June 17th, 2015 Gold Chronicles topics:
*FOMC Meeting Analysis – No rate increase in 2015
*Dangerously low liquidity in bond market
*Back in the 80’s-90’s liquidity in the bond market was a given, virtually any amount could get filled – this is no longer the case
*Today large orders in the bond markets can take days or weeks to fill
*Lack of liquidity combined with High Frequency Trading (HFT) and selling volume is an environment where flash crashes are likely
*Warnings are coming from BIS, IMF, Federal Reserve governors regarding lack of liquidity
*When crashes occur there is always collateral damage – there are no circuit breakers in the bond markets so if there is an extreme panic we may see market closures
*Panics can spill over into other markets – we could see a bond market crash with a rising gold price
*Contagion and spillovers to other markets are typical behavior in a crisis
*Examples of hard assets: Land, Art, Physical Gold Fund
*State Backed hacking of US Government Employee Files
*Compromise of employee files does represent a national security threat
*Any portfolio reliant on all digital related assets is vulnerable to being completely wiped out
*South China Sea – China is claiming the entire South China Sea by creating artificial reefs and islands
*The US is bound by treaty and is obligated to act in the event of China war with the Philippines
*IMF SDR’s versus sovereign fiat currency
*Thoughts on gold confiscation happening in USA, EU, and Switzerland
*Why Switzerland is the best jurisdiction in the world to store precious metals
Listen to the original audio of the podcast here
The Gold Chronicles: 6-17-2015
Jon Ward: Hello, I’m Jon Ward on behalf of Physical Gold Fund, and I’m delighted to welcome you to our latest webinar with Jim Rickards in the series we’re calling The Gold Chronicles.
Jim Rickards is a New York Times bestselling author and former General Counsel of Long-Term Capital Management. He is currently the Chief Global Strategist for West Shore Funds, a consultant to the US Intelligence community and the Department of Defense, and is also an Advisory Board Member of Physical Gold Fund.
Hello Jim and welcome.
Jim Rickards: Hi Jon. Thank you. It’s great to be with you.
JW: I believe you’re in Baltimore today in preparation for an event you have there tomorrow. Is that correct?
JR: I am. I actually lived in Baltimore for five years. I went to college and graduate school here at Johns Hopkins, my daughter went to school here, and my publisher is here, so I have a lot of connections with the town. Baltimore is one of my favorite cities, and I’m just glad to be back.
JW: Excellent. Also with us today is Alex Stanczyk of Physical Gold Fund. Hello Alex.
Alex Stanczyk: Hi Jon. It’s great to be here as well.
JW: Alex will be looking for questions that come from you, our listeners, so let me just say that your questions for Jim Rickards today are more than welcome. You may post them at any point during the interview. You’ll see a box on your screen for typing in your question and, as time allows, we’ll do our best to respond to you.
Well, Jim, I happen to know, because you told me, that you’ve just been listening to Janet Yellen live at a significant press conference. What news? And any first thoughts?
JR: That’s right. Yesterday and today was the two-day Federal Open Market Committee (FOMC) meeting they have eight times a year. That’s when the Fed makes decisions on interest rates to either increase them, decrease them or keep them the same.
It’s kind of interesting if you go back to the fall or late summer of 2014 and recall what Wall Street was debating. They were certain the Fed was going to raise interest rates this year, 2015, and the debate was March versus June. You had your March people and your June people. I said at the time that they would not be able to raise interest rates in 2015.
Well, March has come and gone and now June has come and gone. This was the June meeting and they did not raise rates. Now Wall Street’s debating between the September people, October people, and a couple December people. I’m sticking with my original forecast, which was that they will not be able to raise rates in 2015, and so far, so good.
It is data-contingent, or “data dependent” as the Fed says. I actually think that my methodology stays a little more true to what the Fed says than what the Fed does. What I mean by that is the Fed says they’re data dependent and I say, “Okay, data dependent. That makes sense. I understand that. So let’s look at the data.” Well, the data stinks, it’s lousy, and yet the Fed keeps talking about raising rates this year as if somehow the economy was stronger than it was.
You might ask, “What’s up with that? I mean, why do they not get it?” The answer is that they’re basing everything on their forecast. We all look at the same data. They say, “Yes, the data’s lousy,” but they have a forecast that says it’s going to get better. Based on that better forecast, they then lead the market to believe they’re going to raise rates.
You have to remind yourself that the Fed has the worst forecasting record of any major institution; it’s horrible. Anybody can get a few things wrong or be off by a little bit, we understand that. But the Fed is always wrong by orders of magnitude. Go all the way back to 2009, look at their annual forecast for the last six years, and every one of them was off by a significant factor, not by a little bit.
I see weak data today and the Fed engaging in happy talk. Again, reminding listeners that the Fed has a terrible forecasting record, I see no reason to change my own forecast. I still don’t think they’ll be able to raise rates. Let’s see what happens.
So, after this latest meeting, kind of no news other than people should read the tea leaves when they look at the Fed’s statement and question if there is anything in there that might give a little clue even though they haven’t actually voted to raise rates. The Fed did lower a lot of their forecast figures. I keep saying they have a lousy forecasting record, but I guess they’re trying to get better. They lowered their growth forecast for 2015 to 1.9%. That’s really weak.
Janet Yellen gave a speech in Providence, Rhode Island, on May 22nd. Now, these speeches are not just things they slap together. They get reviewed by staff and the Governors themselves or, in Janet Yellen’s case, the Chair. I read it carefully, and she really gave us their playbook. She said what state of the world they would have to see in order to raise rates. In other words, what do they expect? What is their expectation behind the fact that they say they’re going to raise rates?
Ms. Yellen said very explicitly, “We’re looking for 2% inflation, 5% unemployment, and 2.5% growth.” There are the magic numbers: 2% inflation, 5% unemployment, and 2.5% growth. But she also said that the Fed needs to be forward-leaning to stay ahead of the curve a little bit and not let things get out of control.
That makes sense, so all I did was take those three numbers and haircut them a little bit to say, “What would the trigger be?” If you take the 2% inflation and call it 1.8%, that would be sort of a trigger. Make the 5% unemployment 5.2% and that’s a trigger. Then take the 2.5% growth and make it 2.2% for another trigger. So when you see 1.8% inflation, 5.2% unemployment, and 2.2% growth — all three of them or maybe two out of three — trending in the direction that she would like to get to, then the Fed’s going to raise rates. I would say they’d raise it very quickly. Probably within thirty days.
Using Yellen’s own words, I think we have the numbers or playbook we need in order to know exactly when they’re going to raise rates. The problem is we’re not there. The latest unemployment was 5.5%. That’s up from 5.4% and moving in the opposite direction of her 5% target and my 5.2% trigger.
I don’t have a crystal ball or a fly on the wall and I haven’t bugged the boardroom at the Fed. I’m just using their own words and data that are publically available to do some very straightforward analysis. I still don’t see any rate increase for the remainder of this year. Of course it could change, but these are things I watch very, very closely. Meanwhile, they’ve lowered the forecast and are trying to have it both ways. They’re trying to talk rate increase and, at the same time, not actually do anything because the data is weak. I think that act is getting a little old and the market is wising up.
It’s interesting. Right after the Fed announcement, in the past hour-and-a-half, the dollar went down a little bit. That’s a sign that the market thinks they’re not going to be able to raise rates. If they were going to raise rates in September, the dollar would trade up because you’ve got negative rates in Europe. If all of a sudden we’re going to have higher rates in the US, then global capital flows would come to the US, the dollar would catch a bid, and the dollar would get stronger. The fact that the dollar traded off a little bit — stronger Euro, weaker dollar — means the market thinks they’re not going to raise rates, and I think that’s probably the right conclusion.
That’s my analysis. Chairman Yellen is still speaking live as we speak, but unless she says something earth-shattering in the next ten minutes, I think that’s where we’re going to end up.
JW: Let me turn to a topic you’ve been talking quite a lot about recently, and that is the bond markets. In particular, you’ve been sounding the alarm about liquidity in the bond markets or, rather, lack of it. Given how central these markets are to the global financial system, this sounds, on the face of it, quite serious. Would you explain what’s going on?
JR: Just to give our listeners a little background on my association with the bond market, I talk and write and give presentations on a number of topics in the international monetary system, but I talk quite a bit about gold. Of course, the minute you say what I call the “G- word,” the minute you start talking about gold, you get labeled as a gold bug or whatever term people want to use. I think because I talk about it frequently, people assume I must have been sitting in my basement the last twenty years counting a stack of gold coins. Sure, I’m a gold investor and I recommend gold to clients, but not too much; about 10% of your investible assets. I don’t really regard myself as a gold bug and, unlike some analysts, I have not spent the last thirty years in the gold market. I spent the last thirty years in the bond market.
I began my career at Citibank, but for a large part of my career I was General Counsel and Chief Credit Officer of one of the largest US government securities dealers. It was a private firm at the time. We sold it to a Japanese bank, and later it was acquired by RBS, so when you hear RBS, Royal Bank of Scotland, that’s my old firm. We were one of the primary dealers in US government securities. For those who don’t know, “primary dealer” is a designation. It’s something you’re selected for by the Federal Reserve Bank of New York as an eligible counterparty for bond transactions.
Let’s do monetary policy 101. When the Fed wants to increase the money supply, which they have been doing for a long time, they buy bonds with money that comes out of thin air. When they want to decrease the money supply, they sell bonds. If you buy a bond from them, you send them the money and the money goes poof, it disappears. When they buy bonds, you send them the bonds, they send you the money, and the money comes out of thin air but somehow ends up in your account. That’s how they create money or destroy money or reduce the money supply if they want to.
That’s a lot of buying and selling of bonds. You need someone to buy or sell with because you can’t trade alone, so they have a list of about twenty approved counterparties. It’s all the big banks, the ones you would expect, that are the so-called primary dealers. I spent ten years of my career as Chief Counsel and Chief Credit Officer for one of the primary dealers, so I’ve spent a lot of time in the bond market, and that’s really my roots — more so than gold or other hard assets.
I was doing this in the ‘80s and then later worked for a hedge fund, Long-Term Capital, a major bond trader. The ‘80s and ‘90s were the heyday, if you will, of the bond market, and liquidity was a given. There was almost no size that you couldn’t buy or sell. If you wanted to buy $100 million of 10-year notes or $250 million of 2-year notes, you just picked up the phone (today, it would be automated), put that order in, and it was sold just like that.
As bond dealers, we made two-way markets; we were buyers and sellers. If you wanted to sell, we would buy from you or if you wanted to buy, we would sell to you. We committed our own capital most of the time. We didn’t get too one-sided or reckless, but we would step up and execute the order. Maybe for a short period of time we would want to hold it in inventory, maybe we would like to trade, maybe we would hedge it in the futures market or the options market or eventually move it out the door to somebody who wanted to take the other side of that trade, but we used our own capital and balance sheet to make a ready market. For customers, starting with the Fed but also all major institutions, insurance companies, PIMCO, bond funds, etc., they had no difficulty buying or selling bonds pretty much whenever they wanted.
That was true of government securities. Going down the credit spectrum into corporates and high-yield munis, liquidity was not quite as good, but it was always pretty good. Today, that model I just described is gone, and there are some very specific reasons for it. One is the Basel III rules that have increased capital requirements on a lot of bonds. High quality government bonds still require relatively little capital, but certainly corporate bonds, municipal bonds, asset-backed bonds, etc., have significantly higher capital requirements.
There’s the Volcker Rule, which has to do with whether you’re a proprietary trader versus just making markets for customers. There are different ways to make markets. You can make a market by taking something on your balance sheet but you can also just be an agent where you charge a small commission to pair up both sides of the trade but you never actually take the bonds onto your books. Then, finally, the regulators are breathing down everyone’s back.
Putting this combination together of Basel III capital rules, the Volcker Rule, and regulatory oversight, the banks and primary dealers have, in effect, been frightened out of committing capital or committing balance sheets. As a result, there is far less liquidity in the bond market than there used to be. I’ve spoken to people recently and they’ve said, “Jim, things that back in the day would take maybe a few minutes or a few hours to get done can now take days or even weeks to fill some of these orders.”
Again, liquidity is drying up, but it’s worse than that. A lot of the trading used to be done on the phone with a customer you knew. I’m sure we’ve all seen pictures of people shouting across trading floors. Today the trading floors are nearly gone and the ones that are left are mostly silent, because so much is automated. Inside that automation are a lot of algorithms. Now you have a lots of computers trying to front run each other, you have dealers who are not willing to commit their own capital to make two-way markets, and you have much less liquidity in general for the regulatory reasons I’ve mentioned. That’s a challenging environment, almost a perfect storm, for the kinds of things we saw last October in the flash crash of the bond market.
I think a lot of people know about the flash crash in the stock market on May 6th, 2010, when the Dow Jones fell a thousand points in a matter of minutes, but something very similar happened in the bond market last October 15th, 2014, when yields crashed. Prices went up, so the prices didn’t crash — they skyrocketed — but the yields crashed. That was like being on an airplane, hitting an air pocket, and dropping 2,000 feet, just like that. Everyone without a seatbelt banged his head on the ceiling or was thrown into the aisle or got injured one way or another. That’s what that was like.
We’re going to be seeing more of that, because when the dealers are not there to commit their own capital, customers are left to their own devices, everything is automated, and all of a sudden some word gets recognized or some trading algorithm gets touched off, everyone runs to one side of the boat. The market starts moving, other peoples’ programs get hit, people hit stop-losses, and everyone rushes for the exits all at once.
In the old days when everyone was rushing for the exits, the dealers would remain there and stand up to the market because they could see some profit opportunity. The dealers aren’t there now, so we are extremely vulnerable to these kinds of flash crashes. I think we’ll see more of them, some worse than the ones we’ve seen already, in stocks but also in bonds.
Jon, you mentioned at the beginning of the call that I’m one of the ones warning about it. I am, but I’m not the only one and I’m not the first. These warnings are coming from the IMF, from the Bank for International Settlements, from Federal Reserve Governors, and other regulators. These warnings are being sounded all over the place
From an investor’s perspective, this is all the more reason to be diversified. You really can’t trade stocks or bonds on fundamentals alone anymore. You might have a fundamental view, and there’s nothing wrong with that kind of analysis, but you’re vulnerable to these flash crashes. You’re vulnerable to markets suddenly becoming completely illiquid, so you need some hard assets and diversified assets.
Gold is interesting in that regard. Gold can be a thinly traded market. There are lots and lots of bonds that get traded, so the volume of bond activity is huge. It’s ironic that you have huge volumes but reduced liquidity in bonds; however, gold is funded the other way. The volumes are not big but the liquidity is very good. I’ve never seen a situation where you couldn’t go out and certainly sell gold if you want to, because there’s always a buyer. We might have the opposite problem. There might come a time when people want to buy gold and they can’t get it because there’s been a buying panic. At least for those who want to sell gold, I’ve never seen a situation where there wasn’t a willing buyer at a reasonable price although the market is thinly traded. Gold is thinly traded with good liquidity, and bonds are heavily traded with bad liquidity.
As I say, we have enough to be concerned about with inflation, deflation, Fed policy, weak economic growth, and cyber financial warfare, but I would add illiquidity to the list. And that is something new. You hear people say all the time, “Oh, the Treasury market is the deepest, most liquid market in the world.” Well, it might be the deepest but it’s not anywhere near as liquid as it used to be. I would add illiquidity in the bond market to the list of things that investors should be concerned about.
JW: From an investor point of view, you’re sounding a warning here. Are there systemic implications if there is a major flash crash in the bond market or if there are increasing problems in those markets? Does that have an impact on the larger financial system?
JR: It does, for a couple reasons.
Number one, and this goes way back in terms of my experience on Wall Street to 1987 when the stock market fell 22% in a single day. Down 22% not in a week or a month but a single day is the equivalent of about 3,000 Dow points today. If the Dow Jones went down 300 points, that would be big news. Imagine it went down 3,000 points in one day: that would be the equivalent to what happened on October 19th, 1987.
I saw that, I saw a bond market crash in 1994, and we’re all familiar with the Russia-LTCM crisis in 1998, etc. When these things happen, there are always victims. It might not come out right away but maybe a couple days later or sometimes a week later. Somebody goes bankrupt. There’s an MF Global or a Refco or some firm or an Orange County in the case of the 1994 bond market massacre. Somebody is going broke. When somebody goes broke, that means customer assets could be frozen and counterparty credit could not be honored. Anyone doing business with that firm probably lost some money.
Of course you have investor losses when the market goes down a lot in one direction. Anyone holding those positions has suffered at least a mark-to-market loss. But there’s usually collateral damage. Somebody gets carried off the field feet first on a stretcher and you don’t know who it is. That’s the Lehman Brothers effect. There’s some firm that’s not going to make it, although you don’t know who that firm is and you don’t know what the collateral consequences are.
Number two, sometimes when these flash crashes turn into not just a mini-crash but something that seems to be spiraling out of control, you can’t stand up to the market. I mean, there’s no amount of capital to get in front of a freight train that’s coming down the tracks at a hundred miles an hour. What regulators have to do is actually close the markets. In the case of the stock market, the circuit breakers kick in. We don’t really have circuit breakers in the bond market, but there’s no reason why the Fed or the securities industry couldn’t on very short notice get together and just declare the markets closed. Sorry! It’s like when casinos close similar to that scene in the movie Casablanca when the cops arrive.
From these mini-flash crashes or worse, not only do individual investors have losses, but generally one or more firms go out of business because their capital has been wiped out and, in more extreme cases, regulators will close markets. What does that do? That just feeds the panic that goes from one market to another. Maybe it started in the bond market but it spills over into the stock market or spills over into gold. The panics can go in either direction. There could be massive losses but, as we saw in the bond market last fall, yields crashed but prices went up so there were big gains. You get the flight to quality, and you could have a bond market crash where gold is rallying.
Actually, going back to one of the examples I gave regarding October 1997, my firm made a lot of money because we were not stock dealers but bond dealers. As the stock market was crashing, everybody was trying to buy bonds as fast as they could, so the bond market rallied. Some markets rally while other markets are crashing but, yes, what experts call contagion or spillovers are very likely. What starts in one market will probably not stay there. It’ll spill over into other markets and, in extreme cases, you could see exchanges get closed.
Again, this is another reason to think carefully about some hard assets as we’ve talked about before — whether it’s land, silver, gold or fine art. Obviously, Physical Gold Fund has a solution in terms of having part of your investible assets in actual physical gold. Not paper gold, COMEX futures, options or ETFs, but a fund that actually buys physical gold and puts it in safe, non-bank storage.
These are ways to stay out of the way of some of these tsunamis or digital meltdowns or nervous breakdowns or spillovers. I think you make a very good point, Jon, that this can easily spread from illiquidity and the flash-crash dynamic in a particular market over into things that are much more threatening from a systemic point of view.
JW: Thank you, Jim.
Let’s turn our attention to China for a moment and not for the first time, of course. There seems to be growing concern that the Chinese appear to be flexing their muscles more and more confidently and insistently. We have news of industrial-scale hacking affecting the personal and security information of every US federal employee. That’s millions of people inside the government systems. Do you share the media consensus view that this is China’s handiwork and, if so, what does it portend?
JR: Yes, I think the evidence is very good that this is China although they’re not the only bad actor in the space. Russia is just as good and just as active. It seems that one month we hear about Russia putting attack viruses on the NASDAQ operating system, which they did, and then the next month we hear about the Chinese downloading millions of files from the federal Office of Personnel Management, which they did.
I think a couple of things are important. Number one, these are state actors. These are intelligence and military services. Some of them organize as a cyber brigade. We know what an armored column looks like or a flight of F-16s looks like, but these are cyber brigades. They don’t leave their desk, but they can do a lot of damage from where they sit near Moscow and Beijing. These are state-organized attacks, not criminals trying to get your credit card number so they can steal money from your account.
At the more benign end, they are just stealing intellectual property, blueprints, and so forth. At the malign end, think about the personnel records. Yes, you might get credit card information, social security numbers, name, address, etc., but you’re also going to get a lot of personal information that might include medical records or security clearances. There’s a form, I think it’s the SF-86, you have to fill out to get a security clearance. It’s worse than any college application, I can guarantee that. There are tons and tons of information, references, background checks, results of polygraph tests, and so on.
The point is if you get all that information and combine it with information from public sources like social media, Twitter, Facebook, and all that, you can start blackmailing people, you can start threatening people. You can say, “Hey, we’ve got somebody. This person has a security clearance over here and over there we see that they’re in a little financial distress.” They’re very susceptible to basically becoming traitors or giving up secrets for money, which is one of the main inducements for traitors. These are the things that people mainly betray their country over. So these hackers have to find out who they are, who’s got the clearance, who’s got the vulnerability, who’s got four kids in college or whatever, and then they can start to penetrate the intelligence services.
This is very serious stuff. It can lead to blackmailing, various kinds of threats, targeted assassinations, and penetration of the intelligence community. In fact, I think I saw that MI6, the British equivalent of the CIA (that James Bond famously works for), recalled some of their case officers and agents from foreign postings because they were worried about the fact that these hacks had revealed their identities.
A lot of intelligence agents work overseas under what’s called official covers. If you’re a case officer in the National Clandestine Service (NCS) for the CIA, you may have an ID that says you work for the Agriculture Department or the Commerce Department as a trade liaison in the Embassy in Santiago, Chile, or whatever. You’re using some other official position and diplomatic immunity to conduct your spy activities. Well, what if they learned about that?
That’s the kind of damage that can be done. It’s very serious. The question is, what’s the United States going to do about it? Are we doing something similar to them? Well, we’re probably trying. Is there cyber war going on? I think there’s no question about it. I consider the United States to be at war with China and Russia today. It’s just a war that’s being carried out in cyberspace, not on the physical battlefield. And a lot of industrial damage is being done.
Number two, where will this lead? It certainly doesn’t bode well for economic cooperation. You want to move to less cooperation in the trade realm. Consider the fact that this trade bill got shot down in Congress, and members of Congress were talking about putting up tariffs. I don’t know if anyone heard Donald Trump’s presidential speech yesterday. I don’t get into endorsing political candidates and I’m not going to handicap Donald Trump’s chances, but he was the first candidate I’ve heard speak bluntly about trade wars and putting tariffs on Mexico, China, and Russia. Maybe he’s a fringe candidate, maybe not, but the point is, this is all out there and none of it is good for the globalized society that we’ve all been relying on for inexpensive Chinese imports and so forth.
It is a national security threat. Our audience is obviously most interested in the financial side of things. But just so you know, if they can get into the Office of Personnel Management, they can get into your bank, they can get into your Merrill Lynch account, they can get into your Charles Schwab account. At the risk of repetition, I think any portfolio that doesn’t have a slice of hard assets and any portfolio that’s all digital is vulnerable to being completely wiped out.
JW: Staying with China for one other point here: there’s the digital front, but on another front, there’s also a conflict brewing on the high seas. China seems to be giving new meaning to the phrase “nation-building”. They are building actual islands in the South China Sea, and it’s creating an enormous amount of tension. I’m just curious to know, do you think this is primarily about the oil that’s under those oceans or is it about other assets or is it a broader military strategic move?
JR: It’s probably all of the above. It’s certainly about the oil. The best data says there’s a considerable amount of oil reserves in the South China Sea.
The South China Sea is interesting. It’s sort of egg-shaped, an oval, if you will, elongated from north to south. If you look at a map, that’s where geopolitics gets its name; the politics of geography. The South China Sea is surrounded by the six countries of Taiwan, the Philippines, Brunei, Malaysia, Vietnam, and China. China is the furthest away. China has some coastline on the South China Sea, but it’s really Vietnam and the Philippines that dominate the landscape. Yet, China has claimed the entire thing. They said, “Okay, you other countries, you can have rights to the twelve-mile strip or whatever adjacent to your borders, but the South China Sea itself, we claim the whole thing.”
I don’t know what their basis for that is other than their size and intimidation factor and brute force. As you point out, they are now backing up that claim. Not legally but militarily by using landfill and artificial reefs and other engineering techniques to create islands out of nothing and then populate them. They put military bases on them, run up the flag, and say, “Here we are. You kick us out, which, of course, would be an act of war.” So, you’re just getting that many steps closer to a war between the United States and China.
The United States is not just a bystander. We have treaty obligations with the Philippines that at least legally and politically are on a par with NATO. That is to say, an attack on the Philippines is considered to be the equivalent of an attack on the United States. We would be obligated to come to the aid of the Philippines if there were any attack on them or any act of war. And, yet, China is getting closer and closer to doing exactly that.
The other problem is when you get all these navies and coast guards in close proximity. I don’t know if any of the listeners have ever piloted a vessel, but I’ve done quite a bit at sea. You get two or three boats in close proximity bobbing around on a dark and rainy night, the odds are pretty high that one of them bumps into the other, rams the other, hits the other. It’s not as cut and dried as you think. You could have an accident where maybe nobody wants a war to break out but two vessels hit each other in some adverse conditions, one sinks, and the next thing you know, the other one is launching missiles. This thing could spin out of control very easily. It’s an extra layer of concern.
It is about the oil but it’s also about China really emerging as a world power, which it had been for a millennium before the early 19th century. China went through a period of about 150 years beginning in the 1830s and 1840s with the Opium War when England forced China to buy opium. England had opium from Afghanistan and India and they wanted China’s goods, but they didn’t have anything the Chinese wanted. The Chinese went, “Get out of here. You don’t have anything we want.” The British said, “Here, start smoking opium. Get addicted, and then you’re going to want the opium.” And that’s what happened. The Chinese government tried to keep it out because they didn’t want their people addicted to opium, but the British went in with gunships, opened up the ports in Canton and elsewhere, and forced the Chinese to take the opium. They made them sign treaties, established a sphere of influence, and then the Germans, the Japanese, and ultimately the Americans weren’t too far behind.
There was also the Taiping Rebellion, which was an internal insurrection. Foreign troops were needed to assist the Qing dynasty in putting that down. Then there was the Boxer Rebellion, the Warlord period, the rise of communism, World War II, the Communist Revolution, and then Mao Zedong. That takes you all the way up to 1979 when Deng Xiaoping started to normalize things. So there were 150 years when China was a mess with internal chaos, disintegration, decadence, political disintegration, etc.
It fell off the world stage. Now they’re back, but, from the Chinese perspective, this is nothing new. You go back to Kublai Khan, the Manchu dynasty, the Tang dynasty, and the Sui dynasty — we’re talking about well over a thousand years — when China was the greatest power in the world. China was highly civilized when the Europeans were running around eating their meat with knives and hunting for protein. For China, this is nothing new. They don’t feel that they’re coming out of nowhere; they feel they’re just regaining and reemerging from a place they have occupied for a long time and that their eclipse was temporary.
This means their foreign policy has always been based on buffer states, i.e., all the states around China have to be subordinate to China. They don’t have to conquer them all but they do have to subordinate them all to make sure, (a) that they’re not threats, and (b) that they are economic vassals of a greater Chinese empire. That’s been Chinese foreign policy for over a thousand years, and they’re reestablishing that. As far as they’re concerned, Taiwan is not a separate country. They regard Taiwan as a part of China, they got Hong Kong back, and they look at Korea, Japan, and Southeast Asia as the Chinese sphere of influence.
They would say to the United States, “Okay, you guys can have everything up to Hawaii, maybe Guam, but anything west of Guam, that’s us. That’s our sphere of influence. So you guys, get out.” Of course the United States doesn’t see it that way at all. We have allies in the Philippines and in Japan where the Seventh Fleet is very active. In that part of the world, we project force on a forward basis. We’re very forward deployed in the region, and then the President is trying to do this Trans-Pacific Partnership to create a multilateral trading block that does not include China.
Where there are trade wars, threats of military war, and conflicts over resources (some of this is just taking the world back where it was before everything got locked into the Cold War), the potential for conflict is high. I would expect there will be some kind of incident, a shooting incident, sooner rather than later. That seems almost inevitable just based on history and what’s going on in the South China Sea.
What’s different now versus World War I, World War II, the Opium Wars, and the other things I mentioned is cyberspace. Cyberspace did not exist much before the 1980s, at least in the way we know it today. Warfare will spill over into cyberspace and that means attacks. What do you do in war? You try to destroy the other guy’s economy. If they don’t have an economy, the resources, the capability, the taxing authority, the wealth, and the other things they need, they can’t fight the war. How would you destroy an economy doing prior wars? You would bomb or invade or sabotage. How would you do it today? You would do it in cyberspace.
Again, I come back to this fact: If you have stocks, bonds, bank accounts, and money market funds in your portfolio, I look at that and say you have digital assets. I can wipe out your digital assets in a day if I’m Russia or China. That’s the reason to have some hard assets.
JW: Thanks, Jim. I’m glad I asked the question because it’s always so helpful to get this larger context. In particular, the historical context really makes for a great deal of clarity about what’s happening today.
We do have some great questions from our listeners, and here’s Alex Stanczyk with those questions.
AS: Very good. Thanks a lot, Jon.
Really quickly, I just want to take a moment and thank everyone who’s been sending in questions. We receive questions for these webinars on a regular basis through email, some also come in on Twitter, and many questions come in live as the webinar progresses. We appreciate all those that are sent in. As usual, we have far more questions than we have time to answer. We’ve got about twenty minutes left with Jim, but we will do our best to get some of the pertinent ones answered.
The first question came in by email from Ted G. and I’m going to paraphrase it a little bit. Jim, this is referencing your books, both The Death of Money and Currency Wars. You’ve mentioned in the past that in the next big liquidity crisis, if there is a large financial event, it’s going to be beyond the central banks’ ability to bail it out or to create liquidity in that event. You’ve indicated that you believe the IMF will come into play, and SDRs will play a large role in salvaging the global economy at that point. The question is: if SDRs are world money or international money, what do people use as currency?
JR: That’s a very good question. I’m very much of a global macro analyst, and I do focus on the international monetary system. One of the reasons I talk about the IMF and SDRs is because it’s something I have a lot of acquaintance with. I do view that as world money and a source of liquidity in a future liquidity crisis.
The Fed has printed about three and a half trillion dollars since 2008 in an effort to bail out the economy. I supported QE1 as an appropriate emergency response to a liquidity crisis, but QE1 and the liquidity crisis were over by the middle of 2009. By late 2009 unemployment was still high, growth was low, and we were struggling out of a recession. All those things were true, but there was no liquidity crisis. There was no shortage of money, yet the Fed continued to print money through QE2 and QE3. I think they have been completely counterproductive and no bang for the buck except that they bloated the balance sheet.
Here’s the thing. In 2008, when they started all this, their balance sheet was about eight hundred billion. Today, it’s well over four trillion. If the Fed had somehow managed to take the balance sheet from over four trillion dollars back down to eight hundred billion, I would say, “Okay, nice job. You know, that worked. If we have a liquidity crisis tomorrow, you guys can go print a couple trillion dollars, hand it out, and keep the game going.” But they haven’t. They got to four trillion and they’re still there. They have not normalized the balance sheet. Everyone focuses on interest rates. They haven’t normalized interest rates, but they haven’t normalized the balance sheet, either.
What are they going to do when the next crisis comes? Print another four trillion? Take the balance sheet to eight trillion? Legally they can, but I think that they would push through a confidence limit. There would come a time when people just say, “Okay, this is a joke. Money has lost its meaning. We’re going to get out of the dollar and into alternatives including hard assets.”
This is why I say that when the time comes, this money is going to have to come from the IMF, because the IMF does have a greater capacity to create money. We’ll still have dollars, but the dollar will lose its role as the global reserve currency. It will be a local currency or “walking around money” as we call it in Philadelphia. You and I will still have dollars. I’ll go to the bar or restaurant tonight and pay in dollars, but it’s like when I go to Mexico, I buy pesos. When I go to Turkey, I get some Turkish lira. When I go to the Middle East, I get some dinar. When I go to the UAE, I get dirham.
There are local currencies all over the world, including the Zimbabwe dollar, but none are reserve currencies. Nobody thinks you can buy oil or settle your balance of payments using them. You can’t buy oil with pesos and you can’t settle your balance of payments with dirham. You need dollars or euros to do that .
In the future, I would expect the SDR to be the global reserve currency. Oil would be priced in SDRs, countries would settle their balance of payments between each other in SDRs, and maybe the financial accounts of the hundred or so largest corporations, so a financial report from IBM or Volkswagen or General Electric or someone like that would all be presented in SDRs.
We’ll still have dollars, but the dollar will be a local currency, walking around money, something you need when you come to the United States but which is not particularly valued as an international medium of exchange. We’re not going to have SDRs in our pockets. There was a retirement party for a very prominent central banker in the 1970s where Paul Volcker went to a printer and, as a novelty, had some SDR paper notes printed up as a gag. But in reality there are no SDR paper notes. We’re not going to have them in our pockets and we’re not going to spend them at the ball game. We’ll still have the dollar, but you can think of it as similar to Mexican pesos.
AS: Thank you for pointing that out, Jim, because I think that’s very important for people to understand. A lot of people, maybe those who don’t deal with money on an institutional level, may not have really understood the difference and were concerned about the whole idea of switching to having to use SDRs.
For the next question, if we can switch over to gold for just a moment. We have a number of different people asking similar questions along the same lines, so I’m going to group them together. This question is coming from Fred H. amongst others who are asking essentially the same question having to do with gold confiscation.
As you’re well aware, in the United States history of gold, there was an executive order issued to confiscate gold within the United States. You have mentioned in the past that you don’t feel this is likely now. If we can break this into a couple of different segments: First, why don’t you think gold confiscation is likely in the US? Do you think it’s possible? Second, that may or may not be true for the EU, and in either case, why? And then third, as you know, Physical Gold Fund vaults in Switzerland, so what’s your view on Switzerland in terms of gold confiscation in light of what might happen over in Europe?
JR: Let’s start with the US. I don’t want to be categorical about this. I’m not going to say that confiscation could never happen, but I do think it’s extremely unlikely. The reason is that it’s very, very impractical at this stage.
First of all, believe it or not, not that many Americans own gold. I talk about gold all the time, I advise it and recommend it, but it’s not widely held. I wouldn’t even call this brainwashing, but we’ve had forty years of radio silence.
When I was in graduate school in economics in the ‘70s, it was shortly after Nixon closed the gold window. We did not go off the gold standard immediately, however. In 1971 he ended redemption. It’s like when a mutual fund or a hedge fund suspends redemptions. Nixon said, “Okay, you cannot walk up to the window with dollars and get gold. We’re closing the window temporarily.” He did use the word temporarily. It turned out to be permanent but, at the time, it looked like a temporary expedient. Technically we were still on a gold standard for about three more years.
It wasn’t really until around 1974-75, after a series of IMF meetings, that they officially demonetized gold. That was exactly when I was a graduate student in International economics, so I actually had to study gold as a monetary asset. I think I was the last one or the last class to do so.
Since then, for the last forty years, gold has not been taught. I always say if you know anything about gold, you’re either self-taught or you went to mining college. You must have been around for a while to have been taught gold in an academic context. So it’s not even that people are anti-gold, it’s just that they don’t know anything about it. They think it’s for jewelry, and they don’t think of it as any form of money. Of course, I think gold is money.
Gold is not as widely held as it was in 1933. In 1933 you could still have a $20 gold coin. An ounce of gold was worth $20.67 in the beginning of 1933. It is true that, beginning with World War I, most of the gold was hoovered up, turned into four hundred ounce bars, and put into vaults. Even people who owned gold probably had it in those larger quantities. It pretty much ceased to function as money in your pocket, but it was still legal tender and you could have a one-ounce gold coin worth twenty bucks to pay for dinner or whatever.
That ended in 1933 when it was made illegal for US citizens to have gold. It was at the depths of the Great Depression. The Depression started in 1929 and was the greatest depression in American history. Unemployment was over 20%, industrial production dropped by about 20%, the stock market dropped 85%, there were trade wars all over the world, currency wars, etc. It was a very, very desperate time. Roosevelt was the new President and people supported him. They were looking for a change and, so, when he issued that order, there was not a lot of resistance.
I think it would be completely different today. Most Americans don’t have gold, but those who do probably prize it very much. They have it precisely because they don’t completely trust the purchasing power of the dollar or they don’t completely trust digital assets and dollar assets. They want some diversification, they want some hard assets. So, they’re not just casual holders. They’re probably pretty committed holders.
I think between talk radio, certain members of Congress, certainly prominent Americans like Ron Paul and others — and I would include myself because we’re all advocating for gold —there would certainly be a lot of resistance to this. I’m not talking about civil disobedience, but I think the government would really have to think twice about confiscation. I do feel there are a number of prominent politicians who would stand up and try to prevent that from happening.
I believe it’s unlikely because I think there’d be a lot more resistance and a lot more practical problems. I mean, what are they going to do? Break down every door in America to see if you’ve got a vault or open up every safe deposit box in America? They actually might do that to safe deposit boxes because banks control them, so I recommend private storage or private secure logistics for gold rather than bank logistics. For all those reasons — there’s less trust in government, more willingness to push back, more politicians or public figures that might be on your side, etc. — I just don’t think it’s practical.
Now, will they try something tricky like a 90% excess profits tax on gold? Maybe. I don’t think you can rule that out, but I don’t view that as a reason not to own gold. People say, “Well, gee, what’s the point of owning gold if it goes up a lot? They’re just going to throw an excess profits tax on it. What good does it do me?”
I have two answers to that. Number one, they might not do that. I mean, they might do that but they might not, so let’s not assume that’s a foregone conclusion. Number two, you could see gold going from right now around $1,200 an ounce, a little bit less, to $2,000 an ounce, $3,000 an ounce, $4,000 an ounce, which I do expect. There may come a time when things are spinning out of control and it’s skyrocketing, so it would make sense to sell the gold for $5,000 or $6,000 an ounce and maybe put that money into some other asset class that’s less likely to be confiscated such as land or something else. But we’re a long way from that. I want to be along for the ride. I want to own the gold. I want to participate in that upside.
You can talk about it as gold going up, but I would view it as the dollar imploding and gold retaining its value while the dollar implodes. What’s really going up? It’s the dollar price of gold that’s going up. Another way to put that is every dollar buys you less and less and less gold. What’s really happening is the dollar is collapsing as the dollar price is going up.
I want to be along for that ride. Could there come a time when it gets so extreme that you want to sell the gold and pivot into another asset class? Maybe. That’s something I would watch carefully. But, as I say, we’re so far away from that right now that I want to own gold today and be along for the ride.
Now for the EU, a lot of the same considerations apply with one big difference. They have much more acquaintance with fascism than we do in the United States. Whether it’s Mussolini in Italy, Hitler in Germany, Stalin in Russia or Franco in Spain, I regard all four of them as fascists. I know they have different labels such as Hitler was a Nazi, Stalin was a Communist, and Franco called himself a Nationalist. I understand all that, but let’s consider it in political science terms. Instead of getting involved in name-calling, try to be objective about what kind of societies they were.
Europe has a lot more acquaintance with fascism than we do in North America although maybe we’re not that far behind. For all the socialism that goes on over there, they are a little bit more respectful of privacy rights. Look at Google. Google’s getting a much tougher time in Europe than they are in the United States about privacy, data mining, and what they do with your information and all that. Europe’s confiscatory tradition has been so abused in the past that it might be less active. You might actually be slightly better off in Europe. That would be the first thing I would say.
With regard to Switzerland specifically, Switzerland is my favorite jurisdiction in the world for security and liberty and respect for the rule of law. It’s not perfect, though. For an American doing business in Switzerland, forget it. The Swiss have been bludgeoned by the US government — Treasury in particular — into handing over all records on US citizens. As far as I know, you don’t have to declare foreign gold accounts, but you do have to declare foreign bank accounts. If you have a foreign bank account, you must say so on your income tax return. The US has pretty much hoovered up all Swiss bank records of all US accounts anyway, so if you didn’t declare it, good luck to you because you’ll probably get a phone call from the IRS if you haven’t already.
Bear in mind the US has global tax jurisdiction. Most other countries, in fact I think every other country in the world, taxes you on what you make in that country. If you work in Canada, you pay Canadian tax. If you work in France, you pay French tax. Now if you work in Monaco, you don’t pay French tax, and if you work in the Cayman Islands, you don’t pay Canadian tax even if you’re a Canadian citizen. The US is different. As a US citizen, you’re taxed on your worldwide income. It doesn’t matter where you make it or where you have it.
The Swiss do take this seriously. They have not been invaded successfully for over 500 years or maybe longer. The last time somebody tried to invade them, a Swiss force met them on almost a suicide mission. The Swiss were outnumbered and killed, but they just wanted to prove a point and they did. The invading army retreated pretty quickly.
Of course, the country is heavily armed. A lot of those mountains that you like to ski on and they look pretty from the train, well, guess what? They’re hollowed out and have armaments, artillery, communications, and command-and-control stations. It’s interesting to note that some Swiss vaults are buying hollowed out mountains from the Swiss Army and using them as vaults. Some of the expanded capacity, in terms of Swiss vaulting, is actually inside a number of these mountain tunnels and chambers that have been hammered out for defensive purposes.
For all the reasons I mentioned, i.e., rule of law, national security, integrity, tradition, liberty, I think Switzerland is probably the best place in the world to store physical wealth. I know a lot of people talk about Singapore, but I’m just not a big fan of Singapore. It looks kind of libertarian from the outside with pretty good rule of law, and I do business in Singapore, but it’s a little too close to China. It’s a little too under the Chinese thumb for my comfort whereas Switzerland, I would say, isn’t under anybody’s thumb.
The order of the question was interesting, Alex, because you got an ascending order of security. Obviously, the US may be least secure, the EU is slightly better, and Switzerland is best of all.
AS: Very good. Thank you very much. I think that clarifies a great deal for a lot of people wondering about that topic. With that, it pretty much wraps up our conversation with Jim today. We appreciate it, as always, and I will turn it back over to Jon.
JW: Thank you, Alex. Let me remind our listeners that they can follow Alex on Twitter — his handle is @AlexStanczyk. There are great insights and valuable links from Alex to follow on Twitter.
Thank you, Jim Rickards. It’s always a pleasure and an education having you with us. Of course, you can also follow Jim on Twitter. His handle is @JamesGRickards.
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