CONFIDENCE GAME

AN INTERVIEW WITH JAMES RICKARDS

Octavian Report: Could you take us through what you see happening to the monetary system? 

James Rickards: The dollar, the yen, the euro — all are forms of money. I would say gold is a form of money. Bitcoin is a form of money. In times past, feathers and clam shells have been money. One of the criticisms of many  modern forms of money, of central bank money and Bitcoin in particular, is that they are not backed by anything.

I make the point — and I’m not the first one to say this, I actually learned this from Paul Volcker — that it is backed by one thing, which is confidence. Meaning if we have confidence that something is money, then it’s money. If you and I think something’s money, and you’re willing to take it from me in exchange for goods and services, and furthermore you believe that you can give it to someone else in exchange for goods and services and make investments, then it’s money. It functions as money. But the problem with confidence is that it’s fine as long as it lasts, but it’s very fragile and it’s very easily lost. Once it’s lost, it’s impossible to get back, or at least extremely difficult to get back.

When I talk about the collapse of the international monetary system, people think I must be an apocalyptic doom-and-gloomer. End of the world, we’re all going to be living in caves, eating canned goods. I say no, not at all. I don’t think it’s the end of the world, I just think it’s the end of a system that has in fact collapsed three times in the past 100 years. There’s nothing unusual about breakdowns in the international monetary system. When it happens, the major trading financial powers get together, sit around a table, and rewrite what they call the rules of the game. “Rules of the game” is actually a phrase, a term of art in international finance, for the operating system (just to use modern jargon) of the international monetary system.

All I’m doing is looking at the system dynamics. It’s very easy to see the collapse coming based on that, and then ask the question: when the collapse comes, what will the new system look like? That is, what will it look like after the next Bretton Woods, or the next Smithsonian agreement, or for that matter Genoa in 1922? The next time the powers sit around the table, what deal will they come up with? Then I work backwards from that to today, and ask: what can I or should I do with my portfolio now  to prepare for this new deal?

That’s the scenario. Now, I have the view that basically all the central-bank models, all the risk-management models used on Wall Street and in capital markets around the world are obsolete. There are much better tools available today. The three that I use most frequently — not the only three — are complexity theory, behavioral psychology, and causal inference. Causal inference also goes by the name inverse probability, and it’s also known as Bayes’ theorem. Three branches of science: one’s physics, one’s applied mathematics, and one’s social-psychological. That’s my tool kit, along with some other things.

Using those tools, it’s very easy to see the collapse coming for two reasons. One, in complex systems — and I would make the case that capital markets are complex systems nonpareil — the worst thing that you can have happen is an exponential function of scale. Meaning that as you scale up the system, you don’t increase the risk in a linear way, you increase it in an exponential way. To take a simple example, let’s say that J.P. Morgan tripled the gross notional value of its derivatives. You go to Jamie Dimon and say, “Okay, Mr. Dimon, you tripled your balance sheet. How much did the risk go up?” He would say: “Yeah, we tripled the balance sheet, but it’s long, short, long, short, long, short. The longs offset the shorts. You net it down, the actual risk is quite small relative to the gross notional value. That’s not the way to think about it. We tripled the balance sheet, but the risk went up a little bit.”

If you ask the everyday citizen, they would probably use intuition and say, “Well, if you tripled the balance sheet, sounds like you tripled the risk.” The correct answer is that Jamie Dimon’s wrong, and the everyday citizen using intuition is wrong. The correct answer is if you triple the scale of the system, you increase the risk by a factor of 10 or 100, some X-factor based on the slope of the curve, which is a power curve. It’s basically the degree, the distribution of severity and frequency of risk.

You go back to 2008: what did we hear about? Too big to fail, too big to fail, too big to fail. Today, the five largest banks in the United States are bigger than they were in 2008. They have a larger percentage of all the banking assets, and their derivative books are much bigger. Everything that was too big to fail in 2008 is much bigger today. Given the exponential function I just described, the risk is exponentially greater than 2008. Whatever you saw in 2008, get ready. A much bigger collapse is coming. Probably sooner than later.

I was general counsel of Long-Term Capital Management. I negotiated their bailout, so I had a front row seat for that. I was on the phone with the heads of the major banks. Jon Corzine at Goldman Sachs,  Sandy Warner at J.P. Morgan, David Komansky at Merrill Lynch, Herb Allison and others, and Bill McDonough and Gary Gensler from the Treasury in Washington. I basically negotiated that bailout and saw exactly how close the global system came to complete collapse. We were hours away from shutting every stock and bond exchange in the world. Literally hours away, and the bailout got done. Four billion dollars changed hands. The balance sheet was supported. A press release was issued and the crisis passed. But it was extremely close, and not a foregone conclusion at all that we could get that done.

Having witnessed that, and knowing the team at LTCM — we had sixteen Ph.D.s from MIT, Harvard, Chicago, Stanford, and Yale, and two Nobel Prize winners — I said, well, if the smartest people in the world in this field with 160-plus IQ’s can get it that badly wrong, they must be missing something. There must be something wrong with the theory, because they’re not stupid. Nobody likes to lose their own money, so there must be something wrong with the theory.

I spent the next 10 years working on this, about five years figuring out what was wrong, where the flaws were, and another five years figuring out what actually works to remedy them. I refined my models enough that in 2005 and 2006 I was warning people that a collapse was coming again. That it would be worse.

Now, I didn’t say, Bear Stearns’ hedge fund is going to fail at the end of July 2007. I didn’t say that Lehman Brothers was going to collapse in mid-September 2008. It wasn’t necessary. It was sufficient to say that the collapse was coming because none of the lessons of 1998 had been learned. I’m in the same state today: the lessons of 2008 have not been learned. I’m watching the dynamics, I’m watching it play out, and you can see the next collapse coming. Here’s the tempo. In 1998, Wall Street bailed out a hedge fund to save the world. In 2008, central banks bailed out Wall Street to save the world. Move forward 10 years — let’s say 2018, to pick a number — and who’s going to bail out the central banks? Each bailout gets bigger than the one before. Each collapse is bigger than the one before, which is exactly what complexity theory would forecast based on the scaling metrics and the dynamics I described.

So who bails out the central banks? There’s only one clean balance sheet left in the world. There’s only one source of liquidity. After all, the Fed took their balance sheet from $800 billion approximately in 2008 to a little over $4 trillion dollars today. The problem is they haven’t normalized. Now that the crisis is long over, they haven’t gone back to the $800-billion-dollar level, which would be a more normal balance sheet. They stayed at $4 trillion; they’re stuck there. They’re not doing more QE, but they are rolling over what they have and they can’t reduce the size of the balance sheet.

What are they going to do in the next crisis? Go to $8 trillion? To $12 trillion? What is the outer boundary of how much money they can actually print? Legally, there is no boundary. They could actually print $12 trillion if they wanted to. At some point, however, you cross this intangible, invisible confidence boundary that I described earlier — and that goes back to the original problem of confidence in any form of money. And all the other central banks are in the same situation. The People’s Bank of China, the Bank of England, the Bank of Japan, the European Central Bank. It’s not unique to the U.S. If the central banks don’t have the wherewithal to liquefy the world in the next panic, and if the next panic is coming and you can see it a mile away, where will the liquidity come from? There’s only one source of liquidity left in the world, which is the IMF. They can print world money, which are the special drawing rights or SDRs.

When you get to the endgame, they’re going to have to print trillions of SDRs (each SDR is worth about $1.50) to re-liquefy the world in a global financial panic. Will that work? In theory it could work, but I expect if it works, it will only be because nobody understands it, like something’s happening and, as Bob Dylan sang in “Ballad of a Thin Man,” “Something’s happening here and you don’t know what it is.” At best, it will be highly inflationary.

Now, maybe it won’t work. Maybe people will say, “I’ve lost confidence in Federal Reserve money and European Central Bank money and Bank of Japan money. Why should I have any more confidence in IMF money? It’s just another form of currency, and I’ve lost confidence in all of them and I’m going to go get some gold.”  If that actually happens, the world may have to go to a gold standard. Now, I guarantee there’s not a central bank in the world that wants a gold standard. They may have to go to one, not because they want to, but because they have no choice, because it’s the only way to restore confidence. That raises an interesting question: if you go to a gold standard, what’s the price of gold? I talk about this in The New Case for Gold, about the blunder of 1925 with Churchill taking the U.K. back to a gold standard at a price that Keynes warned him was deflationary. Keynes didn’t favor a gold standard at the time. He did in 1944 and he did in 1914. He didn’t in 1925, but he did tell Churchill if you’re going to do this, you need a much higher price to avoid deflation. Churchill ignored him and threw the U.K. into a depression.

So question is: what is the implied non-deflationary price of gold today? I’ll use M1 of China, U.S., and the ECB, just as a frame. The answer’s $10,000 now if you have 40 percent backing — and over $50,000 if you have 100 percent backing of M2, which is a broader money supply. I don’t think you have to use M2. I don’t think you need 100 percent. It’s a judgement that’s debatable. But even on the modest assumptions of M1 using 40 percent backing, gold would have to be $10,000 an ounce to support the money supply. You may or may not have a gold standard, but if you do gold will be $10,000 an ounce.

Now, if you don’t, if the SDR thing actually works, gold will get to $10,000 an ounce the other way, which is inflation. Gold is going to shoot much higher. In the SDR scenario it will shoot much higher because of inflation, and in the gold-standard scenario it will shoot much higher because it has to, to avoid deflation. It’s not really the price of gold going up, it’s the devaluation of the paper currency. It’s the same thing. The dollar price of gold is just the inverse of the value of the dollar.

OR: Why do you say gold has to be part of a new system? What do you say to the people who think it’s an anachronism?

Rickards: The flaw in that — and I think this is one of the biggest problems today, and certainly an issue with everyone from Milton Friedman to Janet Yellen — is that they take confidence for granted. If you assume that confidence in paper money is infinitely elastic, then there’s no reason why the money supply cannot be infinitely elastic.

There are a lot of gold bashers out there who will be very quick to tell you that gold’s a barbarous relic, blah blah blah. But there are some more thoughtful people out there, among whom I would include Stephanie Kelton, Warren Mosler, Richard Duncan, and others. They’re all different, but they’re smart people. I’ve met a lot of them. Paul McCulley, formerly of PIMCO and a close associate of Bill Gross. They call themselves modern monetary theorists.

I think Adair Turner is coming out this way in his new book, Between Debt and the Devil, and even Larry Summers in some ways. What they’re saying is that there’s nothing you cannot print yourself out of. You get too much deflation? Print more money. Deflation won’t go away? Print more. People won’t spend? The government can spend. Maybe you cannot force people to spend it, but the government loves to spend money, they know how to do that really well. If it increases the deficit, so what? Just issue more debt to cover the deficit, and if people don’t want your debt, the central bank can buy it. Don’t worry about paying it back because the central bank can convert the treasury bonds into perpetual bonds. The whole thing just goes away. You don’t have to worry about the national debtthe Fed can just buy the whole $19 trillion of it, sock it away on their balance sheet, make it a perpetual note, and go play golf. What’s the problem?

This is sometimes called “helicopter money.” It’s called “people’s QE” by Jeremy Corbyn, it’s called “fiscal dominance” by Rick Mishkin. It has different names, but it always says the same thing: there’s no outer boundary on how much money you can print, so what’s the problem?

My thesis — and here I’ll flip over to the behavioral-psychology side a little bit — is that it’s not a problem until it is. In other words, confidence can be sustained until it can’t. You can lose this very quickly, so I don’t believe that confidence is infinitely elastic. There’s nothing in human nature or history that says that. If you’re relying on confidence to say that money can be infinitely elastic, then you’re wrong. The concern is that the elites will go down this road — having been wrong about the wealth effect, about QE1, QE2, and QE3, about Operation Twist — and then they’ll somehow wake up and see they’re wrong again. But they’ll find out the hard way because confidence in the entire system will collapse. At which point, your only two remedies are SDRs and gold.

OR: What’s your take on central banks and gold?

Rickards: With regard to central banks and gold, I always say watch what they do, not what they say. If the U.S. has a budget problem, and we’re sitting on about $380 billion in gold, why don’t you just sell the gold and get some money? That’s what Canada did. That’s what the U.K. did. Why are we hanging onto it?

The question answers itself. Obviously, it has some value. Obviously, it has some role in the monetary system. In my book, I write about a discovery I made — one of those discoveries that’s hiding in plain sight. I had been working on a thesis that the Fed is, at least on occasion, insolvent. My basis for that was to look at the Fed’s balance sheet. They’re leveraged today about 113 to one. That’s unheard of. I’ve been in the hedge-fund business, I’ve been in the investment-banking business, I’ve been in the banking business for decades. Banks leverage maybe 12 to one, broker-dealers and investment banks leverage maybe 15 to one, a hedge fund will lever two or three to one (although that’s getting a little risky). Even Long-Term Capital Management was never leveraged more than 20 to one, and we were very aggressive about leverage. 113 to one is way, way off the charts.

Now, just to be clear, the Fed does not mark its value sheet to market. My thought experiment is: what if they did? There’s a lot of data out there about the composition of the bond holdings of the Fed, particularly those held at the New York Fed. It’s not difficult to get that information, to do some bond math, and mark it to market. Doing that, I discovered that they were in fact insolvent at various times along the way. I had this conversation with several Fed officials. One member of the board of governors, another individual who was not a member of the board, but a very, very close advisor to Bernanke and Yellen, a true insider, a Ph.D. economist, a friend of mine. I was able to have this conversation with him. Interestingly, the member of the board of governors more or less conceded my point, but her rejoinder was, “Well, maybe we’re insolvent, but it doesn’t matter.” In other words, central banks don’t need capital. That’s a point of view.

The other conversation was with the insider: he was adamant that they’ve never been insolvent, ever. Regardless of bond-market moves. He wouldn’t tell me why, so I got to thinking about it. I went back to the balance sheet to see what I was missing. And lo and behold, there was this gold item valued at $42 an ounce. I said, “Well I should mark that to market. If I’m going to mark the bonds to market, I need to mark the gold to market.”

Now, as I was doing this I noticed a couple things. The Fed’s gold holdings are approximately 8,000 tons exactly. Close to exactly the amount held by the U.S. Treasury. In intelligence work, the first rule is there are no coincidences, and this non-coincidence explains why the Treasury stopped selling gold in 1980. Bven as late as the late 70’s, the Treasury was still dumping gold to suppress the price. That’s not speculation; there’s declassified correspondence among President Ford, Henry Kissinger, Arthur Burns, and the Chancellor of Germany that lays this out. The Treasury was actually dumping thousands of tons of gold in the late 1970s, but then in 1980 it just stopped on a dime. The U.S. has sold almost no gold since. Instead, we got everyone else to dump their gold. We got the U.K. to dump six hundred tons in the beginning of 1999. We got Switzerland to dump over a thousand tons in the early 2000s. We got the IMF to dump four hundred tons in 2010. The U.S. has been prevailing upon all these other people to sell their gold, but we won’t sell any ourselves. Why? They can’t. The Treasury has to hold the gold they’ve got in order to honor, on legal and constitutional grounds, the certificate held by the Fed. This was received in exchange for the gold (with an explicit guarantee that the gold was there to backstop the Fed’s balance sheet).

So I was wrong the first time. The Fed has never been insolvent; my insider friend was correct. The reason I was wrong was not because of the bond portfolio, which would have made them insolvent, but because of the gold, which adds about $350 billion to the balance sheet. When you add that to capital on a mark-to-market basis, the leverage ratio drops from 113 to one to about 13 to one, which is pretty healthy for a normal bank. On top of everything else we’re discussing, you find that the Federal Reserve has a hidden asset, which is the value of gold, and that it’s well capitalized — if you count the gold. What does it mean when central bankers and public officials disparage gold, tell you it’s an anachronism, tell you it’s a tradition, tell you it’s a barbarous relic, tell you that you’re a fool to own it — and yet they themselves are propped up and made solvent by gold?

OR: More and more physical gold is leaving the tradable system as China and Russia stockpile it, yet huge derivatives are still being written on it. Can you talk about that disconnect?

Rickards: Well, there is a world of paper gold and there’s a world of physical gold. Now, paper gold to me is not paper gold. It’s paper, but it references the price of gold. There’s not going to be any actual large difference between the paper price and the physical price quoted whether it’s in London or Beijing, because of the arbitrages.

I just recently returned from Switzerland where I met with the head of the country’s biggest gold refinery, who told me that he’s seeing severe shortages in supply. This guy, he knows who all the big sellers are, he knows who all the big buyers are because he’s the biggest gold refiner and he takes it in and ships it out. He knows who all the players are and this is, again, in the physical world. He said that with regard to his selling side, he has more demand than he can handle. He’s sending the Chinese 10 tons a week; they want 20 tons. He won’t provide it because he doesn’t have that much gold and he has other customers to take care of.

The physical shortages are already showing up and they’re getting worse. I’ve heard similar things from wholesale dealers — people who deal directly with London Bullion Market Association members and Comex-approved warehouses. These are the large holders of gold in the world, and they are saying that it is taking longer and longer to fill deliveries. The supply situation is stretched and probably about to break.

Meanwhile, the paper gold market continues to expand with 100-to-one leverage. Warehouses continue to get drawn down, contracts continue to be written. You have a very, very large inverted pyramid, with a broad base of paper gold on top and a tiny sliver of physical gold supporting the whole thing. It’s becoming wobbly, and it’s about to tip over.

Any break in that market — coming back to the issue of confidence — would lead directly to what I would call the mother of all short squeezes and a buying panic. What would I mean by a break? Well, most likely a failure to deliver. Suppose some dealer, some large bank, some exchange, some intermediary somewhere has sold a lot of paper gold and has been called upon by the buyers to deliver. They say, “I don’t want to roll over my contract, I don’t want cash settlement, I want the gold, please. Give me the gold.”

They’re not going to be able to get it. That failure will become public, because it always does, and will create a crisis of confidence. Everyone will run down to their dealers, their exchanges, and their brokers all at once and say, “Give me my gold!”  They’ll then discover that there’s only about one percent of what’s needed to fulfill that demand, and there’s nowhere near enough gold in the world at anything close to today’s prices (even if you could find it, which you probably will not be able to) to satisfy those contracts.

What would happen next? The answer is that, since you cannot deliver the gold, you’re going to have to terminate the contract, and it will come as a surprise to a lot of paper gold buyers that such terminations are totally legal. If you actually read the contracts gold buyers sign you’ll find what are called force majeure clauses or material adverse change clauses, meaning gold exchanges have the power to suspend delivery.  There’s also what’s called trading for liquidation only, which means you can roll over your contract or close it out, but you cannot take delivery. They have emergency powers to do, really, whatever they want to maintain orderly markets. So what they’ll do is they’ll terminate all these contracts using these contractual and governance provisions. They won’t steal your money, they’ll send you a cash settlement for yesterday’s price. But meanwhile the price of gold today will be going up $200, $300, $400, $500 an ounce. Day after day you’ll be sitting there, watching the exact hyperbolic price movements that were the reason you bought the gold in the first place — and you will not be participating in them.

You will be closed out at exactly the time when you most want the contract. That always happens. That’s the conditional correlation effect. The time you most want it is the time you won’t have it, because it doesn’t work for the other guy. They close you out, send you a check for yesterday’s price, and you’ll miss the move. And by the way, even if you want to jump back in, you won’t be able to buy any. Dealers will be sold out, mints will be backlogged, refiners will be backlogged. They won’t even take your calls. That’s what my friend in Switzerland told me. He said if I didn’t know you and you weren’t already a customer, I wouldn’t take your call. I’m not taking any new business because I cannot supply it.

OR: Can you talk about the so-called war on cash and the potential confiscation of gold?

Rickards: The war on cash is over. The government won. We hear about the cashless society and I think Sweden may be the first to get there. Others are considering it. Larry Summers writes an op-ed on abolishing the 100-dollar bill, and there’s a movement in Europe to get rid of the 500-euro note, so there are a lot of significant legal and political trends against cash. It’s really irrelevant, because we don’t use cash anywhere. You might have a few bucks in your wallet, but people get their paychecks from direct deposit, they get their retirement checks from direct deposit, they pay their bills online, they use their credit cards, they use their debit cards, and there hasn’t been a paper Treasury security issue, I think, since the late 1970’s. The dollar is already a digital currency, and so are all the other major currencies.

To the extent we have any paper money at all, it’s a token. To the point where you buy a two-dollar candy bar, you don’t even reach in your pocket and get out a five, you just swipe your debit card. We already live in a world of digital currencies, with respect to the dollar, the major currencies.

People say, “Yeah, but it’s still legal. I can go down to the bank and get $10,000 or $20,000 and stick it in a safe to avoid negative interest rates or have it for an emergency.” They’re wrong. It’s not that easy. If you go actually do it, actually go down to the bank and ask them for $15,000 or $20,000, you will be treated like a drug dealer or a tax evader. Some banks will tell you to come back in a couple days, that they have to order the cash. There’ll be reams of paperwork to fill out. They’ll file a report with the Treasury.

People are kidding themselves about the ease with which they can get cash. They are locked into a digital system. The war on cash is over and the government won. That’s just the prelude to negative interest rates. It’s like slaughtering pigs: you don’t chase the pigs around a field. You get them into a pen and then you slaughter them. What’s happening with savers is that everyone’s being rounded up into one of four or five digital pens, i.e. Citi and J.P. Morgan and Wells Fargo, and they’re going to be led to the slaughterhouse of negative interest rates.

OR: Do you think we are seeing a currency war going on internationally at the moment?

Rickards: About currency wars, let me say I’m always amused when I see a journalist or someone write a story saying “Oh gee, there’s a currency war. Look at this. China’s weakening against the yen.” I make the point that the most recent currency war started in 2010. I talk about it in my book on the subject which came out in 2011. It’s the same currency war. Wars consist of many battles, wars are not continuous fighting all the time. There are big battles and little battles; there are quiet periods and then a new battle erupts. You have an occasional D-Day or Battle of the Bulge, but some episodes are more intense than others.

Currency wars are the same. There are quiet periods, but it’s the same war. What I call Currency War One lasted from 1921 to 1936. What I call Currency War Two lasted from 1967 to 1987. I make the point that the world is not always in a currency war, but when we are they can go on for a very long time because they have no logical conclusion. It’s just back and forth, with a race to the bottom via competitive devaluations. The only conclusion to a currency war is either systemic reform or systemic collapse. Either the system breaks down completely or people get together, as they did at the Plaza Hotel in 1985, to give the system some coherence.

I don’t see the leadership, I don’t see the giants today. I don’t see people like James Baker, Bob Rubin, George Schultz, or John Maynard Keynes. I don’t see people like that on the landscape. I see a lot of people not of that stature in positions of power. I don’t see any awareness that this collapse is coming. So given the two possible outcomes — systemic reform or systemic collapse — I think systemic collapse is the more likely. But we are in a currency war and have been since 2010. We will be perhaps until 2025. Unless the system collapses earlier, which is what I expect.

It’s Time to Break Up Facebook (Chris Hughes)

Mark’s influence is staggering, far beyond that of anyone else in the private sector or in government. He controls three core communications platforms — Facebook, Instagram and WhatsApp — that billions of people use every day. Facebook’s board works more like an advisory committee than an overseer, because Mark controls around 60 percent of voting shares. Mark alone can decide how to configure Facebook’s algorithms to determine what people see in their News Feeds, what privacy settings they can use and even which messages get delivered. He sets the rules for how to distinguish violent and incendiary speech from the merely offensive, and he can choose to shut down a competitor by acquiring, blocking or copying it.

Mark is a good, kind person. But I’m angry that his focus on growth led him to sacrifice security and civility for clicks. I’m disappointed in myself and the early Facebook team for not thinking more about how the News Feed algorithm could change our culture, influence elections and empower nationalist leaders. And I’m worried that Mark has surrounded himself with a team that reinforces his beliefs instead of challenging them.

The government must hold Mark accountable. For too long, lawmakers have marveled at Facebook’s explosive growth and overlooked their responsibility to ensure that Americans are protected and markets are competitive. Any day now, the Federal Trade Commission is expected to impose a $5 billion fine on the company, but that is not enough; nor is Facebook’s offer to appoint some kind of privacy czar. After Mark’s congressional testimony last year, there should have been calls for him to truly reckon with his mistakes. Instead the legislators who questioned him were derided as too old and out of touch to understand how tech works. That’s the impression Mark wanted Americans to have, because it means little will change.

Facebook’s dominance is not an accident of history. The company’s strategy was to beat every competitor in plain view, and regulators and the government tacitly — and at times explicitly — approved. In one of the government’s few attempts to rein in the company, the F.T.C. in 2011 issued a consent decree that Facebook not share any private information beyond what users already agreed to. Facebook largely ignored the decree. Last month, the day after the company predicted in an earnings call that it would need to pay up to $5 billion as a penalty for its negligence — a slap on the wrist — Facebook’s shares surged 7 percent, adding $30 billion to its value, six times the size of the fine.

The F.T.C.’s biggest mistake was to allow Facebook to acquire Instagram and WhatsApp. In 2012, the newer platforms were nipping at Facebook’s heels because they had been built for the smartphone, where Facebook was still struggling to gain traction. Mark responded by buying them, and the F.T.C. approved.

Neither Instagram nor WhatsApp had any meaningful revenue, but both were incredibly popular. The Instagram acquisition guaranteed Facebook would preserve its dominance in photo networking, and WhatsApp gave it a new entry into mobile real-time messaging. Now, the founders of Instagram and WhatsApp have left the company after clashing with Mark over his management of their platforms. But their former properties remain Facebook’s, driving much of its recent growth.

.. When it hasn’t acquired its way to dominance, Facebook has used its monopoly position to shut out competing companies or has copied their technology.

The News Feed algorithm reportedlprioritized videos created through Facebook over videos from competitors, like YouTube and Vimeo. In 2012, Twitter introduced a video network called Vine that featured six-second videos. That same day, Facebook blocked Vine from hosting a tool that let its users search for their Facebook friends while on the new network. The decision hobbled Vine, which shut down four years later.

Snapchat posed a different threat. Snapchat’s Stories and impermanent messaging options made it an attractive alternative to Facebook and Instagram. And unlike Vine, Snapchat wasn’t interfacing with the Facebook ecosystem; there was no obvious way to handicap the company or shut it out. So Facebook simply copied it.

Facebook’s version of Snapchat’s stories and disappearing messages proved wildly successful, at Snapchat’s expense. At an all-hands meeting in 2016, Mark told Facebook employees not to let their pride get in the way of giving users what they want. According to Wired magazine, “Zuckerberg’s message became an informal slogan at Facebook: ‘Don’t be too proud to copy.’”

(There is little regulators can do about this tactic: Snapchat patented its “ephemeral message galleries,” but copyright law does not extend to the abstract concept itself.)

As a result of all this, would-be competitors can’t raise the money to take on Facebook. Investors realize that if a company gets traction, Facebook will copy its innovations, shut it down or acquire it for a relatively modest sum. So despite an extended economic expansion, increasing interest in high-tech start-ups, an explosion of venture capital and growing public distaste for Facebook, no major social networking company has been founded since the fall of 2011.

As markets become more concentrated, the number of new start-up businesses declines. This holds true in other high-tech areas dominated by single companies, like search (controlled by Google) and e-commerce (taken over by Amazon). Meanwhile, there has been plenty of innovation in areas where there is no monopolistic domination, such as in workplace productivity (Slack, Trello, Asana), urban transportation (Lyft, Uber, Lime, Bird) and cryptocurrency exchanges (Ripple, Coinbase, Circle).

I don’t blame Mark for his quest for domination. He has demonstrated nothing more nefarious than the virtuous hustle of a talented entrepreneur. Yet he has created a leviathan that crowds out entrepreneurship and restricts consumer choice. It’s on our government to ensure that we never lose the magic of the invisiblehand. How did we allow this to happen?

Since the 1970s, courts have become increasingly hesitant to break up companies or block mergers unless consumers are paying inflated prices that would be lower in a competitive market. But a narrow reliance on whether or not consumers have experienced price gouging fails to take into account the full cost of market domination. It doesn’t recognize that we also want markets to be competitive to encourage innovation and to hold power in check. And it is out of step with the history of antitrust law. Two of the last major antitrust suits, against AT&T and IBM in the 1980s, were grounded in the argument that they had used their size to stifle innovation and crush competition.

As the Columbia law professor Tim Wu writes, “It is a disservice to the laws and their intent to retain such a laserlike focus on price effects as the measure of all that antitrust was meant to do.

Facebook is the perfect case on which to reverse course, precisely because Facebook makes its money from targeted advertising, meaning users do not pay to use the service. But it is not actually free, and it certainly isn’t harmless.

Facebook’s business model is built on capturing as much of our attention as possible to encourage people to create and share more information about who they are and who they want to be. We pay for Facebook with our data and our attention, and by either measure it doesn’t come cheap.

I was on the original News Feed team (my name is on the patent), and that product now gets billions of hours of attention and pulls in unknowable amounts of data each year. The average Facebook user spends an hour a day on the platform; Instagram users spend 53 minutes a day scrolling through pictures and videos. They create immense amounts of data — not just likes and dislikes, but how many seconds they watch a particular video — that Facebook uses to refine its targeted advertising. Facebook also collects data from partner companies and apps, without most users knowing about it, according to testing by The Wall Street Journal.

Some days, lying on the floor next to my 1-year-old son as he plays with his dinosaurs, I catch myself scrolling through Instagram, waiting to see if the next image will be more beautiful than the last. What am I doing? I know it’s not good for me, or for my son, and yet I do it anyway.

The choice is mine, but it doesn’t feel like a choice. Facebook seeps into every corner of our lives to capture as much of our attention and data as possible and, without any alternative, we make the trade.

The vibrant marketplace that once drove Facebook and other social media companies to compete to come up with better products has virtually disappeared. This means there’s less chance of start-ups developing healthier, less exploitative social media platforms. It also means less accountability on issues like privacy.

Just last month, Facebook seemingly tried to bury news that it had stored tens of millions of user passwords in plain text format, which thousands of Facebook employees could see. Competition alone wouldn’t necessarily spur privacy protection — regulation is required to ensure accountability — but Facebook’s lock on the market guarantees that users can’t protest by moving to alternative platforms.

The most problematic aspect of Facebook’s power is Mark’s unilateral control over speech. There is no precedent for his ability to monitor, organize and even censor the conversations of two billion people.

Facebook engineers write algorithms that select which users’ comments or experiences end up displayed in the News Feeds of friends and family. These rules are proprietary and so complex that many Facebook employees themselves don’t understand them.

In 2014, the rules favored curiosity-inducing “clickbait” headlines. In 2016, they enabled the spread of fringe political views and fake news, which made it easier for Russian actors to manipulate the American electorate. In January 2018, Mark announced that the algorithms would favor non-news content shared by friends and news from “trustworthy” sources, which his engineers interpreted — to the confusion of many — as a boost for anything in the category of “politics, crime, tragedy.”

Facebook has responded to many of the criticisms of how it manages speech by hiring thousands of contractors to enforce the rules that Mark and senior executives develop. After a few weeks of training, these contractors decide which videos count as hate speech or free speech, which images are erotic and which are simply artistic, and which live streams are too violent to be broadcast. (The Verge reported that some of these moderators, working through a vendor in Arizona, were paid $28,800 a year, got limited breaks and faced significant mental health risks.)

As if Facebook’s opaque algorithms weren’t enough, last year we learned that Facebook executives had permanently deleted their own messages from the platform, erasing them from the inboxes of recipients; the justification was corporate security concerns. When I look at my years of Facebook messages with Mark now, it’s just a long stream of my own light-blue comments, clearly written in response to words he had once sent me. (Facebook now offers a limited version of this feature to all users.)

The most extreme example of Facebook manipulating speech happened in Myanmar in late 2017Mark said in a Vox interview that he personally made the decision to delete the private messages of Facebook users who were encouraging genocide there. “I remember, one Saturday morning, I got a phone call,” he said, “and we detected that people were trying to spread sensational messages through — it was Facebook Messenger in this case — to each side of the conflict, basically telling the Muslims, ‘Hey, there’s about to be an uprising of the Buddhists, so make sure that you are armed and go to this place.’ And then the same thing on the other side.”

Mark made a call: “We stop those messages from going through.” Most people would agree with his decision, but it’s deeply troubling that he made it with no accountability to any independent authority or government. Facebook could, in theory, delete en masse the messages of Americans, too, if its leadership decided it didn’t like them.

Mark used to insist that Facebook was just a “social utility,” a neutral platform for people to communicate what they wished. Now he recognizes that Facebook is both a platform and a publisher and that it is inevitably making decisions about values. The company’s own lawyers have argued in court that Facebook is a publisher and thus entitled to First Amendment protection.

No one at Facebook headquarters is choosing what single news story everyone in America wakes up to, of course. But they do decide whether it will be an article from a reputable outlet or a clip from “The Daily Show,” a photo from a friend’s wedding or an incendiary call to kill others.

Mark knows that this is too much power and is pursuing a twofold strategy to mitigate it.

  1. He is pivoting Facebook’s focus toward encouraging more private, encrypted messaging that Facebook’s employees can’t see, let alone control.
  2. Second, he is hoping for friendly oversight from regulators and other industry executives.

Late last year, he proposed an independent commission to handle difficult content moderation decisions by social media platforms. It would afford an independent check, Mark argued, on Facebook’s decisions, and users could appeal to it if they disagreed. But its decisions would not have the force of law, since companies would voluntarily participate.

In an op-ed essay in The Washington Post in March, he wrote, “Lawmakers often tell me we have too much power over speech, and I agree.” And he went even further than before, calling for more government regulation — not just on speech, but also on privacy and interoperability, the ability of consumers to seamlessly leave one network and transfer their profiles, friend connections, photos and other data to another.

I don’t think these proposals were made in bad faith. But I do think they’re an attempt to head off the argument that regulators need to go further and break up the company. Facebook isn’t afraid of a few more rules. It’s afraid of an antitrust case and of the kind of accountability that real government oversight would bring.

We don’t expect calcified rules or voluntary commissions to work to regulate drug companies, health care companies, car manufacturers or credit card providers. Agencies oversee these industries to ensure that the private market works for the public good. In these cases, we all understand that government isn’t an external force meddling in an organic market; it’s what makes a dynamic and fair market possible in the first place. This should be just as true for social networking as it is for air travel or pharmaceuticals.

In the summer of 2006, Yahoo offered us $1 billion for Facebook. I desperately wanted Mark to say yes. Even my small slice of the company would have made me a millionaire several times over. For a 22-year-old scholarship kid from small-town North Carolina, that kind of money was unimaginable. I wasn’t alone — just about every other person at the company wanted the same.

It was taboo to talk about it openly, but I finally asked Mark when we had a moment alone, “How are you feeling about Yahoo?” I got a shrug and a one-line answer: “I just don’t know if I want to work for Terry Semel,” Yahoo’s chief executive.

Outside of a couple of gigs in college, Mark had never had a real boss and seemed entirely uninterested in the prospect. I didn’t like the idea much myself, but I would have traded having a boss for several million dollars any day of the week. Mark’s drive was infinitely stronger. Domination meant domination, and the hustle was just too delicious.

Mark may never have a boss, but he needs to have some check on his power. The American government needs to do two things: break up Facebook’s monopoly and regulate the company to make it more accountable to the American people.

First, Facebook should be separated into multiple companies. The F.T.C., in conjunction with the Justice Department, should enforce antitrust laws by undoing the Instagram and WhatsApp acquisitions and banning future acquisitions for several years. The F.T.C. should have blocked these mergers, but it’s not too late to act. There is precedent for correcting bad decisions — as recently as 2009, Whole Foods settled antitrust complaints by selling off the Wild Oats brand and stores that it had bought a few years earlier.

There is some evidence that we may be headed in this direction. Senator Elizabeth Warren has called for reversing the Facebook mergers, and in February, the F.T.C. announced the creation of a task force to monitor competition among tech companies and review previous mergers.

How would a breakup work? Facebook would have a brief period to spin off the Instagram and WhatsApp businesses, and the three would become distinct companies, most likely publicly traded. Facebook shareholders would initially hold stock in the new companies, although Mark and other executives would probably be required to divest their management shares.

Until recently, WhatsApp and Instagram were administered as independent platforms inside the parent company, so that should make the process easier. But time is of the essence: Facebook is working quickly to integrate the three, which would make it harder for the F.T.C. to split them up.

Some economists are skeptical that breaking up Facebook would spur that much competition, because Facebook, they say, is a “natural” monopoly. Natural monopolies have emerged in areas like water systems and the electrical grid, where the price of entering the business is very high — because you have to lay pipes or electrical lines — but it gets cheaper and cheaper to add each additional customer. In other words, the monopoly arises naturally from the circumstances of the business, rather than a company’s illegal maneuvering. In addition, defenders of natural monopolies often make the case that they benefit consumers because they are able to provide services more cheaply than anyone else.

Facebook is indeed more valuable when there are more people on it: There are more connections for a user to make and more content to be shared. But the cost of entering the social network business is not that high. And unlike with pipes and electricity, there is no good argument that the country benefits from having only one dominant social networking company.

Facebook is indeed more valuable when there are more people on it: There are more connections for a user to make and more content to be shared. But the cost of entering the social network business is not that high. And unlike with pipes and electricity, there is no good argument that the country benefits from having only one dominant social networking company.

Still others worry that the breakup of Facebook or other American tech companies could be a national security problem. Because advancements in artificial intelligence require immense amounts of data and computing power, only large companies like Facebook, Google and Amazon can afford these investments, they say. If American companies become smaller, the Chinese will outpace us.

While serious, these concerns do not justify inaction. Even after a breakup, Facebook would be a hugely profitable business with billions to invest in new technologies — and a more competitive market would only encourage those investments. If the Chinese did pull ahead, our government could invest in research and development and pursue tactical trade policy, just as it is doing today to hold China’s 5G technology at bay.

The cost of breaking up Facebook would be next to zero for the government, and lots of people stand to gain economically. A ban on short-term acquisitions would ensure that competitors, and the investors who take a bet on them, would have the space to flourish. Digital advertisers would suddenly have multiple companies vying for their dollars.

Even Facebook shareholders would probably benefit, as shareholders often do in the years after a company’s split. The value of the companies that made up Standard Oil doubled within a year of its being dismantled and had increased by fivefold a few years later. Ten years after the 1984 breakup of AT&T, the value of its successor companies had tripled.

But the biggest winners would be the American people. Imagine a competitive market in which they could choose among one network that

  • offered higher privacy standards, another that
  • cost a fee to join but had little advertising and another that would allow users to
  • customize and tweak their feeds as they saw fit.

No one knows exactly what Facebook’s competitors would offer to differentiate themselves. That’s exactly the point.

The Justice Department faced similar questions of social costs and benefits with AT&T in the 1950s. AT&T had a monopoly on phone services and telecommunications equipment. The government filed suit under antitrust laws, and the case ended with a consent decree that required AT&T to release its patents and refrain from expanding into the nascent computer industry. This resulted in an explosion of innovation, greatly increasing follow-on patents and leading to the development of the semiconductor and modern computing. We would most likely not have iPhones or laptops without the competitive markets that antitrust action ushered in.

Adam Smith was right: Competition spurs growth and innovation.

Just breaking up Facebook is not enough. We need a new agency, empowered by Congress to regulate tech companies. Its first mandate should be to protect privacy.

The Europeans have made headway on privacy with the General Data Protection Regulation, a law that guarantees users a minimal level of protectionA landmark privacy bill in the United States should specify exactly what control Americans have over their digital information, require clearer disclosure to users and provide enough flexibility to the agency to exercise effective oversight over time. The agency should also be charged with guaranteeing basic interoperability across platforms.

Finally, the agency should create guidelines for acceptable speech on social media. This idea may seem un-American — we would never stand for a government agency censoring speech. But we already have limits on

  • yelling “fire” in a crowded theater,
  • child pornography,
  • speech intended to provoke violence and false statements to manipulate stock prices.

We will have to create similar standards that tech companies can use. These standards should of course be subject to the review of the courts, just as any other limits on speech are. But there is no constitutional right to harass others or live-stream violence.

These are difficult challenges. I worry that government regulators will not be able to keep up with the pace of digital innovation. I worry that more competition in social networking might lead to a conservative Facebook and a liberal one, or that newer social networks might be less secure if government regulation is weak. But sticking with the status quo would be worse: If we don’t have public servants shaping these policies, corporations will.

Some people doubt that an effort to break up Facebook would win in the courts, given the hostility on the federal bench to antitrust action, or that this divided Congress would ever be able to muster enough consensus to create a regulatory agency for social media.

But even if breakup and regulation aren’t immediately successful, simply pushing for them will bring more oversight. The government’s case against Microsoft — that it illegally used its market power in operating systems to force its customers to use its web browser, Internet Explorer — ended in 2001 when George W. Bush’s administration abandoned its effort to break up the company. Yet that prosecution helped rein in Microsoft’s ambitions to dominate the early web.

Similarly, the Justice Department’s 1970s suit accusing IBM of illegally maintaining its monopoly on computer sales ended in a stalemate. But along the way, IBM changed many of its behaviors. It stopped bundling its hardware and software, chose an extremely open design for the operating system in its personal computers and did not exercise undue control over its suppliers. Professor Wu has written that this “policeman at the elbow” led IBM to steer clear “of anything close to anticompetitive conduct, for fear of adding to the case against it.”

We can expect the same from even an unsuccessful suit against Facebook.

Finally, an aggressive case against Facebook would persuade other behemoths like Google and Amazon to think twice about stifling competition in their own sectors, out of fear that they could be next. If the government were to use this moment to resurrect an effective competition standard that takes a broader view of the full cost of “free” products, it could affect a whole host of industries.

The alternative is bleak. If we do not take action, Facebook’s monopoly will become even more entrenched. With much of the world’s personal communications in hand, it can mine that data for patterns and trends, giving it an advantage over competitors for decades to come.

I take responsibility for not sounding the alarm earlier. Don Graham, a former Facebook board member, has accused those who criticize the company now as having “all the courage of the last man leaping on the pile at a football game.” The financial rewards I reaped from working at Facebook radically changed the trajectory of my life, and even after I cashed out, I watched in awe as the company grew. It took the 2016 election fallout and Cambridge Analytica to awaken me to the dangers of Facebook’s monopoly. But anyone suggesting that Facebook is akin to a pinned football player misrepresents its resilience and power.

An era of accountability for Facebook and other monopolies may be beginning. Collective anger is growing, and a new cohort of leaders has begun to emerge. On Capitol Hill, Representative David Cicilline has taken a special interest in checking the power of monopolies, and Senators Amy Klobuchar and Ted Cruz have joined Senator Warren in calling for more oversight. Economists like Jason Furman, a former chairman of the Council of Economic Advisers, are speaking out about monopolies, and a host of legal scholars like Lina Khan, Barry Lynn and Ganesh Sitaraman are plotting a way forward.

This movement of public servants, scholars and activists deserves our support. Mark Zuckerberg cannot fix Facebook, but our government can.

Self-Fulfilling Financial Crises

Many mistaken assumptions about the 2008 financial crisis remain in circulation. As long as policymakers believe the crisis was rooted in the housing bubble rather than human psychology, another crisis will be inevitable.

.. Recall that by mid-2008, home prices had returned to, or even fallen below, levels supported by their underlying fundamentals, and employment and production in the residential construction industry had declined to levels far below trend. The work of rebalancing asset valuations and reallocating economic resources across sectors had already been accomplished.
.. To be sure, there still would have been around $750 billion worth of financial-asset losses in the form of defaults on subprime mortgages and home-equity loans. But that is only one-quarter of what global equity markets lost in seven hours on October 19, 1987. In other words, it would not have been enough to sink the global financial system.
.. Ben Bernanke, then Chair of the US Federal Reserve, seemed confident in the summer of 2008 that the correction in housing prices had not triggered any unmanageable financial crisis. At the time, he was mainly focused on the dangers of rising inflation.
.. And then the bottom fell out. The reason, Gennaioli and Shleifer show, is that beliefs changed.
  • Investors came to believe that financial markets were saddled with highly elevated risk, owing to a number of factors.
  • The interbank market had seized up,
  • homeowners were defaulting on their mortgages,
  • Bear Stearns had collapsed,
  • the US Treasury had intervened to rein in Freddie Mac and Fannie Mae, and, above all,
  • Lehman Brothers had declared bankruptcy.
.. All of this led to the sudden run on both the shadow and non-shadow banking systems, as investors scrambled to dump assets. The increased risk that they had imputed to the system became a reality.
.. And yet nothing about the fallout from the crisis was inevitable. Had the Fed been in possession of contingency plans for putting too-big-to-fail institutions into receivership and becoming the risk-bearer of last resort, we would probably be living in a very different world today.
.. Gennaioli and Shleifer’s second important contribution is to show that “crises of beliefs” like the one that precipitated the disaster of 2008-2009 are deeply rooted in human psychology, so much so that we will never be free of them.
.. Crises of belief are manifestations of a chronic condition that must be managed.
.. When fundamental beliefs have shifted permanently, one should not expect the same policy mix that supported full employment, low inflation, and balanced growth before the crisis to do so afterwards.
.. For a decade now, people have been looking for a silver lining to the disasters of 2008-2018, hoping that this period will bring about a more productive integration of finance, behavioral economics, and macroeconomic orthodoxy. So far, they have been searching in vain. But with the publication of A Crisis of Beliefs, there is hope yet.

Exclusive: Massive Pentagon agency lost track of hundreds of millions of dollars

A damning outside review finds that the Defense Logistics Agency has lost track of where it spent the money.

Ernst & Young found that the Defense Logistics Agency failed to properly document more than $800 million in construction projects, just one of a series of examples where it lacks a paper trail for millions of dollars in property and equipment. Across the board, its financial management is so weak that its leaders and oversight bodies have no reliable way to track the huge sums it’s responsible for, the firm warned in its initial audit of the massive Pentagon purchasing agent.

.. The department has never undergone a full audit despite a congressional mandate — and to some lawmakers, the messy state of the Defense Logistics Agency’s books indicates one may never even be possible.

.. The $40 billion-a-year logistics agency is a test case in how unachievable that task may be.

.. The DLA serves as the Walmart of the military, with 25,000 employees who process roughly 100,000 orders a day on behalf of the Army, Navy, Air Force, Marine Corps and a host of other federal agencies — for everything from poultry to pharmaceuticals, precious metals and aircraft parts.

.. In one part of the audit, completed in mid-December, Ernst & Young found that misstatements in the agency’s books totaled at least $465 million for construction projects it financed for the Army Corps of Engineers and other agencies. For construction projects designated as still “in progress,” meanwhile, it didn’t have sufficient documentation — or any documentation at all — for another $384 million worth of spending.

.. It also warned that the agency cannot reconcile balances from its general ledger with the Treasury Department.

.. the agency also maintained it was not surprised by the conclusions.

.. the Trump administration insists it can accomplish what previous ones could not.

.. That Pentagon-wide effort, which will require an army of about 1,200 auditors across the department, will also be expensive — to the tune of nearly $1 billion.

.. an additional $551 million to go back and fix broken accounting systems that are crucial to better financial management.

.. The accounting firm itself went further, asserting that the gaping holes uncovered in bookkeeping procedures and oversight strongly suggest there are more.

.. has repeatedly charged that “keeping track of the people’s money may not be in the Pentagon’s DNA.”

.. “I think the odds of a successful DoD audit down the road are zero,” Grassley said in an interview. “The feeder systems can’t provide data. They are doomed to failure before they ever get started.”