Jim Rickards and Alex Stanczyk, The Gold Chronicles November 2017
*Understanding golds utility value
*First Principles regarding gold
*How wealth is created
*Why wealth can also be viewed as energy
*How money is a form of storing energy (wealth)
*How investments also store, but also leverage energy (wealth)
*Basic energy inputs which create a good or service that the market will pay for can all be calculated mathematically
*Gold is the only form of money or investment that is indestructible and completely immune to the forces of entropy
*How confidence and agreement is a key component of money
*Summary of theories of intrinsic value (total inputs), Marxist surplus labor theory, Menger’s subjective value theory
*Subjective value leads us back to confidence as a key component of money
*Why central banks are accumulating and stockpiling gold
*Greenspan on gold
*How to create your own personal gold standard
*Australia’s institutional market warming to gold
*Probability of Fed interest rate hike in December update
*Power consolidation in the House of Saud
Listen to the original audio of the podcast here
Physical Gold Fund presents The Gold Chronicles with Jim Rickards and Alex Stanczyk offering insights and analysis about economics, geopolitics, global finance, and gold.
Alex: Hello. This is Alex Stanczyk, and I have with me today the brilliant Mr. Jim Rickards. Welcome, Jim.
Jim: Thank you, Alex. It’s great to be with you.
Alex: Today we’re doing another addition of our Gold Chronicles podcast. In our last podcast, we covered a wide range of topics from institutional allocations in gold to an analysis of how U.S. warfighting policymakers are looking at the North Korea situation, and much more. If you want to hear any of our previous podcasts, the entire archive is available at PhysicalGoldFund.com/podcasts.
Let’s dive into our topics. First, as we often do, will be a discussion on gold. Some of this material may seem a little remedial to some, but a lot of people ask me about these foundational concepts. I continue to find that in the financial professional space, gold’s utility value is widely misunderstood or isn’t understood at all. For purposes of hitting on some of the basic education concepts, let’s break it down into first principles basics.
When I say first principles, that is a method of reasoning where we’re going to start with what we absolutely know to be true. We start with the facts and go from there instead of theorizing about gold being a good investment or a gold standard or anything like that. We’re just going to start with what we absolutely know.
We’ll begin with how wealth is created at its most basic level. A person can expend their labor, i.e., they invest energy. From this, they’re creating either a type of good or service that has value in the marketplace and some entity is willing to buy. A person creates wealth or energy by doing this above and beyond what is required for basic needs. In other words, anything in excess of how we pay for where we live, what we eat, the clothes on our back – basic necessities to survive – that is wealth. One way to look at it is as a surplus of energy. That’s the first part.
Now that we’ve created some wealth, now that we have a little bit of surplus or excess energy, the second part is, what do we do with that surplus or excess energy? You can either invest it or store it in money.
What is money? This is all super remedial, but bear with me. We’re getting to the good stuff here in just a minute. Going back to the basic economics textbooks, money is essentially a few different things – a medium of exchange, a unit of measure, and a way to store value. That last one is what I mainly want to talk about for this segment. Money is a storehouse of value or energy, and this is where gold’s utility value comes into play.
Gold stores value, and that is in fact its utility value. Not only does it store value, it’s the way it does it. Gold stores energy in a form that’s basically indestructible, and that’s the key. I’ll say it again; gold’s utility value is the fact that it stores energy in a form that’s indestructible. Unlike anything else you can invest or store money in, gold doesn’t rely on any external force for that to continue to be true over time. It’s sort of like a battery with no expiration date.
Jim, what are your thoughts on these first principle topics I’ve just talked about?
Jim: I certainly agree with your articulation of that, Alex. As you know, I covered a lot of the same ground, not everything you just mentioned, but some of the same ground in chapter 10 of my first book, Currency Wars, where I advanced the concept that what you call the battery theory, which I think is a good one, is that money is stored energy. I think we need to separate two things:
- What is money or how can we think about the definition of money?
- What is gold’s utility as money?
Obviously, there are many forms of money other than gold. I happen to think gold is a particularly good form of money that has been around for a long time, and I expect it will reemerge in the near future as a preferred form of money. Let’s talk about money first and then come to gold and its utility.
I think money is stored energy. The three things you mentioned are the classic economist definition of money. Economists don’t agree on much, they like to disagree, but this is one of the things they all agree on. I’ve never heard too much dissent. There’s a three-part definition of money:
- One is store value, which you mentioned.
- Another one is unit of account, just a way of counting things, “How much do we make? How much do we have?” etc.
- The other one is a medium of exchange, meaning we can use it to get other things.
Of those three, the unit of account is probably the least important. It’s not unimportant, but anything could be a unit of account such as soybeans, jellybeans, baseball cards or Bitcoin for that matter. Bitcoin is a unit of account, it’s how many Bitcoins you have, and so forth.
Unit of account is an easy one, but medium of exchange and store value are really the heart of it and much more difficult. Medium of exchange really depends on confidence. I lecture quite a bit around the world on money, and one of my slide presentations shows ten forms of money. You’ll see gold and silver, but also digital, credit card, Bitcoin, beads, feathers, and shells. I make the point that all of those things have been money at one time or another, and some of them still are. People will say, “Well, it’s not backed by anything.” My point is, yes, it is. It’s all backed by one thing, and that is confidence.
Forget about intrinsic value and what’s behind it, we’ll talk about that in a second. It’s backed by confidence. Paul Volcker said something I completely agree with, and it goes like this:
- I have something I think is money.
- You also think it is money.
- We both think that somebody else over there thinks it’s money.
- I give it to you for goods or services.
- You’re confident that you can give it to somebody else for goods or services.
- They’re confident that if they take it, they’ll be able to spend it as well.
Again, it could be feathers as it has been in certain indigenous tribes around the world. Maybe it was a small community and it didn’t last too long, but there was a time when clamshells and feathers were money.
It’s all based on confidence. The question is, how do you gain confidence, and what could destroy it? That’s how I think about money. When I think about gold, it has gained confidence over thousands of years and is almost impossible to destroy.
I have some grandchildren in the five- to seven-year-old range. They’re great because they’re curious and inquisitive about everything. If I show them a gold coin, they have an instinctive, natural, “Oh yes, that’s…” They just get it. Picasso said if we grew up painting like children, we’d all be like Picasso. I think if a lot of our PhD monetary economists could understand the intuitive appeal of gold a little bit better, it would have a greater role.
Gold is a very good form of money in the sense that it maintains confidence. Right now, people have confidence in the U.S. dollar, but we’ve seen so-called fiat currencies come and go. I don’t know who’s that confident in Bitcoin. It’s an interesting speculation for a lot of people, but I’m not sure it has much confidence behind it when push comes to shove.
The third thing we mentioned is store of value, and that gets to your battery metaphor. I view it as a form of stored energy, and that’s important, because you can then use physics and dynamic systems analysis, energy equations, and energy mathematics to begin to understand money.
How do you get money? One way is by working. What do you do when you work? You don’t have to be out digging pipeline ditches in the winter. You can be a writer, a lawyer or any white-collar profession, but you’re spending time, effort, and energy whether it’s brainpower, physical power, gas in your car to get to work or electric lights in the office. Whatever it is, you’re expending energy, and they give you money, whether it’s fees, royalties, a paycheck or whatever it is.
Now you have money. You’ve in effect stored up the energy that you exerted in acquiring it. You can then release the energy by hiring someone to work for you. To get your house painted, you hire the painter, the painter comes in and works hard, and you give that person the money. The money that you have has stored up the energy you used to acquire it, and then you can release energy from third parties by spending or investing it.
It fits that battery metaphor. Energy comes from somewhere whether it’s burning oil, natural gas or the sun, it goes into a battery, it’s stored there, and then it’s released later on to run a light bulb or power a tool, whatever it may be. That’s more than a metaphor, it’s actually an exact parallel.
The store value is it stores up the energy spent acquiring it, and it can release energy for your own goods and services. The medium of exchange, basically spending it, depends on confidence, and the unit of account is a little less important, but yes, you can use it to account with.
With all those things said, what is the utility of gold as a form of money compared to other forms of money? Here, we get into the economic history of value. David Ricardo was one of the first – if not the first – economists in the early 19th century to really wrestle with the theoretical concept of value.
There have been big markets since ancient Greece and Rome, and for that matter in the Bronze Age, so markets are nothing new. People have been exchanging goods and value all along, but Ricardo wanted to understand it on a theoretical level. He said the way you value something is to figure out all the inputs. What were the raw materials? What was the energy used to acquire it? How much labor was involved, etc.? Add them all up, and that was the value. That’s the theory of intrinsic value. You hear that a lot when people are talking about money, saying it has no intrinsic value. Let me come back to that, but Ricardo was the author of this theory of intrinsic value.
About 30 years later, Karl Marx came along and agreed with Ricardo but believed that intrinsic value comes from labor and capital. The capitalists owned what he called the means of production (the factory, bank, railroad or whatever it might be), and labor worked for them to receive a wage.
Marx’s critique was that capital captures the surplus value of labor. In other words, labor doesn’t get its fair share; the capitalist gets more than his fair share. That surplus labor theory is his critique of capitalism. Of course, that led to communism, so basically, Marx took Ricardo’s theory of value, which was intrinsic value, and created the surplus labor theory of value, but it was still relying on intrinsic value.
Now come forward another 30 years, and we get to University of Vienna, 1870s, and Carl Menger, the father of Austrian economics. He said, “Nonsense. The whole intrinsic theory/surplus labor theory of value is all nonsense.” He created what’s called the subjective theory of value.
Menger said something is worth basically what other people think it’s worth. That’s a subjective thing that can vary over time and was the basis for markets and price discovery. Like I said, we’ve had markets throughout the history of civilization, but again, the theoretical basis for the role of markets, the benefit of capitalism and what we call price discovery, is that it allows people to explore bids, offers, and preference curves, and subjectively value things.
That’s been the prevailing view on economics ever since. Whether you’re a Keynesian or in the newer Keynesian consensus or a monetarist or an Austrian – all schools of economics – we now agree that Menger’s subjective theory of value is the right way to think about it. When people say a currency doesn’t have intrinsic value, I say, “Who cares? So what?” I compliment them on their firm grasp of Marxian economics, but I say it’s a completely irrelevant concept that’s been discarded as part of the theory of economic history. It plays no role in how we think about value each day, and the subjective value really prevails.
This brings us into the 21st century. When we talk about subjective value, we’re back to the first thing I mentioned, which is confidence. Currencies rise and fall because you lose confidence in the issuer, you lose confidence in the central bank or you gain confidence by its performance in a crisis.
This is one of my critiques of Bitcoin. I get beaten up on social media and Twitter all day long because of my critique of Bitcoin. People say, “You’re a Neanderthal, you’re a dinosaur, you don’t understand technology.” In my snarkier moments, I remind them that I was writing code before they were born, so I understand the code and the technology perfectly well. I’ve read the technical papers, and I’ve actually been at the IBM SLA private laboratories where they’re working on something that’s going to blow existing forms of blockchain away. It’s called Hyperledger Fabric version 1.0. It was released last summer and is now being adopted by the Linux Foundation
Putting that aside, I get the technology, but I wonder whether the techies understand money in the terms we’re talking about right now. One of the things I point out is that Bitcoin has never had a stress test. It was created in 2009 after the last crisis. I’ve lived through a series of crises, whether it’s the mid-’80s emerging markets crisis, the ‘87 crash down 22% in one day, the Mexican Tequila Crisis in ‘94, certainly the LTCM crisis in ‘97-’98, the dotcom crash, the mortgage crisis of ‘07, and the financial panic of ‘08.
When you see enough of these things, you get a feel for them and see them coming. Bitcoin hasn’t seen any of that, yet it’s had a lot of adoption from millennials. I love millennials, I have three millennial children. I think they’re some of the brightest, most creative people on earth, but we all know what we know – let me put it that way. If you’ve never lived through a panic as an adult or an investor or someone with something to lose, you’re not acquainted with that sick feeling in the pit of your stomach when you’re watching markets go down and they seem to have no bottom.
Bitcoin has never been through a panic, a recession or a liquidity crisis. I’ll leave aside all the many other technical difficulties, because we don’t have time today to go through them, but that’s one thing in particular I would caution the Bitcoin fans. You’re dealing with something where confidence in it has never been tested. All the other forms of money we’re discussing, despite their strengths and weaknesses, have been stress tested one way or another.
When you take everything we’ve just discussed, gold has enormous utility for the reason you mentioned. I’ve studied the amazing physical, chemical, and atomic properties of gold. First of all, it’s an element, atomic number 79. It’s practically indestructible. You can blow it up with high explosives, but even then, all you do is spread the atoms around, they fall to the ground, and someone will dig it up 10,000 years from now. You can’t actually destroy it.
Alex: Right, gold molecules are still gold molecules, just in smaller pieces.
Jim: Exactly. As you know in the gold refining process, historically they’ve used mercury, and now they use cyanide. The reason they use cyanide is because it dissolves everything except the gold. Through the milling process, you get a fine powder containing gold and other stuff. That’s reduced to a liquid, you pour in some cyanide, all the other stuff dissolves, and there’s the gold. Gold’s indestructibility makes it possible to extract it from the ore.
Gold has more than stood the test of time, and people have confidence in it. I say it’s not a form of money today in the sense that central banks and finance ministries hate it. You won’t find any international monetary elites who have a kind word to say about gold, but then I say, “If that’s true, why does the IMF have 1000 tons? Why does the United States have 8000 tons? Why does Germany have 3000 tons? Why have Russia and China tripled their gold reserves in the last ten years – China probably more so – if it has no utility as money?”
The answer is, of course it has utility, but the elites don’t want to talk about it. They want to scoop up the gold for themselves and leave everyday citizens and investors out in the cold.
Alex: Yes, they hate it and they don’t hate it. It comes down to, “Watch what they do and not what they say.” They’re saying on one hand that it’s useless – think back to Bernanke’s testimony before the congressional panel when he was basically saying we keep it because of tradition – but at the same time, the facts are, central banks around the world are stockpiling it. They’re not getting rid of it.
Jim: If I had a printing press that could print money and I had a monopoly position such as the Federal Reserve, I probably wouldn’t want people to look at the competition either. We’re not in that position, so we can be objective and analytical. Yes, do as I do, not as I say.
Interestingly, the one global leader who has been candid about this is Vladimir Putin who is acquiring gold hand over fist. Russia is an interesting case study. It’s a petro state, I think the number one oil exporter in the world. In 2014, the price of oil collapsed. That continued through 2015 into 2016 before it stabilized, and Russia’s reserve position crashed along with it.
I’ll use round numbers. Their reserve position went from approximately $500 billion to a little over $300 billion. They lost 40% of their reserves or $200 billion. That entire time, they not only did not sell an ounce of gold, they continued to acquire it at a rate of 5 – 10 and sometimes as many as 30 tons a month, which you know is a lot of gold.
They were selling treasuries, euros, German debt, and whatever they needed to create liquidity in Russia and deal with their balance and payment outflows. They never sold gold, and they kept buying more. That was Elvira Nabiullina who is the head of the central bank of Russia and my favorite central banker. It was clearly greenlighted by Putin; that would not have been happening if Putin didn’t want it to. Despite the stress, they continued to buy gold, so clearly, it is a monetary asset.
The other case study is our friend Alan Greenspan. I think a lot of our listeners know that going back to the 1960s and early ‘70s, Greenspan was a strong, outspoken advocate for a gold standard, gold as money. He was a bit of an acolyte of Ayn Rand at the time, and since retiring as head of the central bank and head of the Fed in 2007, he’s been out on the speaking circuit saying kind things about gold. He occasionally shows up at gold conferences where I’m sometimes invited to speak, etc.
I said, “That’s interesting. Before you were a central banker, you loved gold. Since you retired as a central banker, you loved gold. It’s only when you put on your central banker clothes…” But even then, when all is said and done, you won’t really get this in Sebastian Mallaby’s biography of Greenspan. I like Sebastian’s kind of definitive biography, but you won’t get this in his book. If you look at the price of gold during Greenspan’s tenure as chairman of the Fed, it traded in a narrow range.
It started to spike up after ‘02, but that’s because of Greenspan’s famous episode between ‘02 and ’07 when he kept rates too low for too long. He did that because he was worried about deflation, and gold, as we know, had a fabulous run in those years. If you leave that episode aside and look at the ‘80s and ‘90s, gold traded in a pretty narrow range. It was between $200 – $400 an ounce with ups and downs, but did not break out to the upside or the downside outside of that range. It’s almost as if Greenspan was on a shadow gold standard saying, “If gold gets a little pricy, maybe I’ll tighten a bit. And if it gets a little low, maybe I’ll ease off a bit.”
My view is that he was operating on a shadow gold standard even when he was Fed Chair, but he just couldn’t say so.
Alex: He understood it, right? I’ve got his quote right here in front of me. Fed Chairman Greenspan wrote in his article Gold and Economic Freedom:
“Gold and economic freedom are inseparable. In the absence of the gold standard, there’s no way to protect savings from confiscation through inflation. Gold stands as the protector of property rights. If one grasps this, one has no difficulty in understanding the status antagonism towards the gold standard.”
Jim: I absolutely agree. That’s a brilliant and succinct statement. People lament the fact that we’re not on a gold standard today, and my answer is, “What are you waiting for? Put yourself on a personal gold standard. Why are you waiting for central banks in countries to reinstitute a gold standard or use gold as a reference for a monetary policy?” You can take dollars, euros or yen today and go buy all the gold or whatever allocation you want. I call that putting yourself on a personal gold standard. You don’t have to wait for governments to lead the way.
Alex: Yes, very much so.
One more quick thing on the uniqueness and utility value of gold, then we’ll move on to our next topic. We were talking about how gold really doesn’t rely on any external force for it to continue to have value, basically because it’s indestructible. As long as humans agree that gold has value, it completely resists entropy and is indestructible. Something I was thinking of is this little Twitter exchange the other day when somebody tweeted at you, “Jim, AI systems won’t be using gold,” and you quipped back, “Gold won’t be using the power grid.”
I thought that was hilarious and precisely the point. I would even take it a step further than saying it’s not just good money. Let’s do a thought experiment. Here’s a little challenge for you. Can you think of any form of storing wealth, whether it be an investment in stocks, bonds, companies, real estate, Bitcoin or anything, that is not subject to entropy over time?
What I mean by entropy is everything else requires human effort and interaction in some way or another to maintain. Bitcoin requires electricity, the Internet, computers. Companies and fiat-issued currencies require maintenance. All of this requires human will and interaction to resist the forces of entropy, otherwise they slowly self-destruct over time. The only thing that doesn’t do that as far as I know is gold. Can you think of anything, Jim, to invest in that’s not subject to entropy over time?
Jim: No. In fact I agree with that. Even silver. I’m a friend of silver and have it alongside of gold, because it has some form of utility. Think about a real crisis maybe where Kim Jong-Un has detonated an electromagnetic pulse weapon in the high atmosphere of the United States or the power grid goes down. The power grid could go down for reasons that have nothing to do with North Korea or EMP weapons as we saw in 2003. In that world, the ATMs don’t work, your credit and debit cards don’t work, you can’t do online banking payment systems, you can’t even fill up your car with gasoline because gasoline pumps require electricity, etc.
Civilization has a very thin veneer and lasts about three days. Three days is when you run out of food and water, and then society quickly devolves into looters and vigilantes as we’ve seen. I’m not talking about the Wild West, because we’ve seen this in the days after Katrina, in Puerto Rico very recently, and really all over the world. Gold will be money, there is no question about that. If you’re out to get a couple days’ groceries, an ounce of gold might be a year’s worth of groceries. If you don’t want to sit there with a file and chip off a little piece, a one-ounce silver coin is probably the right amount to go get your family a couple days’ worth of groceries. Some say, “People won’t accept it,” but I say, “Of course they will. Are you kidding?”
One of the ironies of the Puerto Rico tragedy after Hurricane Maria was that a lot of the shelves were stripped bare because people had bought stuff in advance, but there were some places that had stuff on the shelves – water and food – but nobody had any money. Like I said, the ATMs didn’t work.
The Federal Reserve system is 12 regions, each of which have a certain piece of territory. Boston is the first district, and Puerto Rico is under the second district, which is the Federal Reserve Bank of New York. Bill Dudley, as President of the New York Fed, had responsibility for Puerto Rico, so he chartered planes and flew pallets of bills, like $100 bills, to Puerto Rico as fast as possible. They passed them out through tellers and loaded up the ATMs when the power came back, because they were literally out of money. Again, there were stores with provisions that people desperately needed, yet they literally didn’t have a way to pay because credit and debit cards didn’t work, etc.
I dare say, if you walked in with five ounces of silver and said, “Give me $100 worth” of whatever, that merchant would have gladly taken it. In even more dire circumstances, even more so. Having said that, silver is not as scarce or robust gold. Gold is the best, and so I think you’re absolutely right about the uniqueness of gold.
Alex: Yes, and silver still interacts with oxygen, it oxidizes over time.
Jim: Yes, which gold doesn’t. Gold is the most inert thing anybody can think of.
By the way, I just returned a couple of days ago from an extended trip in Australia where I did about 20 one-on-one consultations. It was a pretty grueling three days meeting with six or seven a day of the top hedge funds and institutional investors in Australia. I met with about half of the money in Australia in terms of big banks and insurance companies. I can’t mention the names of clients, but you get the point.
I detected kind of a warming up to gold, and you don’t usually hear that in the institutional investor world. Unfortunately, I can’t get a pulse in the United States, because Americans are going to be the last to know. Russia and China are easy. They get gold, they’re stockpiling it. The same is true in Europe, Austria, and elsewhere around the world. I think people have a good understanding of gold, but definitely not true in the United States or Canada.
I was finding in Australia people who might not have even wanted to talk about it before. In my consultations, I would cover U.S. politics and fiscal policy. When I go abroad and people say, “We really don’t understand U.S. politics,” I say, “Well, don’t feel bad, neither do Americans.” I take them through my main topics, and then people say, “Talk to me about gold.” I would, and I was definitely detecting some interest, so that’s another good sign.
Alex: Very good.
On to our next topic. Jim, in our last podcast, you placed the likelihood of the Fed raising interest rates in December at about 20%. I think that call surprised a lot of people. Has your view on this changed since the last time we discussed it? And if so, why, or why not?
Jim: I’m hanging in there, but let’s be fair to the other side. I’m no stranger to out-of-consensus forecasts, as you know. I was running around between March and June 2016 saying that the UK would leave the EU at a time when that was considered extremely unlikely, and that happened. I was running around in October 2016 saying Trump would win, and he did. The great thing about doing TV is you have the video tape, so if someone says, “You never said that,” here’s the tape, have a look.
Alex: I remember that.
Jim: Thank you. Beginning in December 2016, I said that the Fed would raise interest rates in March 2017 at a time when the market gave it about a 30% probability. That 30% probability prevailed all through January and February. I was saying they would raise, the market was saying they wouldn’t. The market didn’t believe the Fed, they were calling it a bluff, etc.
Suddenly, over the course of about three days at the end of February 2017, the Fed started to panic. They were like, “Hey, we know we’re going to raise rates, but the market doesn’t believe us, so we have to signal.” Yellen, Dudley, Fisher, and Brainard, the four horsemen, went out and gave speeches that were incredibly blunt. They said, “Wake up, we’re going to raise rates.” The market got the message, and the probability went from 30% to 90% in three trading dates and converged on my forecast. You can see this on a chart, it’s one of those hockey stick charts.
As I say, I’m no stranger to being out of consensus, and I’m not uncomfortable with it if I have confidence in the model. Having said that, I’ve never been more out of consensus, because I’m giving it a low probability. Maybe I’ve increased it from 20% to 30%, but I’m still way below 50%. The market is actually at 100%, not 90% or 95%. The market has 100% chance of the Fed’s raising rates in December.
Let’s see how it plays out, but it does have a lot of significance. I won’t belabor it, but let me just spend a minute on the analysis. My baseline scenario is that the Fed is on a path to raise rates four times a year. Twenty-five basis points every March, June, September, and December like clockwork through 2019 to get rates to 3.25%. They’re doing it not because the economy is strong or because there’s that much inflation on the horizon, they’re doing it to raise rates so they can be ready to cut them again in the next recession. The finesse is, can they do that without actually causing the recession they’re trying to cure?
I realize I ran through that quickly, but people can play it twice. That’s the big picture, the scenario. However, there are three pause factors. Many quarters – September 2017 was one of them, and the first seven meetings in 2016 were another example – there are many times when the Fed does not raise rates. So what are the conditions under which they do not raise rates despite the baseline scenario that they will?
First is a disorderly market decline. That’s what happened in January 2016 when the market dropped 10%. The Fed did not hike in March and June of that year in response to that. The second one is if job creation dries up. That’s not much of a factor, because job creation has been strong. It has come down from 250,000 a month to 100,000 a month, but that’s still more than enough to absorb new entrants into the labor force, and unemployment is 4.1%. As far as that’s concerned, it’s mission accomplished. The Fed’s not even thinking about employment except as it relates to the other part of the dual mandate, which is price stability. So market disruption is one, but it’s not present today, and evaporation of job creation is another, but that’s not present either.
The third pause factor that is present is disinflation. The Fed has a goal of 2% inflation as measured using very specific metrics, which is personal consumption expenditure deflator core year-over-year. I realize that’s a mouthful, but they’re all important. It’s PCE, not PPI or CPI, but PCE. It’s specifically core, meaning it excludes food and energy, and it’s year-over-year not month-over-month or quarter-over-quarter. The Fed told us that, so that’s not guesswork.
They have a 2% target. Last December and January, that number came in at 1.9, which is why I said they would raise rates in March even though the market didn’t believe them. Since then, it’s been flat or down nine months in a row. It’s come down .6% and is currently at 1.3%. That was the most recent reading. This is a flashing red light to the Fed saying, “Hey, Fed, you’re moving substantially and rapidly away from your goal. You’re causing the problem with your rate hikes and strong dollar which is deflationary.” There are a lot of voices saying, “Don’t raise rates.” Neel Kashkari, President of the Minneapolis Fed, Charlie Evans, President of the Chicago Fed, and Lael Brainard, who is on the Board of Governors, are all no votes coming up.
I didn’t break into a safe and steal any secret plans here. Based on that and the most recent readings and sticking to my model, I would say the Fed will not raise rates in December. Having said that, there’s one more reading before the meeting. The meeting is December 13th, and the next and final pre-meeting PCE core year-over-year comes out November 30th. For our listeners, 8:30 a.m. Eastern Time, November 30th, check it out and see what the number is. I’m a good Bayesian, so if I get new data, I’ll plug it into the equation. If the probability goes up, it goes up. I’m not going to ignore the evidence.
If it’s hot – and by that I mean 1.6% – 1.7% – that will first of all be close to two. Secondly, it will validate Yellen’s belief that all this other disinflation was transitory. At that point, I’ll join the crowd, throw in the towel, and say, “Okay, they’re going to raise rates.” But that’s not what I expect. If it’s weak, meaning 1.4% or certainly 1.3% or less, that’s going to be the last nail in the coffin, and my expectation is the Fed will not raise rates.
From a market perspective, this sets up a very interesting trading opportunity that I call an asymmetric trade. An asymmetric trade is when a certain outcome is completely priced. The market is not sitting there saying, “50-50, we don’t know, it could go either way.” The market expectation is so high that the event is completely priced into markets, which means that if it happens, nothing happens. If something is priced in and then happens, nothing else happens to the market, because you already priced it. That’s what markets are supposed to do, they’re supposed to discount the future.
On the other hand, if it doesn’t happen, you have a violent, sudden repricing as market expectations get adjusted. The beauty of that is, “Heads I win, tails I don’t lose,” meaning it’s not that you’re going to make money both ways, but you could make a lot of money one way and not lose or get hurt the other way. So, what’s priced in right now? As I said, there is a 100% expectation the Fed is going to raise rates on December 13th. What does that mean? It means strong dollar, weak euro, weak yen, weak gold prices, higher bond yields, and lower treasury prices.
What happens if the Fed doesn’t raise rates? What happens if that PCE number is weak, meaning 1.3% or less? What happens if my analysis if correct and they don’t raise rates? Suddenly, every one of those trades is going to reverse. Gold is going to skyrocket, the euro is going to go from 1.17 to 1.20, yen is going to go from 1.12 to 1.10, gold is going to go from 1270 to 1300 plus, and the dollar index is going to come down. All these markets are going to – probably within hours – adjust to this new reality of the Fed not being able to raise rates.
I wrote a column the other day and said if you were on Mars last week, you didn’t miss anything. Gold just went sideways and has been a little bit boring. There was a little activity over the course of the day Thursday when it ran up and then fell off a cliff with one of those paper gold dumps, but last week it started and ended the week around 1275. Right now, it’s a little bit higher than that, but not much. This is what I mean by gold is not doing anything right now, and neither is the dollar index or the euro. They’re all just sitting there waiting for Guido Menzio or more accurately waiting for Janet Yellen and the FOMC. They priced in an outcome. They can’t do it anymore, because they priced in a 100% chance, so they’re just going to sit there and go sideways absent some geopolitical shock. Now if that inflation number is weak and the Fed doesn’t raise rates, then it’s going to be a wild couple of days in early December.
Alex: We are bumping up against our time limit, and there is one other thing I wanted to quickly cover. Moving into the realm of geopolitics, we usually like to talk about something that’s going on around the world, and more importantly how it affects global economics and markets. The most recent thing since the last time we talked, Jim, is the chaos going on right now over in the House of Saud. It appears to be chaos from the outside, but maybe it’s all very well under control.
About a week ago, we started hearing news of sweeping changes taking place in Saudi Arabia. Senior ministers were being fired, dozens of princes and other wealthy businessmen were being arrested, and assets from all of these people were being frozen. I saw one estimate as high as $800 billion USD’s worth of assets have been frozen.
Apparently, only hours before all of this started happening, King Salman decreed the creation of a new anti-corruption committee headed by the Crown Prince, heir apparent, Mohammad bin Salman. MBS is what a lot of people refer to him as for short. This committee has the power to investigate, arrest, ban people from travelling, and freeze assets of anyone it deems corrupt.
One article I read claimed that the purge against other members of the royal family is unprecedented in the kingdom’s modern history, and that family unity, which guaranteed the stability of the state since its foundation, has been shattered. Jim, what are your thoughts on this? What does this mean for regional politics, and how does that then go on to affect the rest of the world?
Jim: Alex, that’s a very good, succinct summary. This is one of those topics we could spend hours on or could write a book on it. We don’t have that much time, but I’ll try to do the short version of it. Since the founding of the kingdom under King Abdulaziz, he had about 75 children by multiple wives. Forget the sisters, because women don’t play a role in their culture – unfortunate, but that’s just the case. Among the 30 or so brothers, who were mostly half-brothers, they had a succession.
The succession of the kingship in Saudi Arabia did not go from father to son but from brother to brother. The problem was most of them died or at this point they’re in their 80s and not mentally or physically fit, etc. They’re almost to the point where there are only a handful of possible kings, and it has to go to the next generation.
That begs the question, which son of which half-brother is going to be the successor versus some other son of some other half-brother? That jockeying, that sort of house of cards if you will, has been playing out for decades. It’s getting very intense now because of the demographics, because they’re all going to die, and so they have to do something.
It’s been decided by King Salman that his son, Mohammad bin Salman (bin means son of, so Mohammad, son of Salman), is going to be the new king, and they gave him the title of Crown Prince as the second in line. That doesn’t sit well with some of the other princes and their children. They also have all these kingdoms where you find multiple armies. There’s the regular army, then there’s like a national guard which is an internal army, then there’s a police force which is a paramilitary, and then there are personal bodyguards.
Who’s in charge of which? They not only arrested a lot of these princes, but one prince’s bodyguards decided to fight it out. They got in a firefight, and the son of former King Fahd was killed. It’s getting nasty over there. And of course, ice-nine, my theory of freezing accounts when you need to control a situation, is operative as it was in Cyprus, Greece, Catalonia, and a lot of other places around the world.
To cut to the chase, this is a pattern we’ve seen before in Putin’s Russia and Xi Jinping’s China, which is when you want to assert your power, you use the judicial system. This is not objective or fair at all, but it’s under your control to arrest your enemies on grounds of corruption.
The thing you must understand is that they’re all corrupt. Everybody in Russia, China, and Saudi Arabia is corrupt. That’s not the point. The point is, are you with me or against me? If you’re with me, I will ignore your corruption up to a point. If you’re against me, I will use the corruption to round you up and put you in jail.
The best statement of that was from Lavrentiy Beria who was the head of the NKVD secret police under Stalin. His motto was, “Show me the man, I’ll give you the crime,” meaning, as John Lennon said, “Everybody’s got something to hide except for me and my monkey.” You can pretty much bring up anybody on charges as Paul Manafort found out the hard way, so you use these corruption justice tools as a cloak to round up your enemies and disable them.
Will there be pushback? I think MBS may have pulled this off sufficiently fast and callouslesly to have done it successfully.
I was in Riyadh for a few days, and when I left, it was like getting out of jail. The Ritz Carlton there is probably the fanciest Ritz Carlton in the world, and they’ve turned it into the world’s most luxurious prison, because they needed a place to put all these princes. They couldn’t put them in regular jail, so they surrounded the Ritz Carlton with guards, put paramilitary men in black in the lobby, and put all the princes in the suites upstairs under house arrest. I guess if you had to be under house arrest, there are worse places to be.
Let’s see how it plays out, but he’s moved quickly and ruthlessly. That’s the way you have to do it. You can’t have half measures, because you’d give the other side time to rally their forces and push back. Meanwhile, we see escalating tensions with Iran, and Saudi Arabia has some cards to play on Lebanon. I think the best thing we can leave our listeners with is that this is not over, and it’s part of what’s giving a little bit of a lift to the price of oil.
Alex: We’re out of time. Jim, once again, I greatly appreciate the discussion with you. It’s been invigorating. Until next time, thanks a lot.
Jim: Thank you, Alex.
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