Jim Rickards, The Gold Chronicles November 12 2015:
*This is the weakest US recovery on record
*Given length of current economic expansion, US may already be in a recession and data has not caught up yet
*The Fed cannot pull the trigger on a rate hike because the data does not support it
*Detailed discussion of feedbackloops affecting the Federal reserve and zero interest rate
*United States is now a magnet for global deflation
*Fed still unlikely to raise rates in December
*Detailed discussion of IMF Special Drawing Right (SDR) and China’s position
*Sooner or later oil will eventually be denominated / traded in SDR’s
*SDR is backed by nothing, instead value is derived from a peg to a basket of currencies
*Chinese Yuan addition to the SDR basket expected in Sept. 2016
*London is now positioning itself as China friendly
*Indian gold monetization scheme is not likely to succeed
*Indian gold monetization scheme will allow Indian government to lease gold into the market
*Emerging market Central Banks are adding gold to reserves led by China and Russia
*China has lost $500B in reserves in 6 months supporting the Yuan
*During the next financial crisis markets and market makers will be non-liquid and if you do not have alternate forms of liquidity your wealth is at risk
*Jim’s best definition of a financial panic is “everyone wants their money back”.
*Most likely Fed will ease in 2016, and use forward guidance and currency wars as tools
Listen to the original audio of the podcast here
The Gold Chronicles: 11-12-2015
Jon: I’m Jon Ward on behalf of Physical Gold Fund. We’re 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 the Chief Global Strategist for West Shore Funds. He’s the former General Counsel of Long-Term Capital Management. He’s a consultant to the U.S. Intelligence Community and the Department of Defense and is also an Advisory Board member of Physical Gold Fund.
Hello, Jim, and welcome.
Jim: Hi, Jon. It’s great to be with you.
Jon: We also have with us Alex Stanczyk, Managing Director of Physical Gold Fund. Hello, Alex.
Alex: Hi, Jon. Likewise, it’s great to be here.
Jon: Alex will be looking out for questions from you, our listeners. Your questions for Jim Rickards today are more than welcome, and you may post them at any point during the interview. You’ll see a box on your screen for typing in your question. As time allows, we’ll do our best to respond to you.
Jim, Fed Funds Futures are used by investors and traders to effectively place bets on the Federal Reserve’s upcoming decisions. I see that current analysis of these Futures suggests a 68% likelihood of a rate rise in December. So now it’s not just the pundits calling for an interest rate rise; it’s the markets as well. Yet, in a recent article, you continued to insist that the Fed won’t raise rates, and you cite a mathematical phenomenon to support your view — recursive functions. For those of us who are a bit math-challenged, would you help us understand your thinking here?
Jim: Sure, I’d be glad to, Jon. I try to steer away from opinions and predictions. The difference between an opinion and analysis is that if you’re doing analysis, you should have something behind it. If you ask me right now today, “Will the Fed raise interest rates on December 17th at the next FOMC meeting?” I would say no. You’ll find a lot of people who would say yes, and obviously, the markets expect that. But I don’t like to stop there. I like to give the analysis behind it that involves facts and data and what the Fed itself is saying.
One of my biggest sources for my views on the Fed is the Fed itself. In other words, they’ve been talking tough. This time last year, November 2014, I did a series of interviews where I said the Fed would not raise interest rates in all of 2015. At the time, Wall Street was saying March, then they said June, then they said September, and now they’re saying December. I said all along that they wouldn’t raise rates, but I didn’t have a crystal ball. I wasn’t wiretapping the boardroom at the Fed; I was actually listening to what the Fed was saying.
The Fed has laid out their criteria for raising rates, so it’s not a secret. They have a forecast that says 2.5% growth, 2% inflation, and 5% unemployment. Right now, they’re missing on two of those three. They’re nowhere near 2.5% growth or 2% inflation. In fact, both of those have been trending in the opposite direction. Yes, it’s true that unemployment has hit 5%, but that’s really a proxy for a lot of other things that are going on. We did have a blockbuster October employment report, there’s no disputing that the report was strong across the board. There’s good reason to believe they borrowed a lot of strength from November. We’ll see what happens on the November employment report that will be released in early December. That’s just one data point, and it’s an important one.
When you look at all the other data – world trade, export growth, import growth, real wages, manufacturing indices, and quite a few other things – they’re all pointing down, to recession. By the way, recession at this stage should come as no surprise, because this expansion is 78 months old, which is longer than the average expansion since 1980.
Bear in mind, the period since 1980 has been one of very strong growth all the way back to the end of World War II. The average expansion since the end of World War II is about 38 months. The average expansion since 1980 – a very favorable period – is 77 months. This expansion, the one we’re in right now, is 78 months old. It may not feel like an expansion because it’s actually the weakest recovery on record, but it’s a recovery nonetheless. We have been growing continuously since the middle of 2009, so we’re 78 months along.
Recessions don’t die like clockwork just because it’s longer than the average expansion by every metric. It doesn’t mean it’s over tomorrow, but it does mean that nobody should be surprised if it is, because it’s pretty long. So, given all the data, the length of this expansion, and the fact that we’re certainly closer to a recession than not, we actually may be in a recession right now. We never find out until a year or two years after the fact, depending on how long it takes the official National Bureau of Economic Research to declare it. Leaving that aside, we may be in a recession now and not even realizing it. That’s my view based on a lot of data, a lot of analysis, and on what the Fed says itself as to why they can’t raise rates.
You made reference to what we call the recursive function, which I’ve been using to analyze this. A recursive function is just a fancy mathematical name for feedback loop. Any feedback loop is one where the output of the equation equals the input of the next iteration of the equation. So, you have a simple equation, you get some data, you solve it, you take that answer and plug it back into the same equation, run it again, get another answer, take that answer, plug it back in, run it again, etc., over and over. With computers, you can do this a million or billion times and graph the output to get some very interesting results.
Basically, any feedback with a recursive function is an equation that feeds on itself. It can explode exponentially or it can go to zero and get stuck there. They can do funny things, but the graph of the output is very revealing.
Without getting into the equations, let me talk about two feedback loops that are in play right now. The first is the feedback loop between the Fed Funds rate and the FOMC action in terms of raising rates. Jon, you pointed out that the Fed Funds market is giving a 68% likelihood of a rate increase in December. Well, one of the things the Fed has worked very hard to do for over two years is to get the market ready for the rate increase.
We’ve been hearing about it explicitly for a year, and I would say implicitly for two and a half years going all the way back to May 2013 when Ben Bernanke first used the word ‘taper’ in the famous Taper Tantrum. I’m sure he used a technical term like “reduction of long-term asset purchases,” but it’s taper by another name.
Bernanke started talking about tapering in May 2013, and December 2013 was when they actually started tapering. They finished the taper in November 2014 but still had forward guidance, which was a way of telling the market they weren’t going to raise rates quickly. Then, they removed the forward guidance in March 2015. So, they’ve been tightening by talking for two-and-a half-years.
As of March 2015, all bets were off because they removed forward guidance. In 50 speeches since then, they’ve been talking about tightening, but they haven’t actually done it. Why are they talking about tightening in what is clearly a weakening environment? The answer is they want to get the market ready. They don’t want to shock the market, and they don’t want the market to believe that they won’t tighten and then actually tighten. In that scenario, the market is shocked resulting in some kind of meltdown.
The problem is they can’t actually pull the trigger, because the data won’t support it. Until recently, the markets have been expressing that by saying, “We hear what you’re saying, but we don’t care. We’re thinking the same thing. We’re looking at the data and don’t think there’s any chance you can raise rates.” Going into the September FOMC meeting, the Fed Fund Futures market was only giving it about a 35% probability, and now they’re up to over 70%.
Here’s the feedback loop: The Fed wants the market to get ready. The market’s listening to the Fed. The Fed is raising the odds and expectation of a rate hike by saying, “Hey, the Fed really means it this time. Janet Yellen, she’s not kidding around. She said December is on the table.” The Fed looks at the raised expectation and says, “Aha, perfect time to raise rates, because now we know we won’t be shocking the market for the first time in a long time. The market is actually expecting us to raise rates, so what better time to raise rates?” Then they talk tough again and say, “We’re really going to raise rates.” (They gave a bunch of speeches just today.) The market responds, “They really mean it, so we’re going to raise the expectations.”
We have this feedback loop between the Fed talking tough and the market raising expectations. Higher expectations increase the likelihood that the Fed will actually do it, because now they know they’re not shocking the market. It goes around and around with the Fed Funds giving it higher probabilities and the Fed saying, “Well, now that you’re on the same page as us, what better time to raise rates?”
The only problem is that the whole thing is absurd. This is a cat chasing its tail. The economy is weak and we’re bordering on a recession, so why on earth would they raise rates at the beginning of a recession? The time to raise rates was 2010-2011 when the dollar was weak and the economy was doing pretty well, a lot better than it is now. Bernanke blew it; he missed a whole cycle. They should have started raising rates in 2010 so they could have them up to 1.5% – 1.75% by 2012. Then, today, now that we’re getting close to recession, they could cut rates because there would actually be room to cut.
The Fed missed the raising cycle, and now they should be cutting, but they can’t cut because they’re at zero. Although they’re still talking about raising, two wrongs don’t make a right. Just because they blew it in 2011 by not raising rates doesn’t mean they should blow it again by actually raising rates when the economy is weak. That’s tightening into weakness. Having said that, we’re talking about the Fed here. Don’t underestimate their ability to screw this up twice. Given the fact that the Fed usually messes things up, you can’t rule that out.
I’m saying the data doesn’t support a rate hike as we’re probably in a recession or close to one. The Fed and the Fed Funds Futures market are like two cats chasing two tails leading themselves to believe they’re going to raise rates. This would be an incredible blunder causing an emerging markets meltdown and U.S. stocks to melt down. We’re already seeing some of that in the stock market action the last couple of days.
I said there were two feedback loops and just described one of them. The other one is between the FOMC itself and actual deflation. I’m not talking about what the market expects; I’m talking about what the economy is actually doing. This is in reality the more powerful feedback loop that’s been in place since May 2013.
It works like this: The Fed wants to raise rates because they kind of know they should have done it earlier. They say, “Normalize rates.” Whenever people throw that phrase at me and say that the Fed has to normalize rates,” my response is, “Tell me what’s normal about this economy. The Fed’s been manipulating markets for eight years. What do you mean by normalization?”
That’s an aside, so coming back to what the Fed wants to do, they say they want to raise rates, but they also say they want inflation. That’s not a secret; they’ve told us a zillion times they want 2% inflation. The problem is, when you raise rates, you make the dollar stronger. That is deflationary, because a strong dollar means we can buy more imports for fewer dollars. It lowers the dollar price of imports and feeds into U.S. supply chains.
It also hurts exports. If you’re starting with a foreign currency and have to convert to dollars to buy a Boeing aircraft or General Electric wind turbine or an Apple iPhone or whatever, you may need more dollars because your currency is cheaper. So, a stronger dollar hurts exports which hurts jobs. It cheapens the price of imports which imports deflation from abroad. The United States is now a giant magnet for all the deflation in the world.
The Fed says they want to raise rates and they want inflation, but raising rates is deflationary because of a strong dollar. How does that work? The answer is it doesn’t work.
The Fed has been acting hawkish for the last several years by saying, “We’re going to raise rates.” The dollar gets stronger, the economy slows down, the stock market goes down, and the Fed gets spooked. Then, they start talking dovish as they did at the September 17, 2015, meeting when the FOMC decided not to raise rates. At the time, a lot of people in the market thought they would, but they had a dovish press conference, a dovish statement, and a couple of weeks later when the minutes were released, the minutes were super dovish. At that point, two of the Fed governors, Lael Brainard and Dan Tarullo, came out with super-duper dovish speeches. Lael Brainard just got right in Janet Yellen’s face on the nonsense of NAIRU, the Phillips curve, and a lot of other technical things that economists love to debate among themselves.
The point is we went through this whole period from September 17th to October 8th when it was nothing but sweetness and light dovish comments from the Fed. What happened? The stock market went up, because all of a sudden they said, “Well, they’re not going to raise rates, after all. They’re talking like doves. They’re talking 2016 and maybe indefinitely, so more cheap money is on the way.” Stocks went up and markets settled down.
What happened next? The Fed looked around and said, “It looks like the crisis is over.” When I say the crisis, I’m going back to August when China devalued their currency, the yuan, against the dollar on August 10th. That set off a whole chain reaction. Of course, the Shanghai stock market had been melting down since earlier in the summer. That caused a draw down in U.S. stocks, a 15% decline in a matter of weeks that reached an almost borderline panic stage at the end of August.
One reason the Fed didn’t raise rates in September was because the markets were melting down at the end of August. That’s when they got dovish and the markets went up. When the markets went up, the Fed said, “Aha, all clear. Now we can be hawkish again.”
That’s the other feedback loop where the Fed talks dovish, markets rally, the Fed takes that as a positive sign, they talk hawkish, the markets tank again, and the Fed doesn’t raise. Every time it looks like the coast is clear for a rate increase, the markets and the dollar react to the rate increase in ways that prevent the increase from ever happening.
The very simple equation for this is S2 = S1 (1-S1)r. You can plug in a couple of variables for S1 and r and crank up the math to get a number, then put S2 in the place of S1 and solve for S3, and run it again. Do that enough times, and guess what? It goes to zero and stays there forever and ever. So, I think the Fed has got itself into a feedback loop – probably several feedback loops – all of which point to zero rate.
From where we stand right now, I don’t see them raising rates in December. I mean, they don’t listen to me. I’m glad our broadcast participants and some people do, but there’s no reason to think the Fed does. They might blunder since they’ve blundered all along and raised rates anyway. In which case, look for a very serious meltdown towards the end of the year.
There’s one more thing that hasn’t been written about very much, and it’s another reason for not raising rates in the middle of December. The market makers in U.S. Treasury Securities are the so-called primary dealers. In December, primary dealers have to do a lot of what is called window dressing, i.e., reducing their balance sheets and cleaning up the books for year end. That’s when they have to do their quarterly and annual reports and tell investors and the SEC what they’re doing, etc.
That window dressing means reducing leverage which reduces liquidity. This goes back to the famous Lehman 105 Repo that almost brought down the world in 2008. Liquidity and the government bond market is a lot worse than people think, so the dealers are privately telling the Fed, “Don’t do this at year end. If you want to raise rates, do it in January.” It might also be a stupid idea in January, but it’s a lot better to do it in January than December, because the risk of tipping over the markets and causing turmoil, independent of expectations and the recession, just because you’re going to mess up the dealers, is very high. December is the worst possible time to raise rates. You would never want to do it year end, because there’s so much else going on in the market.
Those are my reasons for thinking they won’t raise rates. If I’m wrong and they do it anyway, it wouldn’t be a shock, because they’ve messed up enough things. Then look for a market meltdown towards year end.
Jon: Let’s return to another favorite topic of ours: the currency wars. We’ve just had an announcement by China of direct conversion between the yuan and the Swiss franc. To my mind, this could look like a hostile move against the dollar. But doesn’t China want to play nice right now, as they’re close to getting a seat at the IMF table by having the yuan incorporated in the SDR, the IMF’s own currency? What is China’s game here?
Jim: There’s a short answer and a long answer. I’m always good for the long answer, but I’ll give you the short answer. Playing nice with the IMF is not the same as playing nice with the dollar.
Remember, the IMF doesn’t print dollars; they print SDRs. China’s game is about playing nice with the IMF and about getting included in the SDR, which is on track to happen. But that doesn’t mean it’s not bad news for the dollar. I keep talking about that when I talk about the death of money or the death of the dollar or collapse of confidence in the dollar. This is not something that happens overnight, but it could happen even more quickly than I expect.
It’s also something that could play out in small stages over years. In some ways, that’s even more dangerous for your portfolio because people don’t notice. Some people are prepared for the big catastrophe, but most people probably are not. When it starts to happen, at least the more nimble investors will get out of the way of a moving train and just jump off the tracks. With a slow motion decline or collapse, even savvy investors sometimes don’t notice until it’s too late. That’s kind of how I see the SDR thing playing out.
Let’s talk about China, the IMF, and the SDR for a minute, and then I’ll come back to how that impacts the dollar. SDR stands for Special Drawing Right. That’s a geeky opaque name for world money. The IMF prints this world money although they don’t call it world money because it would probably scare people. They call it Special Drawing Rights or SDR so people don’t really understand what it is. It’s just another kind of fiat money. The Fed prints dollars, the European Central Bank prints euros, and the IMF prints SDRs.
The only difference is that we don’t get SDRs in our pocket. SDRs are not what I call walking around money. It’s world money used by countries to settle up their debts with each other and settle up balance of payments. You can use it for other things, e.g., there’s no reason why the price of oil couldn’t be denominated in SDRs. In fact, I expect it will be sooner than later.
The value of an SDR is computed by reference to four hard currencies. This is confusing because a lot of people call it the basket of currencies. The four currencies in the so-called basket are U.S. dollars, euros, pound sterling, and Japanese yen.
Many people think the SDR is somehow backed by the basket, like there’s a big pile of hard currency sitting in a vault somewhere backing up the SDR. That’s not true. The SDR is not backed by anything, any more than the dollar is backed by anything. The dollar is just printed by the Federal Reserve and you take it on faith.
You have to decide what an SDR is worth. If you want to buy an SDR, how many dollars or euros do you have to pay? That’s where the formula or basket comes in. It’s a three-step formula that’s not too complicated. Take the four currencies and weight them. In round numbers, it’s about 41% for the dollar, 37% for the euro, and approximately 10% each for the yen and sterling. It has to add up to 100. That’s your initial weighting.
Convert it into a slice of each currency that would add up to one, based on current exchange rates. Then convert those to dollars, also based on current exchange rates, add them up, and that’s how many dollars an SDR is worth. An SDR is worth about $1.40 right now, but it fluctuates and was worth about $1.50 not long ago. The fact that the SDR is down in dollar terms is actually a symptom of a strong dollar. It’s the same reason gold, oil, the euro, Australian dollars, Canadian dollars, Chinese yuan, copper, and everything else you can think of is down – because the dollar is up. The dollar price of anything is simply the inverse of the strength of the dollar. The dollar price of the SDR goes up and down, but it’s still a fiat currency they print and hand out.
The big play now is that China wants to join that club. One way I describe it is as joining a very exclusive club. There are only four members of the club right now, so China is kind of knocking on the door trying to get into the club. They’re going to be allowed in as we will see played out over the next year. The executive committee of the IMF will announce this green light sometime in a matter of days. The official announcement of the executive committee is merely saying, “Yes, we’re okay with it, so go ahead and make it happen.” They’ll say that to the staff, then the actual official announcement will come around the end of March 2016 with the effective date of September 30, 2016.
This is really a slow rollout, partly to give large institutional investors time to adjust their portfolios. A lot of investors weight their portfolios using the same weights as the SDR. If you suddenly introduced the Chinese yuan in the basket and it always has to add up to 100%, that means you would have to reduce the other ones, so who would take the haircut? That remains to play out. It does mean the big institutions are going to sell assets in certain currencies and buy assets in yuan in order to rebalance their portfolios to match the SDR. That’s actually a trading opportunity if you want to figure that out and get ahead of it a little bit.
This is what we mean by China being on its best behavior. Best behavior as the IMF defines it means an open capital account and a “freely usable currency” able to be used in trade and selling balance of payments. Countries need to be able to get it to buy reserves or, if they have it because their country is running surplus with China, they want to be able to swap it into Swiss francs, or dollars, or anything else. This announcement— conversion of yuan to Swiss francs — is a big one and it’s important. They’ve been setting up bilateral currency swap arrangements with Brazil and a lot of other countries for a couple of years now, all with a view to opening their capital account.
Is this good news for the dollar? Absolutely not. The dollar is pushed aside as the leading reserve currency and the leading trade currency. I would make the point that there’s a distinction between a trade currency and a reserve currency. Trade currency is what you use to buy and sell stuff. It’s fairly obvious. A reserve currency is where you park your savings.
If you’re a country and you run a surplus or you earned currencies –a surplus from your trading activities – what do you invest in? What stocks and bonds do you buy and what currencies? Do you want to buy Greek sovereign debt? Maybe that’s not such a good idea. Do you want to buy U.S. treasuries? Yes, that’s the number one choice in the world. That’s the reserve currency status. They’re related, because the more liquid you are in trade, the more likely you’ll have a bond market that people can invest in. All that liquidity connects.
Right now, the usage of the yuan in trade is much greater than its usage as a reserve currency. They still have a ways to go because they don’t really have a big bond market, but they’re working on one in London. Xi Jinping, the president of China, was just in London and got a euphoric reception.
According to diplomatic chatter, he felt completely ignored and insulted in New York in mid-September. It was his first state dinner in Washington at the White House, and he felt that the Obama administration kind of dissed him. My advice to Xi Jinping is don’t come to New York the same week as the Pope! The Pope got a much bigger audience than the president of China. That was bad protocol by his guys. Be that as it may, Xi Jinping went to London and was treated like a rock star.
Now we’re seeing London move away from the U.S. a bit and say, “Look, London’s been the financial center of the world for 250 years.” They want to keep a good thing going, so if China’s the financial power and buying gold and going to have the new reserve currency, then why not cozy up to the Chinese?
Just to wrap up the segment, I would say that China is doing everything right and is being green-lighted by the IMF. It’s working not just with Switzerland but London and other financial centers around the world to increase the liquidity and credibility of the yuan. None of this is good for the dollar, because as the dollar is diminished, the margin is less and less confidence. This brings us closer to the day when people lose confidence in the dollar completely.
Jon: Let’s shift now from China to India. The prime minister of India, Narendra Modi, has just announced a gold deposit plan designed to pull gold into the mainstream financial system by allowing banks to pay interest on deposits of physical gold. What’s your take on this, Jim? Is it a local curiosity, or could India’s initiative have an impact on the global market for gold?
Jim: This is my favorite story of the week, month, and year. I love this story because it is such an outrageous, bodacious, transparent fraud for the prime minister and finance minister of a sovereign government to try to pull. Let me explain why.
I do have complete confidence in the Indian people that they’re not going to fall for it. I would say any citizenry, any people, who are smart enough to buy 20,000 tons of gold in the first place are not going to be dumb enough to hand it over to the government. I think this will fail, but I think it’s very revealing as to why they’re even trying it. Let’s take a step back and talk in a little more detail about this, then I’ll give my analysis.
This is proposed legislation. It’s important to understand that in a parliamentary system, if a prime minister with majority control wants something, they usually get it. It’s not like the United States where the president can go to Congress, Congress will say, “Shove off. We’re not voting for that,” or Congress can vote for something, and the president says, “The heck with you. I’m going to veto it.” The U.S. has a completely dysfunctional relationship between the legislature and the executive where they’re barely talking to each other. That’s not true in parliamentary systems, so if the prime minister and the finance minister are in favor of this – which they are and have said so publicly – I think there’s a good chance this will actually become law.
I’ve had this debate for years, because I tend to look at official gold. When I say official gold, I mean the amount held by a central bank, a sovereign wealth fund, a finance ministry or whatever is under government control. That’s a much smaller amount than all the gold in the world. These are estimates, of course, but it’s estimated that all of the above-ground gold in the world (not mining reserves or things like that, but actual gold that’s either in bullion or jewelry or some industrial application) is about 180,000 tons. That is not a lot. I think many listeners know it would fill up one Olympic-size swimming pool but not much more than that. That’s all the gold in the history of the world, so it’s actually extremely scarce. The official gold is approximately 35,000 tons, a small fraction of only about 20% or less of the total gold. That’s where things stand.
I say India has only about 500 tons of official gold, which is not very much for the size of their economy. The U.S. has a lot more relative to its GDP. The economic entity that has the largest amount of gold relative to the size of its economy is actually Europe where the member states have about 4% of GDP in gold. The number for the U.S. is about 2.7% and the same for Russia. China is less officially, but unofficially it’s closer to 2.7%. India is a lot smaller than that. Their number is probably pretty good, so let’s say it’s 20,000 tons.
The plan that the government is working through the banking system is going to create a new deposit instrument. If that happens, Ms. Indian Bride or Ms. Indian Widow will take their gold to the bank, hand it in, and in exchange receive a certificate that pays interest. This is always the wrap on gold: it doesn’t have any yield. Well, I would say gold is not supposed to have yield, because it’s money. Money doesn’t have yield. If you want yield, you have to take risk, including a bank deposit. Nevertheless, the myth prevails that not having yield is an issue. So, give us your gold and we’ll give you a certificate that pays interest, but if you ever want your gold back, come again and you can cash it in. We’ll give you the gold back.
Beyond that, the banks are allowed to lease the gold. Now, think about this for a second. This is 20,000 tons of gold – two-thirds of all the official gold in the world. As I said, I don’t think the Indian people are going to fall for it. That 20,000 tons includes all the gold in all the Hindu and Sikh temples. I was in Malaysia recently and visited a Hindu temple where they had a 40-foot-high statue covered in gold, so there’s a lot of gold in temples. I don’t think they’re going to be melting down the temple gold anytime soon, but just the gold that people might have in jewelry, coins, and bullion stashed away somewhere. Even if that’s half of the total, it’s still 10,000 tons which is almost a third of all the official gold in the world.
People are supposed to hand in their gold and get a certificate, but no worries; you can always get your gold back. Then, the banks can lease it out. Now we’re into what’s called fractional reserve banking. This works exactly like unallocated gold from the London Bullion Market Association.
By the way, it’s the opposite with our host here, Physical Gold Fund. If you invest with them, they buy the gold. It’s your gold, it has a serial number, you have a manifest. If you want the gold, they’ll send you that exact gold. There’s no monkeying around with how much gold relative to how much investment they have. It’s one for one.
That’s not the case with banks. They’ll go ahead and lease out your gold and even ten times as much. They’ll only hold a small reserve relative to the amount of gold entrusted to them. That’s what fractional reserve banking is and has been the way banks work since the 14th century. It’s one of the most successful frauds in history and still going strong.
What’s the point of leasing gold to Indian jewelers? The reason they say they’re doing this is because India has massive trade deficits due to the people continuing to buy gold. Now, the jewelers are in India and the consumers are in India, but India doesn’t have any gold in the ground. They have 20,000 tons of gold that they’re wearing around their necks, but there’s no gold in the ground, so they have to import it, because all the people who have it won’t sell it. If you’re a bride and have a bunch of gold for your dowry, you can have that gold until the day you die, then bequeath it to your daughter or some family member for their dowry and hopefully accumulate it over time. So every time a new bride wants some gold and wants to get a dowry, they have to import it. The imports drive India into a trade deficit, which is what the finance ministry says they’re concerned about.
Think about the idea. You go to the people of India and say, “Give us your gold, and we’ll give you a piece of paper.” Then the bank says, “I’ll lend the gold to the jeweler, and the jeweler will make a nice necklace the bride can buy for her wedding day. We don’t have to import the gold, so that will make our trade deficit go away.” That’s what they say is going on.
They’re taking a necklace from one bride, leasing it out to somebody else, and making a necklace for another bride. Both brides think they have the gold, but there’s only one piece of gold. One may think she can go down to the bank and get the gold whenever she wants, and the other thinks she’s got the gold because it’s around her neck. So, you’ve got two people who think they have an ounce of gold, but there’s only one ounce of gold. Welcome to fractional reserve banking and unallocated gold. Welcome to the gold fraud and gold manipulation. This is how they do it.
The hope is that all those people with certificates don’t run down on the same day and ask for their gold. That’s a run on the bank and has been the problem with banking all along. It’s not just gold, because it can be paper money, bank deposits or anything else. If everybody shows up at the same time, they can’t get their money … unless with paper money since the Fed can print some. But you can’t print gold.
We’re going to a fractional reserve system for gold intermediated by the banking system. It’s a kind of fraud, because you’re going to have multiple people who think they own the same ounce of gold, but there’s only one ounce to back it up. Some of it exists in paper form and some exists in physical form. There’s a lot of mystical intermediation going on in between that no one quite understands.
That’s one thing that gives me pause, but there’s something even bigger here that I think is important. I obviously talk and write and speak about gold quite a bit, and I forecast much higher prices for gold, which I stand by because it’s eighth grade math. Just look at the amount of paper money, how much gold is there, divide one by the other, and hypothesize the loss of confidence in paper when you need gold to restore the confidence. What is the implied non-deflationary price? It’s somewhere between $10 and $40,000 an ounce and going up all the time because they keep printing money all the time. That’s kind of easy to analyze.
But then people say, “When’s that going to happen? How come it hasn’t happened yet?” The answer is that there’s enough gold around to maintain the price suppression, which is done through leasing, through the futures market, through unallocated gold forwards, and through fractional reserve banking as I just described. There’s some evidence it is done through counterfeiting, frankly.
Meanwhile, in the real physical gold world away from the world of paper gold, we know what’s going on. China has been buying thousands of tons (probably three or four thousand tons or more) and Russia has bought over a thousand tons in the last six years. Smaller players from Vietnam, the Philippines, Mexico, Malaysia, Turkey, and Iran are all buying gold, so physical gold is disappearing. I’ve said all along that I thought it would break down but not because the COMEX traders stood for delivery. Why would they do that? They make money on the roll, so they’re going to keep rolling over the contracts. Why do they want to mess it up? The bullion banks aren’t going to mess it up, because they make a lot of money doing this. The players have no interest in shutting down the system, because they’re making money doing what they’re doing. And Americans don’t understand gold or have gold, and the government doesn’t talk about it. So you put all that together, and it’s hard to see what’s going to cause this inverted pyramid to tip over.
One thing I think could start the buying panic and super spike in the price is a failure to deliver. Some place, somewhere, sometime in the system, we could have something that looks a little bit like MF Global or Refco or one of these big brokers going out of business. They would owe a lot of people a lot of gold that has been demanded, and they won’t be able to deliver. Those people wouldn’t get their gold but might get a check or a bankruptcy claim and have to show up in court and produce their claim. The bottom line is they’re not going to get their physical gold. When that becomes widely publicized, everyone else in the world will say, “Wait a second, what happened to the gold?” as they all run down and demand it causing the whole system to implode. That’s kind of how I see that playing out.
That won’t happen as long as there’s enough gold to go around and keep the game going, but what if there isn’t? India is a major country with a billion people. It’s not an unsophisticated jurisdiction. The head of the Central Bank is an MIT PhD crony along with Yellen and the rest of them. He’s a very well-regarded PhD economist who’s in this club of global financial elites that know what they’re doing over there, so when I see them making a blatant grab for even 10,000 tons of gold, it tells me they’re getting desperate and that the physical gold is disappearing.
You asked in your question, Jon, if this is a big deal. I don’t see it being successful because I think the Indian people are too smart for that, but if I’m wrong and they get suckered into handing over their gold, it’s a very big deal. All of a sudden there will be another 10,000 tons that can be levered ten to one, which is 100,000 tons that can be leased out in paper transactions. So it could keep the game going.
I still like gold for a lot of reasons. I like it for insurance reasons and think it’s a good store of wealth. I can make that case at length, but if this actually works, is it good for the price of gold? The answer is No, because it’s going to give the power elites in central banks and the sovereigns more physical gold to play with to fend off the day when somebody drops the ball and you can’t find the physical gold.
Having said that, I smile a little bit, because I really do think the Indian people are too smart for this scam.
Jon: Thanks, Jim. And now Alex Stanczyk is here with questions from our listeners.
Alex: Thanks, Jon. Jim, about your comments regarding India, when this all began or when they started talking about it a couple of years ago, I was thinking the exact same thing. I realized that if they actually were able to monetize some of this Indian gold, it would give them a huge amount of leverage in order to deploy that into the market through leasing just as you mentioned.
It occurred to me at the time that if they were able to figure that out, it could be a huge problem. After thinking about that further, I realized that the Indians are buying gold for religious and traditional purposes, but one of the other reasons they buy and hold gold is to store value, because they don’t really trust the banks or the government. I don’t know if they’ve thought that all the way through, but it’s a really interesting story.
Jim: Yes, I think you’re exactly right, Alex. I’m all for religion and tradition, but I think Indians buy gold because it’s a store of wealth that can’t be inflated, can’t be hacked, and can’t be made to go away other than through outright confiscation. This is confiscation with a smiley face.
Another point is, once the bank got the gold and you showed up in a panic with your little certificate in hand and said, “Give me my gold, please,” they’ll just shut the bank. They’ll say, “Oh sorry, we changed the rules. Force majeure … you can’t have your gold.” So these people will never see their gold again, but I do think they understand that.
Also, I mentioned if the central authorities and global financial leads had another 10,000 tons of gold to play with, could they keep the game going? Could they keep the manipulation going? Yes, it would give them some fresh ammunition to keep the manipulation going.
I want to make another point, which is that when confidence breaks, no amount of reserves are enough. Look at China’s reserves being drawn down. There’s a run on the bank going on in China. They had the famous $4 trillion equivalent in reserves and lost $500 billion in about six months. Those reserves are running out the door. China is desperate to prop up the yuan, because everybody wants to sell yuan and buy dollars or Canadian or Australian dollars, get a condo in Melbourne, Sydney, Vancouver, Samoa, Rome, London, New York, or San Francisco – you name it.
The rich and elite in China are getting their money out as fast as they can. Four trillion dollars sounds like a lot of money until everybody wants their money back, and then you find out it’s never enough. Even with more gold to play with, when the gold-buying panic hits and the super-spike come, it’ll fall apart quickly, and no amount of gold will be enough to save you.
Alex: That’s very interesting, and I happen to agree. As a side note, the COMEX futures, etc. basically have exactly what you said already in their rules. When people come and ask for delivery, they can simply say, “So sorry, we’re not going to do that.”
Jim: Everyone accuses them of changing the rules, but I remind people that I’m actually enough of a geek that I read all these rule books. They have a rule that says they can change the rules, so they could say, “We’re not really changing the rules, because we have this rule over here that says we can change the rules.” Don’t ever rely on the futures exchange promises.
Alex: If it were Monopoly, who would even play, right? To go now to some of the questions, as usual, we have a ton of questions in the queue. We’re going to try to answer as many as possible, but we will not be able to answer all of them.
I’ll get started with the first one that I’m going to paraphrase. It’s coming from LS, and his question is: “If there is a global financial crisis, how will clearinghouses be affected? In addition to that, will we be able to get our funds back if these brokerage houses have problems or issues?”
Jim: The answer is No. Consider the last two extreme financial crises – and I’m not talking about market drawdowns or various panics of the past that have happened throughout history. I’m speaking specifically about 1998 and 2008.
I had a front row seat in 1998 and negotiated that bailout for Long-Term Capital Management sponsored by the Federal Reserve. As for 2008, it’s painfully fresh in the recollections for most of our listeners. They know what happened there. In each case, markets were close to shutting down. In the case of 1998, they were hours away from shutting down completely all over the world. In 2008, they were probably a couple of days away. Nobody wanted to get that close, because there was even more at stake, but these panics and the liquidity crises were so severe that they used extraordinary efforts – bailout efforts. In ’98, Wall Street bailed out a hedge fund; in 2008, the central banks bailed out Wall Street.
Coming ahead to the next financial panic, say ten years or 2018 if not sooner, the problem keeps getting bigger. In other words, ’98 was severe enough to threaten a shutdown of every market in the world, and that’s not an exaggeration. Greenspan and Rubin testified to that and I saw it firsthand. 2008 was even bigger than 1998. Wall Street couldn’t do the bailout so the central banks had to bail out Wall Street. The next time, it’s going to be bigger than the central banks, because the central banks have bloated their balance sheets and used up all their dry power.
The $4 trillion that the Fed printed to bail out the system the last time is still on the balance sheet. They haven’t done anything to reduce the balance sheet or normalize anything. The same is true in even more extreme form for the People’s Bank of China, the ECB, the Bank of England, and the Bank of Japan.
They’ve all exploded their balance sheets exponentially, so they’ve got very limited capacity to do it again. Then who’s going to bail out the central banks? The answer is the IMF. One way to do it is with SDRs, but the other way to do it – and actually, I think both of these things will happen – is to just shut down the banks.
Here’s the best description of a financial panic I’ve ever heard: Everybody in the world wants their money back. When times are good and you have the appearance of liquidity, people think of everything as money. If they have money market funds, it’s, “Oh, I can call my broker today and the money will be in my account tomorrow.” Well, if they shut down the market tonight, you’re not going to have the money in your account tomorrow.
In other words, it’s only money if it’s physical gold, if you have cash, or if you have access to an ATM or something. I’m not saying you should have 100% of your wealth in physical gold; I recommend 10%. Just understand that anything that’s not gold or cash is not money. You have some kind of counterparty risk, i.e., some kind of potential to be told, “Sorry, I’m not going to give it to you right now.” And that’s what’s going to happen.
I would expect that banks and brokerage firms would be shut down, ATMs would be reprogramed to dispense $300 a day for gas and groceries, and the government would say, “Why do you need more than $300 a day? That’s enough to eat and put gas in your car and get to work. We’ll get back to you about the rest of your money, but you don’t need it right now and we’re not going to let you have it.”
That’s not a reason to sell everything, pull all your money out of the bank, and stick it under a mattress, but it is a reason to have some of your net worth in physical gold or silver or cash, although it’s really hard to get cash because of the war on cash. People ask me how the war on cash is going. I say it’s over. The government won. Be that as it may, you do want 10% in physical gold in readily accessible form outside of the banking system, because when the crisis comes, they’re going to shut down the banks.
Alex: To take that thought a little bit further regarding liquidity, the IMF says that the gold bullion component of monetary gold is the only case of a financial asset with no counterparty liability. I take that to mean even they consider cash, or the money of sovereigns, to be not quite in the same category.
Jim: That’s right. Pull a dollar bill or a ten dollar bill out of your wallet and read it. A piece of paper money and everything in the bank is just a digital representation of the piece of paper. Where I went to law school, they always said to read the contract. A dollar bill is a contract between you and the central bank, so read the contract. It says Federal Reserve. Again, where I went to law school, a note was a liability. If you look at the balance sheet of the Fed, that’s where you find it. The money is on the liability side of the balance sheet of the Federal Reserve.
I think of what most people call money – paper money, dollar bill, or even if it’s in the bank in digital form – as a perpetual non-interest bearing liability of an insolvent bank.
Alex: We have time for one last question here. There have been a number of people asking about negative interest rate policy. I know you’ve commented on this, but as a tangent, this question is from Dean M. He’s saying that, Jim, you talk about possible QE4 in March of 2016, but you have also mentioned negative interest rates. I think he wants to know which is more likely, and why?
Jim: What I’ve said is March 2016 is my estimate of when the Fed will have to ease. Of course, the whole world is expecting them to tighten in December, but my view is they’ve been tightening for two-and-a-half years, and now we’re getting close to recession, so they’re going to have to ease.
There are five ways for the Fed to ease. One of them is negative interest rates, which makes you want to take your money out of the bank and go spend it because if you leave it in the bank, they’re going to take some of it. The second way is a QE4. The third way is forward guidance. The fourth way is currency wars, which is when you cheapen the dollar. The fifth way to do it is helicopter money, which is a combination of physical and monetary policy, or “QE for the people” as Jeremey Corbin calls it in the UK. With negative interest rates, QE4, forward guidance, currency wars, and helicopter money, the Fed is not out of bullets. They have five ways to ease monetary policy even when interest rates are zero.
I expect forward guidance. The listener said I’d been predicting QE4, but I actually have been predicting ease. I think the way they’ll do it is by reinstating forward guidance, because forward guidance is the easiest one to do. That just means sticking a word in the statement like “patient” like they did the last time. Now they’ll come up with a synonym for patient. Look it up in the Thesaurus: forbearance, or super-patient, or something.
That’s a message to the markets saying, “Not only are we not raising rates at this meeting, we’re not going to raise rates for at least six months, maybe longer, so knock yourselves out.” Put on the carry trade, risk on, invest in emerging markets, buy stocks, get margin loans, or whatever. All this stuff people have been doing to prop up the markets for the last seven or eight years will be risk on again.
The risk of borrowing short and lending long is this: I borrow overnight, convert my dollars to some emerging market’s currency, buy some stock market that’s going up a lot, leverage the trade, make 50% returns on equity, and I tell everyone I’m a genius when in fact, all I’m doing is making an incredibly risky leverage bet in cross-currencies.
The risk of the trade is that short-term rates go up. My cost to carry goes up, and I’ve got to unwind the trade, sell it, and pay back the dollars, because I’m short dollars in that situation. If the Fed says, “We just took that risk off the table, we’ve got your back, go knock yourself out, because when we use forward guidance, we’re telling you we’re not going to raise rates, so you can do this trade safely, at least until we say otherwise,” then that’ll get the game going again. So that’s actually what I expect. It’s funny that you can tighten and ease just by sticking a word in a statement, but that’s how messed up things are.
I don’t expect QE4. The academic research is starting to come in on QE1, QE2, and QE3, and I actually agree. Most people think QE1 served a purpose that was a necessary response to a liquidity crisis in 2008, and that’s what central banks are supposed to do. But QE2 and QE3 was pure experimentation by a mad scientist named Ben Bernanke. Now that the academics are looking at it, they’re starting to conclude that it didn’t really do any good, except it blew up the Fed’s balance sheet, created asset bubbles that are going to burst, and cause the next financial panic. QE is kind of getting a bad rap, so I doubt they’ll go to QE4. I don’t think they’ll use negative interest rates although they could. They are using negative interest rates in Europe and Switzerland right now and I think soon in a few other places, but I don’t think you’ll see negative interest rates in the US. The reason is that the US has a huge, huge money market industry, which is not true of the rest of the world. Money markets are a uniquely US phenomenon, and money market funds can’t run on negative interest rates. They need some positive carries so they can charge fees.
Remember, they have to take a little spread just to keep the lights on, pay the administrator, pay the lawyers, pay salaries, and protect their phony baloney jobs. They need some positive carry. Going to negative rates will completely destroy a trillion dollar industry, so they probably don’t want to do that.
I think currency wars is on the table. Helicopter money is when you spend more money, increase the deficit, the treasury covers the deficits by borrowing, and then the Fed buys the bonds by printing money. It’s a different form of QE, because you’re printing money but doing it specifically to monetize deficits, and it is spending that’s designed to ease monetary conditions and give the economy a lift.
The problem with that is it requires cooperation of the White House and Congress to enact whatever fiscal policy they want to do. As I mentioned earlier, the White House and Congress are barely on speaking terms, so politically that’s a tough one, especially in an election year. Negative interest rates, QE4, and helicopter money are unlikely, although not impossible, but I think a cheaper dollar and forward guidance are the most likely, and I think we’ll see those probably by March or shortly thereafter.
Alex: That wraps up our time, so Jim, I want to thank you. As usual, you’ve done a great job. We appreciate your time, and I will turn it back over to Jon.
Jon: Thank you, Alex, and thank you, Jim Rickards. It’s always a pleasure and an education having you with us. Most of all, thank you to our listeners for spending time with us today. You can also follow Jim on Twitter at @jamesgrickards.
Good bye for now, and we look forward to joining you again soon.
Listen to the original audio of the podcast here
You can follow Alex Stanczyk on Twitter @alexstanczyk
You can follow Jim Rickards on Twitter @JamesGRickards
You can listen to the Gold Chronicles on iTunes at:
You can Listen to the Global Perspectives on iTunes at:
You can access transcripts of our interviews at:
You can subscribe to our Youtube channel to access these interviews and more at:
By listening to this podcast or reading its associated transcript (collectively, this “Podcast”), you agree with the following.
This Podcast is not an offer to sell, nor a solicitation of an offer to purchase, any security. This Podcast is intended for general education and information purposes only, and may include broad discussions of markets, geopolitics, monetary policy, and geoeconomics. Nothing in this Podcast constitutes investment, legal or tax advice, nor an evaluation of or prospectus for any particular investment or market, including gold. This Podcast should not be relied upon to make any investment decision. You are encouraged to seek the advice of qualified financial, legal and tax advisors before making any investment decisions.
This material is provided on an “as is” and “as available” basis, without any representations, warranties or conditions of any kind. In particular, information provided by third parties in this Podcast has not independently evaluated or confirmed. Furthermore, we take no responsibility to update this Podcast to reflect any changes in any of the information presented. Physical Hard Assets Fund SPC and Physical Gold Fund, its officers, directors, employees or associated persons will not under any circumstances be liable to you or any other person for any loss or damage (whether direct, indirect, special, incidental, economic, or consequential, exemplary or punitive) arising from, connected with, or relating to the use of, or inability to use, this Podcast or the information herein, or any action or decision made by you or any other person in reliance on this information, or any unauthorized use or reproduction of this Podcast or the information herein.