The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: Today, James Rickards.
David: Our conversation with Jim, well, who is he? An investment banker, risk manager, lawyer. If you look at his CV, it’s a fascinating mix of experience in the capital markets, a negotiation with Long-Term Capital Management, as it was in the midst of being dissolved, how it was going to be bailed out and who was going to be involved, who was going to pick up what weight. He has done a variety of things, advising the Department of Defense and U.S. intelligence communities. He is constantly talking with hedge funds from around the world.
It was very interesting. Back in 2009 he served as a facilitator for the first-ever financial war games.
Kevin: This was in Virginia.
David: Conducted by the Pentagon. Obviously, you have probably seen and heard of him on CNBC, CNN, Fox, C-SPAN, those kinds of things, but also, lectures at Johns Hopkins. We could go on and on and on. I think what I like, and you will find this with many of our guests, is that they tend to be good lateral thinkers, from one category to another, from one field of endeavor to another. The fact that he has a legal background means almost nothing except that it’s just a part of who Jim is. The fact that he has capital markets experience, 30+ years, doesn’t define him, it’s just a part of what he brings to the table, and there is a lot that he brings to the table.
It’s one of the reasons why, on occasion, there are books that I consider nonnegotiable reads. I tend to buy them by the case, and in certain instances, require that they are read by as many people as possible. This is a book you must read, I’ve read it three times, and I think you will see quite clearly why, and how, we are today on a knife’s edge between depression and hyperinflation.
Kevin: David, you had the office read this book, and of course, when we read the books we also write reports. We come at it from our own view and then we gather and discuss. You buy everybody pizza and we take hours to discuss the book. But I’ll tell you, this one in particular had so many elements, we could have done this over and over and over. He talks about complexity, he talks about the financial markets. He understands currency wars. But what I think he really understands most is the value of real solid currency, and probably the return to that currency.
But in the meantime, Dave, there are ways to fight wars, and we are seeing Japan right now, declaring a currency war with their own yen just recently, but we have been seeing currency wars creep up, really, for the last two or three years.
David: It was Martin van Creveld who opened the idea to military strategists that the nature of warfare was forever changing, and he suggested that we would have low-intensity conflict becoming more of the norm. What Jim Rickards brings to this is something that I think, whether it is the professional soldier, or the student of history, and certainly the market practitioner will appreciate, there is something to be understood here. Financial and monetary destabilization, which is, like that low-intensity conflict, deliberately orchestrated, with domination, with displacement, with defeat, similar objectives, but outside that classic notion of armed conflict.
The idea of currency wars certainly goes back in history. Jim, you point out that there are two other instances of such conflict in the last 100 years, 1921-1936, and 1967-1987. Starting in 2010 we started to hear a lot more of that language. Brazilian Finance Minister Guido Mantega described it as an international currency war which had already broken out. This is the challenge, I think, for many of our listeners. Without a body count, without the physical destruction of war, I am sure people might appreciate clarification. What is a currency war? What are the inherent dangers? I know it is your contention that this is the third currency war in the last 100 years. How do these conflicts tend to be resolved?
Jim Rickards: Well, you have actually touched on two very important vectors, and let me kind of separate them, but they do come together. One is the idea of asymmetric warfare, and the other one is the idea of currency wars. The first one is exactly why this is a large area of strategic study right now, which is, if you look at conventional military warfare, there is not a country in the world that can stand up to the United States, that can go toe-to-toe with the United States, in terms of kinetic warfare, kinetic meaning things that shoot or explode. Our navy can sink any other navy. Our air power can suppress any other air force. Other aspects of our military can dominate any theater, not without loss or casualty, of course, but no one can really come close to us.
As a result of that, rivals of the United States, starting with Russia and China, but also Iran and others, are working on what are called asymmetric warfare tactics. What would those be? Some of them are obvious, biological warfare, chemical warfare, we’ve seen some of that in Syria today. Cyber warfare, of course, that is going on all over the world.
But one of the new fields is financial war, where you would actually try to disable or disadvantage your enemy or reduce their capacity, by fighting in the financial space using stocks, bonds, derivatives, commodities, etc. to actually wage war. That is one large field of study and I think was are going to be hearing more about that in the future, and I do talk about that in my book in the first two chapters. We describe the first-ever financial war game conducted by the Pentagon. This was conducted in 2009 at a top secret weapons laboratory outside of Washington, D.C., by the office of the Secretary of Defense. But there are many other components, the U.S. government intelligence community, Federal Reserve, and Treasury, who were present, as well as outside experts, myself included, and some folks that I recruited from Wall Street.
We spent two days doing this. We had the usual teams. There was a Russia team and a China team, but we also had a team that wasn’t a country – it was sort of hedge funds and Swiss banks – a U.S. team, etc., and it played out over a couple of days, but the rules were that you could only use financial weapons. I had worked with those on the China team and we worked with the Russia team to develop a gold-backed currency and said, starting now, anybody who wanted to buy Russian energy exports or Chinese manufactured export, had to use this particular gold-backed currency. So I will leave it to the readers, I hope they enjoy that, it’s described in a lot of detail, but apart from an individual war game, this is a growing field of study and engagement and will be an important part of the battle space in the future.
Now, the second thing you touched on is what I call the currency wars. These are more economic than military. They are fought out in the global macroeconomic space, but this is more conventional economic competition among countries. You aren’t really trying to fight a war, what you are trying to do is grow your economy, but you do it by cheapening your currency and stealing growth from your neighbors. This is the kind of thing that has been going on for centuries, and I do point to currency wars that you mentioned, one in the 1920s, one in the 1970s, but the currency wars is the topic of the book, but the book really covers both, the military aspect, and the economic, or financial aspect.
David: These conflicts obviously have an international context, but the purposes served are largely domestic, when you are facing declining growth, high unemployment, banking sector weakness, fiscal issues. These are things that you mention in your book. If you imagine a pie, as that pie shrinks, the pie being global GDP, there is greater competition to maintain the old slice, if you will. Nobody wants to see that happen, and this is where those policies, beggar thy neighbor policies of the 1930s, emerged, in competition for what there was, in a context that was changing for the worst.
It is these domestic issues that are driving international conflict. You describe three different theaters. Maybe you want to explore what those theaters look like.
Jim: Sure, David, and I think you are right. You make a very important point, that the currency wars are fought globally, but they are caused by domestic considerations. The main domestic driver in the U.S. right now is insufficient growth, either nominal growth or real growth, for that matter. One of the ways to stimulate growth, and we try to, but of course these are all forms of market manipulation, but the Fed always took the view that they could cut rates, lower interest rates, which would stimulate borrowing, consumption, investment, get the economy moving again. The problem, of course, is that in 2008 it got down to zero and they couldn’t cut any more.
So the policy question is, how do you stimulate the economy if you are the Fed, if you can’t cut rates any further because you are already at zero? And the answer is, you can cheapen the currency. Well, how does cheapening the currency cause inflation? A lot of people think that cheapening the currency is a way to promote exports. It can have some effect in the export sector. If the dollar gets cheaper and you are Indonesia, and you have to buy an airplane, you are looking at Airbus versus Boeing, maybe a cheaper dollar causes you to give the order to Boeing, and that creates some exports, and creates some jobs, so you do have those effects.
But that is not the main reason the Fed is doing it. The main reason they are doing it is to import inflation. The U.S. is not just an exporter, we are a large importer. In fact, we import more than we export. So when you cheapen the currency, what happens is your import prices go up. That creates inflation in the supply chain, which increases nominal GDP, if nothing else, but what the Fed really hopes is that because the inflation will cause people to spend more money, that will increase velocity, and that will kind of feed on itself and become self-sustaining and grow the economy.
Now, it hasn’t worked at all. I’m explaining what the Fed is trying to do, but I think it is important to point out that it is actually not working, partly because people are so shocked at what happened in 2008 they are hanging onto their money. They are clearly in a liquidity trap. But I would like to say, if you want something and you don’t get it, try harder, and that’s what we’ve seen with the Fed, first cutting rates, then QE-1, QE-2, QE-3, nominal GDP targeting, Operation Twist, forward guidance, currency wars, communication policy. The Fed has tried every trick in the book to get this economy moving, and it hasn’t worked, and it won’t work, at the end of the day. But they are going to keep trying, so I would expect that we will see a lot more money printing before all is said and done.
That is really the genesis, if you will, of the currency wars. It is an effort by countries to cheapen their currencies, not so much to promote exports, but to import inflation and drive GDP.
David: This is in the context of an incredibly complex system. We still have the dangers of 2008. Some would argue that there are future dangers. Some would argue that they are very much present dangers, but they are certainly not past tense. On your recommendation I’ve been reading Tainter’s book, The Collapse of Complex Societies. Maybe you can tie in the idea of complexity to the issues we inevitably face in our financial and monetary spheres.
Jim: Sure, David. I think it is a very good question. A lot of people throw the word complexity around to serve as an all-purpose descriptor of the fact that things are kind of hard to figure out, and they use complexity and complication interchangeably, but that’s not technically correct. Something can be complicated, but not necessarily be complex. For example, my watch is complicated. If you take the back off my watch, you will see springs and gears and jewels and all kinds of parts. It’s very complicated, but it’s not complex. A complex system actually has certain properties that go way beyond complication. One of them is the ability to throw up what are called emergent properties. Emergent properties are things that just seem to come out of nowhere in financial markets. People call them black swans. Black swan is a nice metaphor, but in fact, there is a lot of science behind it.
Tainter looked at the collapses of civilization through the millennia, and of course everyone has a little bit of familiarity with the decline and fall of the Roman Empire and that is one that is held up as an example of collapse, and indeed it is. But there are many others. There have been collapses of numerous Bronze Age civilizations around 1100 B.C., and a lot of smaller civilizations, some that many people have never heard of, have collapsed.
And we study them, and people say, well gee, what caused the collapse of the civilization, and they look at specific causes and they say, well, this one had a drought, or this one was invaded by barbarians, or this one had a disease, or this one had an earthquake and the physical infrastructure was destroyed. An invariably those things happen.
But what Tainter pointed out was that civilizations that fell to barbarians have had barbarian invasions before. And civilizations that collapsed due to an earthquake have had earthquakes before. In other words, those causes that historians point to have happened many times before, and the civilization withstood them, but suddenly it happened and they couldn’t withstand them, so he was looking at deeper causes. Rome is a good example. They fended off barbarian invasions for centuries, and then one day they couldn’t do it anymore. The barbarians came in and destroyed the empire. But what was different?
What he discovered is that civilizations over time become more and more complex, economies become complex, and what you get are these elites. It can be a priesthood, it can be an aristocracy, it can be a king and his court, and they become very extractive, and they take more and more wealth out of society, and eventually society hollows out from the bottom up. In other words, everyday citizens get tired of supporting the elites because they require so much money and energy and taxation to support these complex societies, and they just give up. That’s when the earthquake comes and they don’t rebuild, or the barbarians come and the don’t resist, or the disease comes and they don’t recover.
A lot of people imagine that, for example, when the barbarians invaded the Roman Empire, they had to fight their way all the way to Rome. That’s not what happened. What happened was that they invaded and the farmers welcomed them. The barbarians had a better tax policy. The barbarian tax policy was 10%, and they gave you protection and they left you alone. The Roman taxes at the time were closer to 20%, and they didn’t leave you alone at all, and if you tried to get out of paying taxes by not growing crops, for example, they would tax you on the crops you could have grown but for the fact that you didn’t choose to, so there was oppressive taxation from the center, oppressive control, a parasite class of elites who extracted wealth and didn’t produce anything of their own, that caused the bottom rungs of society to just give up, and then the entire empire fell.
So that’s Tainter’s thesis. He has very good evidence to back it up. As applied to the United States today, you can see this same thing happening. Tax burdens are becoming intolerable, more and more regulations, more and more taxation. Who is benefitting from that? It is the banking elite, the corporate elite, and the politicians.
Unemployment in Illinois is 9% statewide. But in Washington, D.C. it’s closer to 5%. Why is Washington D.C. doing so well? The answer is that they are taking wealth from the rest of us and spending it on themselves. I’m not saying the U.S. society is going to collapse tomorrow. What I’m saying is we are moving very dangerously in the direction of more and more complexity, more and more wealth extraction by the elites for their own benefit, and beginning to see some of the symptoms of a society in decline.
David: What we also saw from 2008, and it exists today, is the consequence of deregulation from the derivatives market. Ten years ago, the commodities futures modernization act, increase in the use of leverage derivatives and futures instruments by banks and hedge funds. This brings more complexity into the system, and as you say, there are these opportunities for there to be emergent properties, issues that are unforeseen, those black swans, as a consequence.
Now, tie into that, we, today, have the underlying physical markets being bullied and overwhelmed, whether it is the copper market, the oil market, the gold and silver markets, these comes to mind. Going back to our original idea of this being a conflict, a symmetric warfare, currency wars, etc., how do these derivative products serve as a tool, leaving companies more vulnerable to outside attack? That’s part #1 to the question. Part #2 would be, does this diminish the importance of fundamentals in those underlying physical markets?
Jim: Again, a very good question, David. I think that what you point to, the rise of derivatives, when the system collapses, and I do expect the international monetary system to collapse sometime, sooner rather than later, meaning the next 3, 4, 5 years. It’s not a 10-year forecast, but it’s not something that is necessarily going to happen tomorrow or next year, but in that 2-5 year range, we have the makings of a collapse in the international monetary system.
By the way, that is not meant to be a provocative statement. The international monetary system actually has collapsed three times in the past 100 years. It collapsed in 1914, again in 1939, and again in 1971, so it wouldn’t be that unusual or unexpected for that to happen again. When it happens, by the way, it doesn’t mean we all go to caves and eat baked beans. What it means is that the major financial powers and trading powers sit down and they reform the system. They have to recut their decks, so to speak, and one of the interesting questions to me is, what will that future international monetary system look like?
But coming back to the causes of the collapse, often when you have a catastrophe, it is something where we had some warning, there was some reason to believe it was coming. We had our warning in 1998 with the collapse of Long-Term Capital Management and the global financial crisis at the time. It was 15 years ago, a lot of people have forgotten about it. Certainly the amounts involved seem small compared to what happened in 2008, but it almost caused the complete closure of global markets. I was very involved in it, myself. I actually negotiated the bailout of Long-Term Capital Management, so I have a very good working knowledge of what happened there, and we were literally hours away from the collapse of global markets.
It was rescued at the last minute and it didn’t happen, so people didn’t pay attention to it, but just because we found the runways and landed the plan without a fire didn’t mean that it wasn’t very close to a catastrophe. The lesson, the warning, that came out of 1998 should have been to reduce derivatives, reduce the interconnectedness, reduce the risk, etc. What did Congress and the president actually do? They did the opposite. They increased the risk.
In 1999 we had the repeal of Glass-Steagall, which allowed banks to act like hedge funds, and then in 2000 we had the repeal of swaps regulation, which meant that not only could a bank be a hedge fund, but you could leverage yourself sky-high through these swaps. Then later on in 2004-2006, the SEC reduced the capital rules for broker-dealers, so instead of 15-to-1, which was the old maximum leverage, you could now go 30-to-1. Basel-II came along and allowed banks to increase leverage.
So here you are, you have this warning, this near-disaster in 1998. The disaster is telling you to reduce risk and reduce derivatives and instead public policy does the opposite. They let banks become hedge funds, they let them do more derivatives, they increased the leverage across the board. So I could see, in 2008, disaster coming a mile away. I was out in 2004 and 2005 lecturing and writing about my experiences in 1998, warning that this collapse was coming, and when it came it was completely unexpected.
I’ll give you a very concrete example of the law of derivatives. When the subprime crisis started in 2007, there were a lot of smart people, a lot of commentators, think of Ben Stein, in particular, who is an economist and a lawyer, who said this is nothing to worry about. By the way, Bernanke said the same thing. And here was the analysis. There was about 1 trillion dollars’ worth of subprime and other mortgages that were sort of like subprime. There were a trillion dollars of those. Historically, default rates had been sort of 4%. 5% was considered extremely high as a default rate on a mortgage.
So what did commentators say? Let’s assume a 20% default rate, which was outrageous. It was way beyond historical experience. So we have a trillion dollars in loans at 20% default rate, which is very high. That means 200 billion dollars of losses. In real terms it was not greater than the S&L crisis of the 1980s. So we said, okay, worst case we have 200 billion dollars of losses. That’s a lot, but we can deal with it, the system will bounce back. What they missed is that there may have been 1 trillion in mortgages, but there were 6 trillion dollars of derivatives.
So now, apply the same 20% assumption to the 6 trillion in derivatives, and you are looking at 1.2 trillion dollars of losses, 6 or 7 times the S&L crisis, and that is actually what happened. The reason it was so severe and so catastrophic, and so many firms failed, and so many more firms would have failed but for the government intervention, was because people were unaware of, and underestimated, the multiplier effect of derivatives on the underlying losses.
Well, guess what? In 2008 everyone said these banks are too big to fail. That’s a problem. Today, they are bigger. The five biggest banks in the United States are larger today than they were in 2008. They have a larger percentage of the total banking assets. They have large derivatives books. They are more interconnected. So everything that led to the catastrophe in 2008, which shouldn’t have happened, because we should have learned our lessons in 1998, today is even bigger. Now we have had two warnings, 1998 and 2008. I think we’ve had our last warning. Next time it collapses it will be for good.
David: Here’s the issue. We have command economy dynamics muting the market messaging system. This is really where the question emerges for me. To what degree has price discovery been damaged by Fed activism? Investors look at the markets today and arguably, as you said, too big to fail is now bigger, the derivatives market has not been tamed, there are risks as great as 2008, if not greater, and yet there are distortions in the marketplace which would lead you to believe and if you certainly hold to the efficient market hypothesis, there is nothing to worry about here, nothing at all. How do we approach the markets? Is the bond market telling us anything of relevance? Is the stock market telling us anything of relevance? In fact, the old litmus for stress and strain in the market, gold, is going down in the context of this “risky environment.”
Jim: It’s very hard to find a market that is sending out pure price signals these days, or a market that is not directly, or indirectly, manipulated by the Fed, and the reason is the Fed is engaged, obviously, in what they would call policy, I would call it manipulation, and fixed income markets. But the problem is, they are manipulating the price of money. And what is the price of money? Well, it is an interest rate. A high interest rate means money is expensive, a low interest rate means money is cheap or easy, as the case may be.
Well, there is not a market in the world that is not denominated in some kind of money. Whether you go to gold, or stocks, or other commodities, or any market you name, you put a dollar price on it. We say Apple is $450 a share, or we say gold is $1250 now, as the case may be. When you are manipulating money, which the Fed is doing, you are manipulating all these other markets, because they are denominated in money, or they involve exchanges for money.
And the problem is, the Fed is relying on markets to tell it what it is doing, but the markets, themselves, are distorted by the Fed’s own action. And so you create a feedback loop where you think you’re issuing policy over here, and you are looking at these other markets to tell you if you are doing a good job, but the other markets, themselves, are giving you distorted signals, because they are affected by the first thing you are doing, and that’s the curse of the function of the feedback loop. So the Fed is drinking some Kool-Aid right now.
Having said that, the markets are telling us a few things. You see the declining dollar price of gold, and we are all aware of it. It reached a peak of about $1900 an ounce in August 2011. Today it is, as we speak, somewhere down around $1250 an ounce. That is over a 30% decline, so a massive decline in the past almost two years. What is that telling us? What it is telling us is that the bigger concern is not inflation, but deflation. The way I think about it, you can hold the dollar constant, and look at the price of gold go up or down and say gold is volatile, or it is coming down, but what I prefer to do, analytically, is hold an ounce of gold as my constant, and then see what is happening with the dollar.
When you see the dollar price of gold going up or down, the way I think of it is, gold is constant, and what is actually happening is that the dollar is moving around, not the gold. So today, with the dollar price of gold coming down very sharply in recent months, what that tells me is that if gold is constant, then the dollar is getting stronger. Well, think about it. The Fed wants a weaker dollar to create inflation, but they are getting a stronger dollar, which is deflationary. The Fed is actually getting the opposite of what it wants. It’s a pretty scary thing when a central bank wants inflation and they can’t get it. That shows you how powerful the deflation is, and that’s what the price of gold is telling us.
So if you are the Fed, you have two choices. You want to just give up, throw in the towel, say, “Okay, we’ve tried everything, we’ve printed 3 trillion dollars, we talked a good game, we tried to trash the dollar, and did all these things to create inflation and it just didn’t work, so we give up.” That’s one approach.
Well if they do that, forget it. The asset prices are going to fall, and the gold will go down, and so will housing and stocks. I like to tell people, in that world, in the world where the Fed gives up and deflation takes over, gold could go to, let’s say, $800 an ounce, but the problem is, the S&P will be at $800 also. In other words, nothing moves in isolation. If gold goes down in nominal dollars, it won’t be alone. It will be because we’re in a massive deflationary vector and stocks are going to go down even more.
In some ways, you might like $500 gold better than $5000 gold, and the reason is that if gold goes to $5000, and I expect it will eventually, there are lot of ways to make money, but if gold goes to $500 that is such a deflationary, depressionary world, that gold might be the only way to preserve your wealth. In other words, the nominal price could be down, but the relative price, the real price, could be high. You always have to think about things in nominal and real space.
But I don’t think the Fed is going to do that. I don’t think they are going to throw in the towel. What they will do, as I said, is to try harder, and particularly with Janet Yellen, if she is the next chairperson, then you would expect the Fed’s balance sheet to go to 4 trillion, and they are getting close to that now, 5 trillion, 5-1/2 trillion, maybe 6 trillion. They are just going to keep printing until they have done the velocity curve and people start spending.
At that point, inflation will take off and the Fed thinks they can keep a lid on it, but they will find out that they can’t. In other words, the Fed thinks that they can take inflation from 1%, to 2%, to 3%, to 4%, and if it gets a little hot they can dial it back down again. But what they are going to discover is that it will go to 4%, and then it will go to 9%. In other words, it will spin out of control, which is exactly what happened in the 1970s. I’m not sure where it will go in the short run, but we might be a year, a year-and-a-half, or even two years away from that. These things don’t happen overnight.
David: Seeing inflation as a monetary issue, you have super-, or hyperinflation, which takes on more of a psychological or sociological dynamic. What do you see as triggering a loss of confidence in paper currencies? That is Part I. Part II – we had an interesting conversation with Guilio Gallarotti a number of years ago dealing with the international monetary system, the history, the role that gold has played, and I know that at some point in the future you see gold re-emerging as a part of the monetary system. How does that happen?
Again, Part I, what triggers a loss of confidence in paper currencies? And is that the circumstance that then opens up gold being remonetized to some degree?
Jim: Yes, I think it triggers as not a very important question or thing to think about, actually trivial, and let me explain why. What is important is not the trigger, but the instability of the system. And the metaphor here, but it’s more than a metaphor, because actually the mathematics and the complexity science and the critical state dynamics are the same.
Imagine a mountain, just think of the mountain back at Aspen Highlands, for skiers who are familiar with that, but a mountain where an enormous amount of snow has built up, and it is very unstable, and there is avalanche potential. But the avalanche hasn’t started yet, it’s just sitting there, but you know that potential is there and you know there can be an avalanche at any time. Now a snowflake comes along and hits and disturbs a few other snowflakes, and that slides, and it disturbs more, and it loosens more, and turns into a snowslide, then a chute, and then all of a sudden it gathers momentum and the whole mountainside falls loose and the avalanche comes and buries the village.
In that dynamic, what is important? Is it the snowflake? Or is it the instability of the mountainside? I would say it’s the instability of the mountainside. In other words, if it wasn’t one snowflake, it could have been the one before or the one after. If you have an unstable system, eventually something will cause it to go critical and collapse. The something doesn’t really matter because, first of all, you’ll never see it coming, secondly, you only know after the fact, and thirdly, it doesn’t matter. What matters is the thing collapsed.
When a nuclear bomb explodes, you look at the neutron generator and say, “Gee, was it that neutron over there?” It doesn’t matter. What happened is you destroyed a city and killed several hundred thousand people. What you care about is the critical state dynamics and the explosion, not the particular neutron that caused it. So I don’t worry about the neutron, I don’t worry about the snowflake. What I worry about is the instability of the system, because if you have an unstable system, it’s just a matter of time.
Thinking about, “Oh gee, will this failure, or this bankruptcy, or this act of Congress cause it?” You’ll never know, it doesn’t matter. What matters is, do you have an unstable system? And the answer to that is, yes we do.
David: I would recommend everyone read the book and look at some of the ideas you have relating to inflation being used as a policy lever, rearranging social and economic relations. There are a number of things in the book that I think are very, very intriguing. But as we wrap up, maybe you can look at this. If we were to return to a gold standard, how do you arrive at a price for the metal? The argument in the mainstream media is that there simply is not enough gold, therefore there are liquidity issues that would plague the system, and it just wouldn’t work. What does that look like?
Jim: Well, that is a standard objection to a gold standard, and that is complete nonsense, because there is always enough gold. It’s just a question of price. In other words, is there enough gold at $1200 an ounce? No. But there is plenty of gold at $12,000 an ounce. I am not necessarily predicting $12,000 gold, but what I am saying is, there is always enough gold to support the international monetary system, to support trade and finance, you just have to get the price right.
This is the great blunder of the 1920s. Prior to World War I, there was a very successful, what is called, the classical gold standard. The United States, at least, did not have a central bank prior to 1913. We had a growing economy, great innovation, great technology, expanding world trade from 1835 to 1913, and had no central bank. There was no Fed. We had a gold standard that worked very well.
That gold standard was abandoned suddenly in 1914 because of World War I and the countries knew they needed to print money to fight World War I. Once World War I was over and we were now in the 1920s, the major trading financial partners, France, England, Belgium, and others, wanted to go back to the gold standard. But it raised the question, “What should the price of gold be under the new gold standard? And France looked at that question and said, “Well, we printed an enormous amount of money to fight World War I, we cannot possibly go back to the old price. We have to have a much higher price so that the parity between gold and the money supply reflects the reality of a new higher money supply.” So France devalued the franc and at least in French franc terms, you had a much higher price for gold.
Great Britain did the opposite. They looked at the same problem, this was actually Winston Churchill’s decision, and he said, “We want to go back to the old parity, the old pre-World War I price of gold,” and in dollar terms, that was about $20 an ounce. But they had doubled the money supply. So, if you had an old parity and you doubled the money supply, and you want to go back to parity, you either have to double the price of gold, or cut the money supply in half. So England said they wanted to go back to the old price. That meant they had to cut the money supply in half, which was extremely deflationary and depressionary, and gave them an overvalued currency and contributed to the Great Depression.
With that as a history lesson, now move forward into a future potential gold standard. One of the most important things that they are going to have to do, whether this is done by the G20 or the IMF, is that they are going to have to get the price of gold right, and it is really 8th grade math. You just divide the amount of gold by the money supply and that gives you the price per ounce.
And there were some technical questions there. When you say money supply, do you mean M0, M1, or M2? You have to answer that because they are all different. And when you say backed by gold, what percentage backing? 100%? 40%? 20%? We can debate all those, and they are all different, but given those variables, given those inputs, I’ve done this math, the indicative price of gold is at the low end, $3000 an ounce, and at the high end, $45,000 an ounce, depending on who is in the club, what countries participate, what definition of money you use, what backing you use.
I expect that gold will be $7000 an ounce. That’s kind of middle of the road, but that is the nondeflationary price of gold based on current quantities of gold in the current money supplies to support world trade without deflation. It’s not going to happen tomorrow, but if we do go back to the gold standard, and you want to avoid the mistake of the 1920s, you are going to have to get the price right, and the indicative price, based on all the information we have, is about $7000 an ounce.
David: That’s very different than Roubini suggesting that we are going to $1000, or other “experts” who would say, clearly, the trajectory of the dollar is higher, therefore gold lower. I guess what you are really saying is that the half-life of the dollar is accelerating to the downside, even if we see something of a rally here in the dollar, or, as you say, if you treat gold as the constant, that’s really not where we are seeing volatility. It’s just in the currency. Am I correct in saying that you do see the dollar going lower over the next several years, or maybe just hitting a wall at some point?
Jim: Well, put it this way. The Fed wants a lower dollar. They are not getting it right now. The dollar is actually getting stronger. That’s because they have made noise about withdrawing policy, and interest rates have gone up, so U.S. capital markets have suddenly become more attractive, so money is falling out of the emerging markets into the U.S. market and that is putting a floor under the dollar and making it stronger.
But that’s not what the Fed wants. The Fed wants a cheaper dollar to import inflation, to drive nominal GP, as we explained earlier. So therefore, it they want something and they are not getting it, what are they going to do to get it? The answer is, keep printing money. So I think over time they will get there, but it doesn’t mean they get there right away.
David: Now you have the Fed and the PBOC saying the same thing. “We’re going to tighten.” The markets don’t like it. Who wins in this conflict between tightening, the suggestion of easing up on current monetary policy, and what the Fed has conditioned the market to expect – easy money, and lots of it?
Jim: I think the central banks are going to have to back off because when they understand the implications of what they are doing, when they stare into the abyss, they are going to lose their nerve, which is exactly what they did in 2008.
David: Jim, thanks for joining us. I would suggest – not suggest, I would insist – that any of our listeners read your book, Currency Wars, a primer on the past conflicts that we have experienced, and a real work of anticipation, as well, things that are in real time from the capital market perspective occurring, and risks that have to be addressed, either from portfolio management, or just appreciating the change in the nature of culture and our participation in it.
Thank you for your contribution, Jim. I know this is your first book, but I certainly hope it is not your last.
Jim: Thanks, David.
Kevin: David, something that Jim said that I think is so absolutely important to understanding the markets right now is that they are not sending clear signals. Price discovery is so important in being able to make correct decisions, and right now, when you are in a period of time when no market is sending a correct signal, including the gold and silver market, sometimes you have to step aside into what a person says is the stable money. When you are not playing the game, you are in gold. When you are playing the game, you are in currency, you are in stocks, you are in bonds, what have you. Doesn’t that make sense right now? No matter what the gold price does, if you want to step aside, be in gold.
David: Absolutely. I think one of the things that is important is to emphasize how imperative it is that the book gets read and is studied by our listeners. There are so many things that he talks about, whether it is a time frame, looking at a slack economy, where less developed countries will see an immediate impact to monetary policy, whereas more developed countries you can put in place monetary policy and you don’t see the inflationary impact for some time, because there is slack in the economy. There are those issues.
There are the issues of capital controls, both in terms of defending hot-money capital flows coming in, as well as the notion that people need to diversify geographically and have money outside of an area where you are talking about currency collapse occurring. One of the things that he highlights is that it is oftentimes the case that you have an increase in asset values in the context of the early stages of an inflation, and no one considers the inflation to be of any real concern because all they are looking at is being knee-deep in clover, not realizing that they are on the cusp of being knee-deep in something else.
Kevin: I think his point about the Federal Reserve testing the water a little bit by talking about tapering, it just is not going to work. These guys are so stuck in this system at this point, the Federal Reserve is so necessary, that they are going to have to continue to print, and he even named all the different names that they call it, from monetization, all the way to quantitative easing. They can call it what they want to call it, but it is still the creation of more money.
David: Kevin, you recall the conversation we had with Giulio Gallarotti. His emphasis was on, “We will not go back to a gold standard per se, but we will go back to something with the characteristics and disciplines of the gold standard.” I think for Mr. Gallarotti, what he is considering is current circumstances in which the establishment is not particularly open to a gold standard because of the disciplines that it brings into the system.
Kevin: But with a context change, like you were talking about.
David: And that is what I think Jim Rickards is considering. You are dealing with a radically different environment altogether. You are dealing with a collapse in confidence, and in that environment the only thing that restores confidence, historically, and future tense, is the role that gold plays in that monetary system. Jim’s not alone in this. There are a growing number of Wall Street and hedge fund experts that would say, “This is an inevitability. Now, what exactly is the time frame?
Kevin: Yes, time frame. When does that final snowflake cause the trigger of the avalanche?
David: The time frame is really up for grabs, and I think this is where experts in the field would say that 0-3 years is one scenario, and in that 0-3 year period, it could be tomorrow, or sometime in the next 36 months, that we see a 30%, 40%, or 50% decline in the value of the dollar. The other camp would say, I think, as Jim has put his flag in that camp, maybe it’s 3-5 years, nothing immediate, these things do take time. It is the Mark Twain notion of how did you go bankrupt? “Slowly, and then all at once.” How did the currency collapse? “Well, it was almost imperceptible, and then it was overnight.”
That’s his notion, I think 3-5 years, where we do have some time to play for. Let’s be thankful for that time. Let’s get our houses in order. And by all means, don’t neglect the reading and study of Currency Wars, by Jim Rickards.