t account or prepare us for Black Swans.

Foolishly, rather than learning the lessons taught by Taleb’s book, many in the financial services industry began twisting the meaning of “Black Swan” to suit their own agendas. Brokers referred to stock market corrections as Black Swans. Insurance agents tried to sell disability insurance by telling people they needed to be prepared for the Black Swan of being disabled. All of a sudden, where once there were none, it seemed like Black Swans were everywhere. But perhaps the most egregious misuse of the term came when our economy and our financial system swooned in 2008.

People told their congressmen and senators they didn’t want their money used to “bail out” Wall Street banks. It was perfectly reasonable thinking.

What made it reasonable was that many Americans figured that if Paulson, Bernanke et al couldn’t identify the causes of the storm before it happened, how could they be so sure their proposed Trillion Dollar bailout would make it go away? In other words, if they couldn’t identify the problem, how could these folks propose the solution?

For one brief moment the government piggy-bank was slammed shut. You could sense the frustration on the part of the economic experts and financial wizards as the people called their bluff. So the guys at the top turned to a one-two punch to knock out all resistance.

Punch #1, a right cross, was Taleb’s Black Swan: what happened was a one-in-a-gazillion year event that no one could possibly see coming, no less predict.

Punch #2, a left hook: scare the wits out of everyone by claiming that we were looking at nothing less than the total “collapse” of the world’s financial system – maybe even the whole economy – if Congress didn’t authorize the Trillion Dollar bailout.

In the end, resistance melted and they had their bailout.

Eventually, everything that the guys at the top couldn’t predict became a “Black Swan”: the subprime mortgage mess, the real estate debacle, the collapse of AIG, Bear Stearns, Lehman Brothers, Washington Mutual, and on and on. The “logic” was something along the lines of: we didn’t predict it, so it must have been an unpredictable event.

Of course, that was all nonsense. Each of these events, subjected to careful analysis beforehand, would have yielded enough evidence to allow an astute, albeit sophisticated, investor, to make a lot of money. Indeed some did. For example, the now-legendary John Paulson figured out that sub-prime mortgages would default in great numbers. He bet millions of his own money, along with his clients’ money. He made billions as the mortgages defaulted.

But even if you didn’t run a hedge fund with a staff of smart quantitative analysts to crunch the numbers, anyone who wanted to could see the gigantic credit bubble that had been steadily ballooning for the previous 30+ years. For example, a credit analyst named Doug Noland, published his Credit Bubble Bulletin every week (and still does) which addressed the growing Credit Bubble. I read them in the years leading up to 2008. So how could anyone claim that the sub-prime debt collapse, followed by the broad liquidity collapse in 2008 (brought on by the expanding Credit Bubble) were Black Swans? Beats me.

Meanwhile, the election of a new President, Jimmy Carter, in 1976 brought promises to reform the “corrupt” administration of Richard Nixon who had been impeached in 1974 as a result of the Watergate scandal. (It was Richard Nixon who unceremoniously dumped the Bretton Woods monetary system in 1971.) One thing Carter didn’t reform, unfortunately, was the nasty habit of printing money that began with President Johnson’s “guns and butter” policies of the 1960’s, and continued under Nixon in the 1970’s. In the new administration’s first two years, the supply of dollars increased by 55 billion, roughly 18 percent. It didn’t escape the notice of some in the U.S., and certainly didn’t escape the notice of our trading partners and foreign investors.

In 1971, the price of gold was $35 per ounce. By the time Carter took office in 1976, the price of gold was $100 per ounce. Within two years, it increased to $200 per ounce. A crisis was brewing.

I hope you can see that the first dollar crisis itself – as was the case with the 2008 crisis – was decidedly not a Black Swan. Anyone paying attention could see that the dollar was sinking in value relative to gold – and indeed relative to the currencies of countries like Switzerland whose government was not in the money-printing game at that time.

Ironically, the U.S. government would not only set the stage for the first dollar crisis by its money printing, but would also actually create the Black Swan that almost killed its own currency.

For the United States, though, the shock was accompanied by a human and political crisis that took center stage in the form of the kidnapping of 52 Americans who were then held hostage in Iran’s capital of Tehran by the revolutionaries.

But while international crises such as this one often rattle currency markets, it would not be the actions of the revolutionaries, but rather a 1 – 2 punch administered by the U.S. government itself that would drive the dollar to the brink.

Punch #1 – What Nearly Drove the Dollar Off a Cliff

As part of its reaction to the hostage-taking, the Carter administration did something as unexpected as it was dramatic: in 1979 it froze Iranian assets held in the United States. While this may not sound like such a big deal now, it was then. The last time the U.S. government froze another government’s assets was when it was at war with that country.

The theory here was: you have our citizens but we have your assets. But the young revolutionaries weren’t wealthy people who held assets in the U.S., so it failed to scare them into making a deal. Unfortunately, it did scare other wealthy Middle East investors, some of whose governments did not have the best of relations with the U.S. government at the time. Fearing that this expanded use of the “frozen asset” policy might someday turn in their direction, they began to dump their dollars in favor of gold. And so these Middle East investors began an international run on the dollar. But the government wasn’t finished yet.

Punch #2 – Why the Crisis Came to a Head and Almost Led to a Calamity

The very next year, 1980, the Soviet Union would invade Afghanistan. In retaliation for what the U.S. government considered a threat to global “stability,” President Carter prohibited American farmers from selling grain to the Soviet Union – a big customer at the time – along with other, vaguer threats. (One, which was carried out, was that the U.S. would not participate in the 1980 Summer Olympic Games in Moscow.) The theory again was that this pressure would cause the Soviets to leave Afghanistan and global stability would be restored.

Unfortunately the Soviets continued their invasion in the face of these threats, but now people around the world began to fear that the U.S. would pressure its Western allies to freeze the assets of the Soviet Union and other Soviet Bloc countries. At the time, Western banks held some $80 billion in Soviet Bloc debt. If Soviet Bloc assets were frozen, the fear was they would default on their debt, which would hit the balance sheets of dozens of banks holding the debt.

Investors knew that governments would be tempted to bail out the banks by printing money (sound familiar?) and so banks and currencies everywhere were threatened. Carter’s embargo, having not accomplished its real goal of getting the Soviet Union out of Afghanistan, instead called into question the integrity of the currencies of not only the U.S. but of other Western nations. The price of gold and silver skyrocketed as investors bailed out of all paper money. In response, the rate of interest that governments had to pay on their paper money soared in order to attract investors.

In fairness to the Carter administration, we doubt they expected that their actions would result in massive dumping of U.S. assets and an international run on the dollar.

And indeed, after some months, seeing that the assets of the Soviet Bloc countries were not being frozen, fear subsided. Some trust was restored to the world’s paper money system. The price of gold and silver drifted down. Over time, interest rates followed suit.

But the world’s investors had their first taste of what life would be like in a world where governments were no longer subject to the discipline of a gold standard of some sort – even if it was only the watered down version represented by the old Bretton Woods System.

Yet even as things calmed down, a new, less stable monetary system would evolve. Central banks began to print money with less restraint, and governments created more debt as interest rates continued falling through the 1980’s.

As for Wall Street, all this new money and increasing sovereign debt would simply represent fuel for newer, ever more risky financial “products” that would be developed in increasing numbers at increasing speed. Fortunes would be made. But that’s a story for another time.

Second, what happened in 2008 should not have shocked anyone – just as the possibility of future crises we will face in the coming years shouldn’t shock us. What we don’t know is exactly how and when a crisis will hit. But, again, the how and when may very well be the work of some future Black Swan.

Third, when you hear that the U.S. dollar could never collapse or be replaced as the reserve currency of the world, remember that people said the same things during the first dollar crisis. Frankly, it was a close shave – certainly too close for comfort. In fact, many of the ideas being suggested now to replace the dollar as reserve currency have their roots in the 1970’s and 1980’s: a basket of currencies, a basket of commodities, a combination of the two, SDRs (Special Drawing Rights), and more.

With the right Black Swan, we may not be so lucky this time around.

Are you prepared?

The initial fear that enveloped the streets drove me to my office building, praying earnestly, wondering whether death would find me that day (yes, it was that frightening in those first minutes). After the collapse of the second tower, the fear gave way to an overwhelming desire to get home to my family, especially as I wasn’t able to get through to anyone by either land-line or cell phone for a couple of hours.

I could write pages about the sounds, smells and images of that day and the months I spent working downtown after that. But rather than that, I wanted to share a simple reflection on the evil and ultimate futility of using power to get what you want. I’m not going to try to explain why it never really resolves anything either justly or, for that matter, permanently. Instead, I’m going to rely on some incredible music to make the point.

My first example comes from Tchaikovsky’s opera “Pique Dame,” also known as “The Queen of Spades.” Prince Yeletsky sings a beautiful aria to his fiancé, Liza. He senses that she has become uncomfortable with their relationship. I’ll spare you the rather tortured Slavic plot line except to say that we in the audience know that her discomfort springs from a misplaced fascination with some guy named Herman, a strange, obsessive character.

The important point here is that the Prince has the power to have his way, but instead appeals to Liza by expressing his love.

I found a version of the aria sung by the great Russian baritone Dimitri Hvorostovsky. It includes a translation into English. I hope you find this aria and this performance as moving as it was when I first heard it at the Metropolitan Opera.

And if opera’s not your thing (or even if it is) here’s some music that makes the same point in a different way. Stevie Wonder performed his song “Love’s in Need of Love Today” on the “Tribute to Heroes” broadcast only days after the attacks. I always liked the song, but, for me, this performance gave the song a special indelible meaning.

Sincerely,

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